What Is an LLC Operating Agreement?

An operating agreement for a limited liability company (LLC) is an important legal document that details who owns the business and also provides essential information pertaining to member duties. An LLC operating agreement establishes the financial relationship between business owners (“members”) and the basics of the working relationships between those owners and the managers who oversee daily operations. 

It must be noted the terms “owners” and “members” are used synonymously in the context of LLCs. However, LLC members are distinct from managers who run the business. Let’s take a closer look at what LLC operating agreements are all about.

Why LLCs Need an Operating Agreement

While not required in some states, an LLC operating agreement is similar to a form of insurance in that it provides legal and financial recourse for a number of situations. If conflicts arise between LLC owners pertaining to any of the following issues, the operating agreement will provide clarity.

One of the most important reasons to have an operating agreement is to establish a clear separation between the LLC and its members. The LLC is its own entity with its own debts and obligations, which is why LLC members have personal liability protection. Without an operating agreement that establishes that separation in writing, the members’ personal liability protection could be put at risk.

The operating agreement will also govern how decisions for the LLC are made and how disputes will be resolved. This can prevent members from having to take legal action against each other because the operating agreement is binding. The specific language of the operating agreement details exactly how such conflicts will be resolved. This document details how the business is structured, the dynamics of operations, and more. 

The operating agreement will also address how to handle unexpected situations, such as the failure of the business or the death of a member.

Though certain states have default rules on the books that address some of the potential challenges that might arise between LLC members, the LLC operating agreement has the potential to override such presumptions.

What to Include in an LLC Operating Agreement:

The operating agreement should define several aspects of the LLC.

1. Percent of Ownership 

Ownership of the LLC will be defined in the operating agreement either in percentages or in a number of units. For example, there may be two members, each of whom owns 50% of the LLC. Alternatively, members could decide to create 100 units of ownership, with each member owning 50 units. 

2. LLC Management Structure 

An LLC can be member-managed or manager-managed. In a member-managed LLC, all members have an active role in the management of the company. In a manager-managed LLC, one or more members are designated as the managers of the LLC, sometimes in conjunction with a manager hired from outside. Other members of the LLC are passive members and do not have a role in management. 

3. Members’ Roles and Responsibilities/Decision Making 

Each member’s role should be clearly defined, as well as their ongoing responsibilities. For example, one member may be designated as the CFO to manage the finances of the business, while another member will manage the operations of the business.

Decision making procedures also need to be defined in terms of voting. Each member will have a share of voting power, and procedures should be spelled out for when and how voting occurs. It should also define what happens in the case of a tie vote. 

The agreement should include provisions outlining the liability of members and managers, and the indemnification of members and managers for actions taken on behalf of the LLC.

4. Capital Contributions and Distributions

The operating agreement should outline the initial capital contributions made by each member to the LLC and any additional contributions required in the future. It should also specify how profits and losses will be allocated among members and the timing and method for making distributions.

5. Record Keeping and Financial Reporting

The agreement should provide guidelines for maintaining financial records and the preparation of financial statements. This includes determining the accounting method to be used (e.g., cash or accrual basis), as well as the frequency of financial reporting and auditing.

6. Tax Classification

The operating agreement should specify the LLC’s tax classification, such as a partnership, S corporation, or C corporation, and any tax-related requirements or obligations for the members.

7. Member Meetings 

Meeting frequencies and procedures need to be specified, as well as how meeting minutes will be recorded.  

8. Admission and Removal of Members

The admission or removal of a member can happen for several reasons. A member may be added if the current members want to add another partner, or if an investor comes on board. Removal of a member may occur because a member may want to voluntarily leave the business, or some members may have cause to remove another member. Additionally, the operating agreement will specify what happens if a member becomes disabled or dies.

9. Transfer of Ownership

When a member is admitted or removed, a transfer of ownership will occur. How their ownership is transferred must be specified by including buy-sell and buyout provisions in the agreement. This is critical to include, as without clear provisions, members could end up in court if they don’t come to an agreement on the ownership transfer.

10. Dispute Resolution

To avoid costly litigation, the operating agreement should include a dispute resolution mechanism, such as mediation or arbitration, to resolve conflicts among members.

11. LLC Dissolution 

If the business fails or needs to end for some other reason, the LLC must be officially dissolved. The operating agreement will specify the procedures to do so, which usually begins with a member vote. The dissolution procedures will also define what happens to any remaining assets of the LLC after debts are paid.

12. Amendments to the Operating Agreement

The operating agreement should outline the process for making amendments, including any required voting thresholds or approval procedures.

How to Create an LLC Operating Agreement

An operating agreement for a single-member LLC is fairly straightforward since the member will be a 100% owner, and no voting is required. However, it’s still important to have one in place to establish the separation between the LLC and the sole member. It also should specify how a member can be added to the LLC later, how ownership will be transferred if the business is sold, and what happens if something happens to the sole member.

An operating agreement for a multi-member LLC is clearly more complex. All members will have to agree on the provisions of the agreement when it’s created.

In both cases, it’s highly recommended that you have an attorney involved in the drafting of your operating agreement. They can ensure that all bases are covered, that proper language is included, and that the at the rights of all members and the LLC are protected.

Some states require LLCs to have an operating agreement in place, including California, Delaware, Maine, Missouri, and New York; though some state laws governing LLCs state that the operating agreement can be implied, written, or oral. In these cases, if there is no written nor oral operating agreement, the state assumes the LLC members wish to have default provisions govern them and their business. 

