Operating Agreement: Takeaways
- An operating agreement is one of two essential LLC formation documents.
- An operating agreement governs the internal affairs of the LLC, including control of the LLC, profit distributions, rights and obligations of the owners or managers, and the transfer of interests and admission of new owners.
- State LLC law assumes that all LLCs will have operating agreements to govern the internal affairs of the LLC. The provisions of state law are mostly default provisions for LLCs that fail to plan.
- Single-member LLCs need operating agreements to help protect against veil-piercing and define the management structure.
An LLC without an operating agreement is like a person without a will. Both have failed to take advantage of crucial planning opportunities, both are entirely reliant on fallback provisions of state law, and both may suffer adverse legal consequences. This article explains the importance of LLC operating agreements in the LLC formation process.
What is an Operating Agreement?
An operating agreement is an internal agreement among the members to provide for the management of the LLC and the economic relationship of the members and managers. The operating agreement adds structure to the LLC. It allows the LLC owners (members) to customize the LLC to the individual needs of the business owners.
The operating agreement is a contract between the members. This contract serves as a blueprint to guide the LLC’s operations, including important issues like control of the LLC, profit distributions, rights and obligations of the owners or managers, and the transfer of interests and admission of new owners.
An operating agreement is an essential component of proper LLC formation and—along with the formation document (usually called a certificate of formation or articles of organization)—is one of two organic documents that govern an LLC. State LLC laws view the operating agreement as the primary document for governing the internal affairs of the LLC.
The formation document and operating agreement work together. The formation document officially forms the LLC and notifies others of the LLC’s existence; the operating agreement details how the LLC will be governed and specifies the rights and obligations of the members and managers.
Why All LLCs Need Operating Agreements
The role of the operating agreement in the LLC formation process is often misunderstood. This misunderstanding stems from a failure to recognize the fundamental nature of an LLC.
As detailed in our discussion of LLC law, an LLC is a hybrid business entity that is derived from partnership law. State LLC acts borrow heavily from partnership law. Like state partnership acts, state LLC acts assume that the details of LLC governance—including control of the LLC, distribution of profits, and admission of new members—will be detailed in the operating agreement.
Without exception, all state LLC acts place great emphasis on the operating agreement, treating it as the primary governing instrument for the LLC. State LLC laws recognize that “a key function of the operating agreement is to override statutory default rules.”1 Most provisions of state law are only default provisions in case the members fail to properly structure the LLC through the operating agreement.
LLC attorneys recognize the LLC operating agreement as the LLC’s key governing instrument. If attorneys were the only people to form LLCs, almost all LLCs would have valid operating agreements. But with the rise of the internet, many LLC founders use online LLC formation providers to form LLCs. These online providers cannot legally provide advice or draft customized documents, and most lack the legal knowledge to use an operating agreement to properly structure the LLC.
Because they are unable to draft customized operating agreements, non-attorney formation services often equate LLC formation with filing a simple formation document—usually called a certificate of formation or articles of organization—with the state agency. These simple forms, usually just a page or two, were never intended to be the primary governing instrument for the LLC. They are simple notifications that most business founders could easily file themselves.
Business owners form LLCs for a reason. Their goals are usually to protect against liability, avoid double taxation, and provide for the orderly affairs and operation of the business. If there are multiple members, they might also want to deal with the rights of the members, including how profits will be divided, how decisions will be made, and how deadlocks will be resolved.
The formation document does not effectively accomplish these goals. The formation document simply establishes the company with the state agency. It serves as little more than a notice that the LLC exists. It does nothing to provide for the internal operations of the company—a function that state LLC acts reserve for the operating agreement. An operating agreement allows the members to:
- Specify the Percentage Ownership. The operating agreement allows the members to document how much of the LLC each member owns. This is critically important information, especially if the members have unequal ownership interests.
- Document Initial Capital Contributions. The members’ initial contribution to the LLC in exchange for an interest is called a capital contribution. If the members are not contributing substantial funds, the capital contribution may be a nominal amount needed to open the business bank account. Either way, though, it is important to document the initial capital contribution. The initial capital contribution will create a capital account for the members, which is important for tax purposes.
- Determine How Profit Will be Divided. The operating agreement determines whether distributions of profit can or should be made. Some LLCs will reinvest income; others will pay income to the members. Without an operating agreement, the members may not have a consensus on how or whether distributions should be made. Decisions about profit distribution can result in litigation if not properly addressed in the operating agreement.
- Provide for Tax Distributions for Phantom Income. For LLCs that do not plan to make distributions, phantom income can be a problem for the members. If this is an issue, the operating agreement may be drafted to require distributions to pay tax liability on phantom income (tax distributions).
- Determine the Voting Rights of the Managers or Members. Regardless of whether the LLC is manager-managed or member-managed, the operating agreement should specify the voting rights of the members and, if applicable, the managers. If the LLC is manager-managed, the operating agreement may also specify the means for appointing or removing managers.
