Why Do You Need an LLC Operating Agreement?

Limited Liability Companies (LLC) are extremely versatile business entities. They allow for an ownership and control structure that has characteristics of a partnership and a corporation. For example, it can have a single owner (member) or multiple members. Though a few states require than at LLC have more than one member. It can be managed by all members or managed by managers choses from the members or from outside individuals. Members are relieved from personal liability for the debts and obligation of the LLC. It can also choose to be taxed as a partnership or corporation.

Every state has laws that apply to the LLC business entity form. However, most states allow company owners to override the default legal rules concerning ownership and control structure. This is done through two documents: the articles of organization and the operating agreement.

The articles of organization is the document filed with the state’s secretary of state’s office to bring the LLC into existence. If accepted, the state will issue a certificate of organization. The operating agreement is the governing document of the company. It contains numerous provisions concerning the rights and obligations of members and managers.

Having an operating agreement adds certainty and minimizes the level of misunderstanding between members. 

Primary Provisions of the Operating Agreement

The primary provisions of the operating agreement address the:

• Company Information - This is the name of the company, its place of business, and registered agent.

• Statement of Intent - This is the date that the LLC comes into existence.

• Business Purpose - This is a statement of the LLCs purpose for existence. Normally, it will state the business’s primary purpose and include language allowing the business to engage in any lawful business activity.

• Term or Duration - Some LLCs are formed for a specific purpose or project. If the LLC is to have a finite life, this provision will indicate as much. Otherwise, the LLC will indicate that it continues on in perpetuity.

• Tax Election - The members of the LLC will choose whether to be taxed as a partnership or corporation. If the members choose corporate taxation, they may choose to be taxed under subsection S or C of the internal revenue code.

• Identification of Members and Managers - The operating agreement will often identify the members and managers of the company, their titles, addresses, and ownership interests. It will also identify whether the LLC will be managed by all members or whether specific managers will be appointed. If the LLC is manager-managed, the document may identify the names, titles, responsibilities, length of employment, salary, etc., of the individual managers.

• Contributions of Capital - Generally, members of the LLC receive an ownership interest in exchange for services rendered to the company or contributions of capital or other resources. The ownership interest received is either a percentage ownership or membership units representing a single share of ownership. In either event, the ownership percentage of each member is recorded in the operating agreement. The ownership percentage may change will any receipt of distributions or contributions of new capital.

• Rights of Members - Members have extensive rights as owners of the company. The primary rights are as follows:

⁃ Member Meetings - State law generally requires that a company have owner meetings. The operating agreement will law out the time, place, and manner of these meetings. It will also lay out the types of meetings, such as annual or special purpose meetings. It is at meetings where members generally vote for decision items.

⁃ Member Voting - Members have a right to vote on various aspects of company management. The extent of these rights will depend upon whether the LLC is member-managed or manager-managed. Generally, each member will receive one vote for each unit or ownership or votes commensurate with their ownership percentage. It will also lay out the requirements for a member vote, such as quorum requirements and simple-majority or super-majority approval.

⁃ Approval Rights - Often, the operating agreement will provide approval rights to members. This means that members must vote to approve specific actions of the LLC managers or members acting as managers.

⁃ Member Compensation - Members are generally compensated as owners of the LLC or as manager employees. How a member-manager is compensated will depend upon the company’s tax election. If taxed as a corporation, members can receive a salary for work performed for the company and a distribution as owners. If the company is taxed as a partnership, members will receive compensation as a distribution based upon their ownership interest or salary to the company.

⁃ New Members and Dissociation of Members - The document should lay out the process for adding new members. This will generally include provisions concerning the vote of members. This section will also address the repercussions of a member leaving the LLC. This is known as dissociation. It will also address the situation where a member wishes to sell or transfer her ownership interest. These are commonly referred to as buy-sell provisions. The agreement will generally protect existing members by offering a right of first refusal to purchase the ownership interest up for sale. It will also address concerns with passing an ownership interest on to heirs and the process for buying back such interests.

The LLC operating agreement may include any number of provisions. The extent of the LLC provisions included will depend upon the nature of the LLC and its purpose going forward. When drafting an operating agreement for your business, you should consult a professional concerning the legal and tax implications.

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