Every business needs a “What if?” document that serves as a guide through the process of dealing with questions of ownership and business management. For limited liability companies (LLCs) this “What if?” document is called an operating agreement.
The New York Division of Corporations notes that an operating agreement is a document that establishes the rights, powers, duties, liabilities, and obligations of all members of an LLC.
A better name for an operating agreement might be a membership agreement. This agreement is similar in form to a partnership agreement for a business partnership.
Is an Operating Agreement Required?
An operating agreement is an important document, even for an LLC with only one member (called a single-member LLC). No state requires you to file your operating agreement with the state, but several states require that you create an operating agreement for your records. For example:
- California requires LLCs to maintain an operating agreement but not to file it, as not all documents can be filed.
- New York, Missouri, and Delaware require an operating agreement, but it doesn’t have to be filed with the Department of State.
Other states may have similar requirements. Check with your state’s business division (usually in the Secretary of State’s office) to be sure you are meeting all of the legal requirements for having an operating agreement.
What Must Be Included in an LLC Operating Agreement?
- Name of the LLC: Some states may require that the term “LLC” or “Limited Liability Company” be included in the name. See your state website for more details.
- Information about the Articles of Organization: This document is filed with your state to register the LLC and includes the state where it’s registered and the date.
- Duration of the LLC: The options are “until dissolved” or until a specific date.
- Address: This should be the principal office of the LLC.
- Name and address of the Registered Agent: This is the person who receives legal correspondence and notices.
- Purpose of the business: This is what you are in business to do.
Members, Contributions, and Interest
This section of the operating agreement focuses on how members join the LLC, their contributions, their capital (ownership) accounts, and how the profits and losses are distributed to members. It should include:
- Names of the initial members
- The amount of their contribution
- Their ownership interest (percentage)
- How new members make initial capital contributions and the required amount per member
- If and when additional contributions are required and how members decide
- The process for admitting new members
- How members receive the profits and losses each year
- How the taxes on this distribution are allocated and distributed
Management of the LLC
You have two options in the management of the business:
- It’s member-managed, which includes a single managing member
- A hired manager who is an employee
Unless the LLC is very small, it’s usually best to designate one person (a member or a manager) to manage the business. You might want a separate compensation and reimbursement agreement for the managing member or outside manager.
Other parts of this section include how decisions are made. Does a majority have to agree? Are there some decisions that must be unanimous? Even though you have a manager, your members may want to approve certain decisions, which should be spelled out in this part.
Leaving the LLC or Ending It As a Whole
This section describes what happens when a member leaves the LLC, when the business automatically ends, and the process for ending the business. It includes:
- When and how a member can leave, and how a member can be asked to leave the LLC
- The process for buying back a member’s interest, including how the purchase price is determined and paid
- The process for transferring a member’s interest, including restrictions on transfers
- Liquidation procedures, including distribution of member property
Indemnification and liability limitation clauses are an important part of an operating agreement. The legal language says the members have limited liability for their actions as members.
These provisions might include a description for the process of amending the agreement, how notices must be communicated, and the governing law (what state law governs the LLC).
Some LLC operating agreements may include special agreements that must be signed by all members. These may include:
- A non-compete agreement, restricting members from joining competing businesses
- A conflict of interest policy, stating that the member’s first loyalty is to the LLC
- A non-disclosure agreement, stating that the member won’t disclose information owned by the LLC, even after they leave the business.
Keeping Records for Your LLC
Your operating agreement is a good place to describe recordkeeping requirements.
Keep information about initial member contributions, owner percentages, and additional contributions in a membership record book.
Each state has specific recordkeeping requirements, so be sure to check yours. The IRS also offers some information regarding the types of records that you may want to keep for your business. These include receipts, purchases, expenses, assets, employment taxes, and more.
Why You Shouldn’t Use a Free Operating Agreement Template
It’s never a good idea to use a business contract or agreement unless it’s been written specifically for your business and for your state. The many dangers of using a free agreement form may include:
- The wrong form
- Missing language that is critical and should have been included
- A lack of language that describes your specific business
- Specific language required by your state is missing
The agreement outlined in this article is not intended to be a complete agreement or to be specific legal or tax advice. While not required, you may want to consider working with an attorney to help you write your LLC operating agreement.