What Is an LLC Operating Agreement?

An LLC operating agreement is a document that customizes the terms of a limited liability company according to the specific needs of its members. It also outlines the financial and functional decision-making in a structured manner. It is similar to articles of incorporation that govern the operations of a corporation.

Although writing an operating agreement is not a mandatory requirement for most states, it is nonetheless considered a crucial document that should be included when setting up a limited liability company. The document, once signed by each member (owner), acts as a binding set of rules for them to adhere to.

The agreement is drafted to allow owners to govern the internal operations according to their own rules and specifications. The absence of an operating agreement means that your business has to be run according to the default rules of your state.

How LLC Operating Agreements Work

An LLC is a type of U.S. business entity that is easy to form and simple to manage, and importantly limits the liability of owners. Since an LLC is a hybrid of a partnership and corporation, it provides the twin benefit of pass-through taxation with limited liability.

To take full advantage of having an LLC, you should go one step further and write an operating agreement during the startup process. Many tend to overlook this crucial document since it is not a mandatory requirement in many states. Only a few states specify the need to register an operating agreement when creating an LLC. The operating agreement is thus a document that spells out the terms of a limited liability company (LLC) according to the members. It sets forth the path for the business to follow and brings in more clarity in operations and management. A typical LLC operating agreement is a 10- to 20-page contract document which sets up guidelines and rules for the LLC.

In states such as California, Missouri, and New York, it is mandatory to include this document during the incorporation process. While most other states do not insist on including it, it is always considered wise to draft an operating agreement, as it protects the status of a company, comes in handy in times of misunderstandings, and helps in carrying out the business according to the rules set by the members.

Businesses that do not sign an operating agreement fall under the default rules outlined by the states. In such a case the rules imposed by the state will be very general in nature and may not be right for every business. For example, in the absence of an operating agreement, some states may stipulate that all profits in an LLC are shared equally by each partner regardless of each party's capital contribution. An agreement can also protect partners from any personal liability if it appears they are operating as a sole proprietorship or a partnership.

Benefits of an LLC Operating Agreement

Even if a business venture only has a single owner/employee, it can still be beneficial to codify the relationship with an LLC operating agreement. Having an operating agreement establishes a legal boundary between the LLC and the owner, so that the owner is not held accountable for the LLC's debts or liabilities. Otherwise, creditors to the LLC may pursue the owner's personal assets. An operating agreement also allows the owner to codify the rules of succession for their business, as well as governance procedures such as meetings and voting. Without an operating agreement, ownership of the business is handled according to the state's default LLC rules.

What to Include in an LLC Operating Agreement

There are many issues that must be covered in the LLC operating agreement. The general format of the document includes the following:

1. Each member's ownership expressed as a percentage
2. The members' responsibilities and voting rights
3. A layout of the duties and powers of members
4. The profit and loss allocation among members
5. The rules related to holding meetings and taking votes
6. The issues related to the management of the LLC
7. Buyout and buy-sell provisions, when a member wants to leave and sell their share (should also include what will happen in the event of a member's death)

LLC operating agreements should also outline the specific definitions of terms used in the agreement, as well as list the purpose of the business, a statement of its intent to form, how it will handle new members, how it chooses to be taxed, how long it intends to operate, and where it is located. Just as “one size doesn’t fit all,” the state default LLC rules don’t suit all. The best way to counter this problem is by writing an operating agreement, which gives freedom, protection, and control to your business. Though it's best to include an operating agreement in the initial stages, if you have missed on that, it’s never too late to put it in place, provided all members agree to it. The document can also be modified at a later stage with the guidance and help of an attorney.