What Is Operating Agreement?
An operating agreement is a foundational legal document for a limited liability company (LLC). It outlines the business's financial and functional decisions, including rules, regulations, and provisions, essentially governing the internal operations of the business to suit the specific needs of its owners48, 49. Once signed by the members of the LLC, it acts as an official contract, binding them to its terms47. This document falls under the broader financial category of business law, as it dictates the legal and operational framework of a business entity.
History and Origin
The concept of the limited liability company (LLC) and, by extension, the operating agreement, originated in the United States in 1977, when Wyoming became the first state to pass legislation allowing for their formation45, 46. This innovative business structure was reportedly the result of work by accountants and lawyers for the Hamilton Brothers Oil Company, who sought a hybrid entity offering both the limited liability of a corporation and the pass-through taxation benefits of a partnership43, 44.
Initially, the adoption of LLCs was slow due to uncertainty surrounding their tax treatment by the Internal Revenue Service (IRS). The IRS initially stated that any entity providing limited liability protections would be taxed as a corporation, which would negate one of the primary benefits of an LLC—avoiding double taxation. 41, 42However, in 1988, the IRS issued a ruling that clarified the tax status of LLCs, allowing them to be taxed as partnerships, which significantly boosted their popularity. 38, 39, 40Following this, other states began to introduce their own LLC legislation. 37The Uniform Law Commission (ULC) further contributed to the standardization of LLC laws by promulgating the Uniform Limited Liability Company Act (ULLCA) in 1995, and later the Revised Uniform Limited Liability Company Act (RULLCA) in 2006, aiming to promote uniformity among state laws governing LLCs across the U.S..
34, 35, 36
Key Takeaways
- An operating agreement is a legal contract that defines the operational and financial framework of a limited liability company (LLC).
- It helps protect the LLC's limited liability status and provides clarity among members regarding their roles, rights, and responsibilities.
- The agreement outlines how profits and losses are distributed, how decisions are made, and procedures for various business events like member exits or disputes.
- While not always legally required, having a well-drafted operating agreement can prevent future misunderstandings and costly legal battles.
- Without an operating agreement, an LLC will typically be governed by default state laws, which may not align with the members' intentions.
Interpreting the Operating Agreement
An operating agreement serves as a critical guide for the internal functioning of an LLC. It provides a framework for interpreting and applying the rules and regulations governing the company. For example, it will detail the percentage of ownership for each member, which directly influences their share of profits and losses. 32, 33The agreement also specifies the voting rights and responsibilities of members and managers, dictating how significant business decisions are made.
30, 31
When a situation arises, members refer to the operating agreement to understand established procedures. This could include rules for holding meetings, admitting new members, or handling the transfer of ownership interests through buyout and buy-sell rules. 28, 29In essence, the operating agreement is the primary reference document for resolving internal disputes and ensuring the smooth operation of the LLC, aligning with the principles of corporate governance.
Hypothetical Example
Consider a hypothetical scenario where three friends, Alex, Ben, and Chloe, decide to start a graphic design business and form an LLC called "Creative Canvas LLC." They draft an operating agreement to formalize their arrangement.
In their operating agreement, they specify the following:
- Ownership: Alex owns 40%, Ben owns 35%, and Chloe owns 25%.
- Profit and Loss Distribution: Profits and losses will be distributed proportionally to their ownership percentages.
- Management: It will be a member-managed LLC, meaning all three will participate in daily operations and decision-making.
- Voting: Major decisions (e.g., taking on debt over $10,000, admitting a new member) require a unanimous vote. Routine operational decisions require a simple majority vote.
- Capital Contributions: Alex contributed $10,000, Ben contributed $7,000, and Chloe contributed $5,000 as initial capital contributions.
- Dispute Resolution: In case of a dispute that cannot be resolved amicably, they agree to mediation before pursuing litigation.
- Buyout Clause: If any member wishes to leave the company, the remaining members have the first right of refusal to purchase their ownership interest at a price determined by a mutually agreed-upon valuation method.
Six months into their business, Chloe decides to move to another city and wants to sell her share. Because their operating agreement includes a clear buyout clause, they avoid potential conflict and confusion. Alex and Ben follow the outlined procedure, engage a third-party appraiser to value Chloe's 25% interest, and then purchase her share based on that valuation. This demonstrates how a well-defined operating agreement streamlines transitions and maintains business continuity.
Practical Applications
An operating agreement finds practical application in various aspects of forming and managing an LLC. Its primary role is to establish a clear and legally binding framework for the business, which is particularly crucial for maintaining the limited liability protection afforded to LLC members. 25, 26, 27Without this formal document, an LLC might be perceived as a sole proprietorship or general partnership, potentially jeopardizing the personal asset protection of its owners.