Operating Agreement vs. Articles of Organization

An LLC operating agreement is different from the articles of organization, which is the public document you file with the state to form your LLC. All of the LLC’s basic information is contained within the articles of organization, including:

• Company name
• Management approach
• Registered agent’s name and address

LLC operating agreements provide more information, detailing how the LLC is to be managed and the member rights, liabilities, duties, and so forth. Furthermore, unlike the articles of organization, the operating agreement is private as opposed to public.

How to Amend an Operating Agreement 

You can amend an operating agreement if the members reach an agreement about the changes being made. You should draft a resolution proposing the changes, and have the members vote on the resolution and then sign it. Then you can create a revised operating agreement that will then become the governing document for the LLC.

Again, it’s best to have an attorney involved in the amendment to make sure that it’s handled properly.

More Tips For An LLC Operating Agreement

Don’t Start an LLC Without an Operating Agreement

Instead of putting your faith in such default provisions, it’s better to be proactive by creating an operating agreement approved by each member.

It’s also a good idea to refuse a verbal or implied agreement even if the other LLC members believe such an agreement will suffice. LLC should put in place a formal written operating agreement that spells out the rules, procedures, and other details of how conflicts will be resolved. 

Keep in mind, even if you and the rest of your LLC members are in agreement on everything today, you may not see eye-to-eye on all matters down the line. If you don’t have a formal written LLC operating agreement in place, you and fellow members of your LLC will be subjected to supposedly fair and just rulings as dictated by the language of state statutes. 

But it’s wise not to let such statutes determine your financial fate, as their language tends to be confusing and unclear. Instead, move forward with an LLC operating agreement written by your trusted business law attorney.

The LLC Operating Agreement Is an Opportunity to Futureproof Your LLC

No one can predict the future, especially when it comes to the highly competitive business landscape. 

One of your LLC members could become ill or incapacitated. Your LLC might be the target of an aggressive takeover attempt by a larger corporation. Perhaps conflicts will arise between LLC owners pertaining to how the business is managed or whether it will expand to new locations. 

The moral of this story is that plenty that can go wrong in the months and years ahead. An LLC operating agreement helps members overcome such obstacles, even if they are completely unpredictable.

Sweat the Small Stuff of Your LLC Operating Agreement

It could be a grave mistake to print an LLC operating agreement template from the web and fill in your LLC and member information. 

Your LLC operating agreement should be tailored to the specifics of your LLC, as a generic operating agreement might have vague language that could expose its members to a successful legal challenge. 

Your LLC operating agreement must be extensively detailed, containing information such as:

• How the LLC will be managed
• How management is selected
• Member responsibilities
• How business decisions will be made

Truly comprehensive LLC operating agreements detail how the LLC will be managed in terms of whether members or a manager are put in charge. The LLC operating agreement details should extend to the actions required of a member. Even the specific percentage of votes necessary for approval should be identified. 

The best LLC operating agreements consider events that could cause the dissolution of the LLC, so it’s generally a good idea to meet with a business attorney to address such potential events in your operating agreement. 

This lawyer could also ensure your operating agreement details how profits are to be allocated to members and outlines procedures for adding members or transferring ownership interest.

Creating an LLC Operating Agreement is not a DIY Project

The do-it-yourself ethos certainly has its merits, but it may be unwise for a project as important as creating an LLC operating agreement. Resist the temptation to use a web template for your operating agreement. 

Instead, do the smart thing by consulting with a business attorney who has experience drafting, reviewing, and amending LLC operating agreements. 

A business attorney knows exactly how this legal contract should be written to protect your interest. Unlike templates available on the web, LLC operating agreements created by attorneys specifically tailor the language to the business in question and incorporate the state’s rules governing how businesses operate. 

Plan for the Worst and Hope for the Best

The top business attorneys brainstorm potential scenarios that might arise down the line and plan for them by shaping the operating agreement’s language as necessary. 

Comprehensive LLC operating agreements created by experienced attorneys detail each member’s management and financial rights. This is the type of specificity that simply cannot be achieved with a basic LLC operating agreement printed from the web. 

Such templates are typically outdated, lack important language, and generically explain member rights in a manner inapplicable to the nuances of the average LLC. 

LLC operating agreement templates on the web often have missing information that renders the operating agreement null and void, or at least partially meaningless. 

As an example, if your LLC operating agreement does not have extensive information pertaining to how conflicts will be resolved, you might end up spending a considerable amount of time and money pursuing litigation.

Have an experienced business law attorney spearhead the creation of your LLC operating agreement or at least review such a proposed agreement on your behalf and you will move forward with your LLC in full confidence. 

The last thing you want is for a supposedly bulletproof LLC operating agreement to contain a litany of errs that set the stage for you to lose your stake in the business or receive a smaller share of the profits. 

The little bit of money you spend for the guidance of a savvy business attorney to create or review your LLC operating agreement will pay for itself in due time, as it will prevent costly litigation and financial losses that could have been prevented with a well-written LLC operating agreement. 

Don’t Let Your LLC Operating Agreement Collect Dust

Once your LLC operating agreement is in place, make several copies. Keep one for your business records, hand one to your attorney and keep a third in storage for safekeeping. 

It’s a mistake to simply stop thinking about your LLC operating agreement once it is completed, approved, and out of sight. This crucial business document should be reviewed at least once a year to verify it accurately reflects member wishes and the current state of the business.

If your business has significantly changed, if a member has passed away, or if a member’s desires in the context of the LLC have changed, meet with your business attorney to have the LLC operating agreement amended.