An LLC is formed when the formation document—usually called articles of organization or a certificate of formation—is filed with the Secretary of State. The formation document includes the bare minimum of information needed to form the company. It is a simple document that most founders could file on their own.
Although LLCs are formed by a simple online filing, they are governed by the terms of their operating agreement and any related organizational documents. Although state LLC statutes provide a patchwork of default rules as gap-fillers, these rules were intended to be fallback provisions. State LLC statutes mostly defer to the operating agreement to define the rights and responsibilities of the owners.
What is an Operating Agreement?
An operating agreement is a written agreement among the owners (members) of an LLC that deals with the operations and management of the company. The operating agreement defines the rights and obligations of the members and serves as a blueprint for running the LLC.
Although the operating agreement need not be filed with the Secretary of State, third parties will often request it. You 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 is usually a critical factor in determining liability.
Why All LLCs Need Operating Agreements
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 with respect to each other, including how profits will be divided, how decisions will be made, and how deadlocks will be resolved.
The certificate of formation does not effectively accomplish these goals. The certificate of formation simply establishes the company with the Secretary of State. Unless the members just want bragging rights for having an LLC, an operating agreement is an absolute necessity. 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. This can result in litigation if not properly addressed.
- 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 take any tax considerations into account.
- 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 restrict transferability of membership interests 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 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 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 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 for mandatory 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, many 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.
Operating Agreements for Single-Member LLCs
Operating agreements are also important for single-member LLCs. LLCs with only one member are at an increased risk for a veil-piercing claim. 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. This risk can be avoided by ensuring that the LLC has an operating agreement and other organizational documents that would normally be a part of an operating business.