23, 24
Furthermore, the operating agreement is vital for clarifying verbal understandings among business owners and preventing future misunderstandings or communication breakdowns. 21, 22It details how the business will operate, including the distribution of profits and losses, the allocation of powers and duties among members and managers, and the protocols for holding meetings. 19, 20This preempts common sources of internal conflict and provides a clear point of reference for all parties involved.
The U.S. Small Business Administration (SBA) emphasizes the importance of an operating agreement in outlining financial and functional decisions and safeguarding the limited liability status of an LLC. 17, 18The Internal Revenue Service (IRS) also issues guidance, such as Publication 3402, "Taxation of Limited Liability Companies," which details how LLCs are classified for federal income tax purposes and can elect to be taxed as a partnership, corporation, or an entity disregarded as separate from its owner. 13, 14, 15, 16This tax flexibility is often managed and documented within the operating agreement itself.
Limitations and Criticisms
While an operating agreement offers significant benefits, it also has potential limitations and criticisms, primarily stemming from its nature as a private contract and the variability of state laws. One notable limitation is that while most states allow for considerable flexibility in drafting an operating agreement, some states have default rules that will apply if specific provisions are not addressed or if no operating agreement is in place. 11, 12These default rules might not align with the intentions or best interests of the LLC members, potentially leading to unforeseen consequences or disputes.
Another criticism can arise if the operating agreement is poorly drafted or incomplete. Vague language or the omission of crucial provisions can lead to ambiguity, making it difficult to resolve conflicts among members without resorting to costly legal intervention. 10For instance, without clear guidelines on dispute resolution or exit strategies for members, internal disagreements can escalate and even threaten the viability of the business.
Furthermore, relying solely on an operating agreement without proper adherence to its terms can undermine its effectiveness. If members do not follow the procedures and stipulations outlined in the agreement, particularly concerning formalities like holding regular meetings or maintaining accurate financial records, the limited liability protection of the LLC could potentially be challenged by creditors or in court. While the Revised Uniform Limited Liability Company Act (RULLCA) aims to provide a more uniform legal framework for LLCs, the fact that not all states have adopted it uniformly means that variations in state laws can still create complexities, especially for LLCs operating across state lines or those whose agreements were drafted under different jurisdictional guidelines.
8, 9
Operating Agreement vs. Bylaws
An operating agreement is a document specific to a limited liability company (LLC), detailing its internal management, operational procedures, and the rights and responsibilities of its members. It serves as a contract among the members, providing flexibility in structuring the business to meet their specific needs, particularly concerning profit distribution, decision-making processes, and transfer of ownership.
In contrast, bylaws are the governing documents for a corporation. Bylaws outline the rules and regulations for the corporation's internal affairs, including the duties and powers of its directors and officers, meeting procedures for shareholders and the board of directors, and voting protocols. While both documents define internal governance, the fundamental difference lies in the type of business entity they regulate. An operating agreement allows for a more customized and less formal structure, reflecting the contractual nature of an LLC, whereas bylaws adhere to the more rigid corporate legal framework.
FAQs
Is an operating agreement legally required for an LLC?
While many states do not legally mandate an operating agreement for LLCs, it is highly recommended. Without one, your LLC will be governed by default state laws, which may not align with your specific business needs or the agreements you have with other members.
6, 7### What happens if an LLC does not have an operating agreement?
If an LLC operates without an operating agreement, it will be subject to the default rules of the state in which it was formed. These default rules are often general and may not cover specific situations or the unique arrangements agreed upon by the members, potentially leading to disputes or an unfavorable outcome during internal conflicts.
4, 5### Can an operating agreement be changed?
Yes, an operating agreement can typically be amended or changed. The process for modification should be outlined within the agreement itself, often requiring a unanimous vote or a supermajority vote of the members. It is crucial to follow the amendment procedures specified in the existing agreement to ensure the changes are legally binding.
Does a single-member LLC need an operating agreement?
Even for a single-member LLC, an operating agreement is highly advisable. It helps reinforce the distinction between the owner's personal assets and the business's assets, strengthening the limited liability protection in the eyes of the law. It can also outline succession plans or procedures in case of the owner's incapacitation or death.
How does an operating agreement impact an LLC's taxation?
An operating agreement can influence how an LLC is taxed by the IRS. An LLC offers flexibility in its tax classification; it can elect to be taxed as a sole proprietorship, partnership, S corporation, or C corporation. 1, 2, 3While the operating agreement itself doesn't make the tax election, it often outlines the members' intentions regarding tax treatment and the distribution of profits and losses, which aligns with the chosen tax structure.