An operating agreement is a legal document that outlines the internal operations, ownership structure, and management responsibilities of a limited liability company (LLC). While not all states require an LLC to have an operating agreement, it is highly recommended to create one as it helps establish the rights and obligations of the LLC’s members and provides clarity in decision-making processes.
An operating agreement is also important for taxes because the operating agreement lets your CPA know how to allocate income and expenses among LLC members, how much capital each member has contributed, and any other tax related items.
Key Components of an Operating Agreement
- The purpose and nature of business of the LLC.
- Formation and Membership: It outlines the formation date of the LLC, the names and addresses of the members, their ownership percentages, and the initial contributions made by each member.
- Management and Decision-Making: This section specifies how the LLC will be managed and who will make decisions on behalf of the LLC. LLCs can be either member-managed or manager-managed. Member-managed means all members have the authority to participate in the management of the LLC, while manager-managed means certain designated managers are responsible for making decisions on behalf of the LLC.
- Voting and Decision-Making: The operating agreement defines the voting rights and procedures for major decisions, such as admitting new members, removing members, making significant financial commitments, or amending the operating agreement.
- Tax treatment: This section will define if the LLC wishes to be treated/taxed as a Partnership, S-Corporation, or C-Corporation.
- Profits and Losses: This section explains how profits and losses will be allocated among the members. By default, an LLC’s profits and losses are divided among members based on their ownership percentages, but members can decide on their own percentages. For example, if you and your friend decide to start a restaurant and you contribute all the money, but your friend is the chef, you can choose (within the operating agreement) to divide profits and losses 50/50 even if your friend did not contribute any money to the LLC.
- Capital Contributions and Distributions: It outlines the rules for making additional capital contributions to the LLC and how distributions will be made to members.
- Transfer of Membership Interest: This section covers the procedures and restrictions regarding the transfer of membership interests, including whether members can sell or assign their ownership stakes and any approval requirements from other members.
- Dispute resolution: the operating agreement will outline how disputes among members will be resolved.
- Dissolution and Winding Up: It explains the circumstances under which the LLC can be dissolved and the procedures for winding up its affairs, including the distribution of remaining assets.
- Changes to the operating agreement: Since the operating agreement is a binding contract, it will also include details of who has the authority to make changes to the agreement.
- Additional provisions: This section can cover items not discussed in other sections of the LLC such as:
- Reimbursement of business expenses to LLC members.
- Unreimbursed expenses: what expenses are not paid by the LLC on behalf of its members.
It’s important to note that an operating agreement is a flexible document, and LLC members have the freedom to customize it according to their specific needs and requirements. It is advisable to consult with an attorney and a CPA to ensure that the operating agreement complies with applicable state laws, tax rules, and addresses the unique aspects of your LLC.