- Determine the Tax Classification of the LLC. Depending on the circumstances, LLCs may be taxed as partnerships, sole proprietorships, C corporations, or S corporations. Each of these tax classifications has its own set of rules. The operating agreement can specify how the LLC should be taxed and include provisions to help ensure that the tax classification is respected.
- Provide for the Creation of a Series (for Series LLCs). For the LLC to qualify as a series LLC, special language must be included in the operating agreement. This language provides missing guidance for creating a series and determining the rights and obligations of each series.
- Determine the Steps Required to Transfer an Interest or Admit New Members. Most state LLC statutes prohibit members from transferring an interest without the consent of the other members. These default rules may not match the members’ intent. The operating agreement can override these rules and provide clear guidance on the transferability of a member’s interest and the process required to admit new members to the company.
- Deal with Community Property Interest of Spouses. In community property states (like Texas), most property acquired during the marriage is community property. Special planning—including a spousal consent—is required when one spouse forms an LLC and the other spouse will not be involved. Without addressing community property issues, it can be unclear how much say a member’s spouse has in the operation of the business.
The items listed above apply to all operating agreements. Depending on the circumstances, the operating agreement may also include more advanced planning. Advanced options include:
- Provide for Capital Calls or Mandatory Loans. If the members will be responsible to contribute capital if needed (capital call) or make loans to the company (mandatory loans), the terms of these obligations must be specified in the operating agreement.
- Sweat Equity Provisions. If the LLC may issue membership interests in exchange for equity, the operating agreement must specify the terms (including any vesting requirements) of the issuance of incentive equity.
- Create Different Classes of Membership Interest. Like corporations, LLCs may have different classes of equity. The LLC may issue voting and non-voting interests or structure equity to have liquidation or distribution preferences. The creation of different classes of equity must be specified in the operating agreement.
- Include Drag-Along or Tag-Along Provisions. If the LLC will be owned in disproportionate shares, the members may want to include drag-along and tag-along provisions. These provisions ensure that both the majority and minority members participate in any sale of the company.
- Include Buy-Sell Provisions. Buy-sell provisions deal with the death, disability, divorce, and retirement of the members. They can include provisions requiring buy-out of members upon various triggering events and specify the terms of the sale.
- Deadlock Resolution Provisions. There may be situations where the members reach an impasse on the correct decision to make. Depending on the percentage ownership held by each member, these situations can create a deadlock that can result in economic harm to the company. An operating agreement can include provisions for deadlock resolution.
- Provide for Special Allocations of Tax Liability. LLCs that are taxed as partnerships (the default classification for multi-member LLCs) may include provisions in the operating agreement to allocate profits and losses among the members in a way that differs from the proportionate ownership of the company. These provisions—which can be complex—must be specified in the operating agreement.
Unless the LLC has an operating agreement, the planning opportunities listed in this section are lost. The members of the LLC must rely on default provisions of state law, which may change and which may not match the members’ intent. Using an operating agreement allows the members to take full advantage of the flexibility of the LLC structure and create a business that matches their specific goals.
Although the operating agreement need not be filed with the state, third parties will often request it. Business founders may need to provide your operating agreement to banks and other lenders, investors, title companies, accountants, and lawyers. If the LLC is involved in a lawsuit, the operating agreement will be produced in court and can be a critical factor in determining liability.
Operating Agreements for Single-Member LLCs
The role of operating agreements for one-owner (single-member) LLCs is not always apparent. If the LLC has only one member, why would an agreement be required? Who is there for the single LLC member to agree with?
Operating agreements are important for LLCs because they protect against veil-piercing. A veil-piercing claim is an argument by a creditor that the limited liability protection offered by the LLC should be disregarded because the LLC is simply the “alter ego or mere instrumentality” of the single member.
Single-member LLCs are at an increased risk for a veil-piercing claim. In a veil-piercing context, courts scrutinize single-member LLCs carefully to be sure that they are treated separately from the single member.2 This scrutiny often puts the burden on the LLC member to demonstrate that the LLC was organized and operated as a legitimate company and not as an alter ego of the member.
When an owner of a single-member LLC signs an operating agreement, the operating agreement creates a contract between the member, as an owner, and the LLC, as an entity independent of the owner. The treatment of the LLC as an entity separate from the owner is a critical factor in a veil-piercing claim. The risk of veil-piercing is mitigated by ensuring that the LLC has an operating agreement and other organizational documents that reflect the LLC’s existence as an entity that is independent from the owner.
Single-member LLCs should also use operating agreements to define the management structure. If the single-member LLC is manager-managed (which it often should be), the operating agreement defines the relationship between the member and the manager. Even if the same person will serve as member and manager, the operating agreement is necessary to treat the two roles as distinct in order to take full advantage of the manager-managed structure.
- Comment 13, Revised Uniform Limited Liability Company Act § 102.
- See Heminway, The Ties That Bind: LLC Operating Agreements as Binding Commitments, fn. 60.