What is an LLC Operating Agreement?

An operating agreement is a document created by the owners/members of a limited liability company (LLC) as part of the LLC formation process, to outline the terms and conditions relating to its structure.

It includes an LLC’s financial and functional decisions, administration and voting rules, capital contributions, regulations, and provisions. 

And because it’s a legal document, an operating agreement acts as a recognized contract between you and your co-owners. 

What’s the Purpose of an Operating Agreement?

The purpose of a business agreement is to create your own operating rules to run your business your way. 

When LLC members sign an operating agreement, it becomes an official contract, binding them to its terms and conditions and removing any chances of internal conflicts that could damage the LLC’s functional ability and reputation. 

The best operating agreements meet a company’s specific needs and ensure it runs like clockwork without disagreements. 

Is an operating agreement a must for an LLC?

Most U.S. states don’t require LLC operating agreements. Nonetheless, it’s advisable to have one, especially if an LLC has more than one member. While it’s not a requirement, in the bigger scope of the idea behind an LLC, it will help you to keep your limited liability protection (more on that below).

If you choose to use an LLC operating agreement, make sure you keep it on file at your business location and with your solicitor or registered agent.

Can I write an operating agreement myself?

Yes, because there aren’t any legal requirements to what an operating agreement must contain, and they don’t require a lawyer.

How much does it cost to draft an operating agreement?

If you’re a single-member LLC, you can write a business operating agreement without a lawyer, but consider seeking legal advice if there’s more than one member.  

Recent marketplace data shows the average cost of employing a lawyer to draft an operating agreement is $570.  

What’s the difference between operating agreements and bylaws?

Both operating agreements and bylaws exist to govern the internal affairs of a registered business entity, but they differ in several ways.

The fundamental difference is an operating agreement records an LLC’s internal operating procedures, while bylaws contain internal governing documents for corporations.

Both are binding documents, but those bound by them differ:

1. An operating agreement binds everyone who signs it. In contrast, a corporation’s board of directors draft and execute bylaws but aren’t tied to abide by them.  

2. Only 5 U.S. states require an LLC operating agreement. In contrast, 36 states require corporations to have bylaws.

3. Operating agreements are often more extensive than bylaws, including the percentage capital contribution of members, how profits and losses are distributed, and tax structure. 

Bylaws and operating agreements are private internal documents and are closed to the public.

Do I Need an Operating Agreement?

Whether your state requires an LLC operating agreement or not, having one is a good idea as it outlines your business’s rules and regulations, and its member’s rights and responsibilities.

An operating agreement can also include essential topics like managerial organization and finances, percentage of interests, allocation of profits, and losses. 

Multi-member LLC

An LLC operating agreement protects the limited liability status of its members, meaning they aren’t liable for any company debts or lawsuits. 

If LLCs’ terms and conditions aren’t written and agreed on, they are of little use if members disagree because of miscommunication and misunderstandings.

An operating agreement containing business arrangements and operation agreements provides a governance template in cases of conflict.  

Single-member LLC

Even though it’s impossible for a single-member LLC to have an internal dispute, you should still write an operating agreement because single-member LLCs can be judged as sole proprietorships in litigation cases. 

In contrast, an operating agreement acts as a legal declaration outlining your LLCs structure, and it’s usable in court to prove that you and your LLC are separate entities, ensuring your limited liability protection.

States that require operating agreements

The 5 states requiring an operating agreement are California, Delaware, Maine, Missouri, and New York. But while you must have an LLC operating agreement, you don’t have to file it. 

Key Factors of an Operating Agreement

While there aren’t any rules outlining how to write an operating agreement, there are crucial elements every operating agreement should include to protect its members’ legal rights. 

Organization

You can organize the internal structure of an LLC any way you like. For example, it could resemble a partnership or a corporation regarding equity shares and voting rights. All that matters is the members agree and record it in the operating agreement. 

Management

An LLC allows members to appoint a manager or manage it themselves. If members choose to enroll a manager, the operating agreement should outline how you’ll select applicants and who’ll appoint them.

This section of the operating agreement would also include the level of power a manager or managing members would have, their duties and responsibilities, manager and member meeting schedules, and voting percentages and procedures.  

Voting

Typically, all LLC members’ voting rights are in proportion to their percentage ownership. Meaning the more you invest, the greater your say. 

However, the owners can design voting rights as they see fit with an operating agreement, giving more to one member and less to another depending on duties, etc.

For example:

Distribution of Capital

If an LLC has 2 partners with equal shares, with an operating agreement, they could both receive 50% of the profits or losses over a chosen year. 

Or one member with a 50% interest receives 25% of the total income for an agreed-upon time, while the other partner takes nothing to increase business equity.

Distribution (profits & losses)

Owners can also determine the equity structure, including proportionate allocation of profits, losses, and distributions among members.

Your operating agreement should include all its members’ interests, contributions, and capital accounts, and outline how they share the LLC’s profits and losses.

Dissolution

Even the most successful businesses include a dissolution agreement in their operating agreement, known as “a get-out clause.”

A get-out clause describes the situations that warrant an LLC dissolution and how it will proceed. And in case of illegal activity or internal disagreements, it’s a good idea to have one as it allows members to request involuntary dissolution. 

Tax Considerations

An operating agreement should also address issues regarding tax, such as:

What if an LLC Doesn’t Have an Operating Agreement?

Would you hire a contractor without first signing a contract or drive a car without insurance? Probably not since it’s not worth the risk, right?

Well, running an LLC without an operating agreement is like skydiving without a backup parachute. And it’s a needless risk to take because if things go wrong, it could damage your reputation, cause loss of earnings, broken relationships, and the failure of your business. 

Not to mention, your state’s default rules could decide your future. 

I’ll explain: 

Subject to default state laws

If members disagree and there’s no operating agreement in place, your state will implement default rules. Meaning they’ll decide your business’s terms and conditions and resolve any issues for you.

One example is if a company fails, they can equally divide the losses or profits between members without considering their percentage of investment. And if one member invested more than another, it’s an unsatisfactory resolution.

Risking court interpretation of your status

An LLC operating agreement ensures that courts recognize your limited personal liability.

And that’s especially important for a single-person LLC because if you operate without an operating agreement, your LLC will resemble a sole proprietorship with no limited liability protection. 

In contrast, courts will recognize your limited liability status when you have a formal operating agreement, and you won’t be held accountable for company debts, etc. 

Members Disputes

Sometimes LLC owners, percentage members, and good friends in business disagree. 

But when you have a business operating agreement, you’re equipped to deal with any misunderstandings and reach amicable settlements on serious subjects like finances and profit-sharing, management and decision-making, and how to go ahead with the departure of original members. 

Remember, if you don’t create an operating agreement, you’ll have to follow your state’s default laws. And if that happens, you’ll be dancing to their tune, not your own.

Conclusion

Whether you’ve yet to start your business or are already established, it’s always a good time to write an operating agreement.  

Once written, ensure all members sign it, make copies and keep them safe. Review your operating agreement annually to ensure it’s still relevant to your business needs and reflects each member’s wishes. 

If your LLC operating agreement does need modification, it’s best practice to seek guidance from an attorney. 

This portion of our website is for informational purposes only. The content is not legal advice. All statements, opinions, recommendations, and conclusions are solely the expression of the author and provided on an as-is basis. Accordingly, Tailor Brands is not responsible for the information as well as has not been evaluated the accuracy and/or completeness of the information.