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Making LLC Operating Agreements

LLC operating agreements are much like corporate bylaws in that both types of documents govern the workings of your business.

LLC operating agreements allow the owners of a business to configure the running of their business in a way that best suits their needs. Normally, an operating agreement for an LLC will lay out various key points, such as each co-owner's percentage ownership share of the business. In addition, LLC operating agreements lay out the share of profits - or losses - that each owner will receive, the rights and responsibilities of the owners, and typically also detail what will happen to the business if one of the owners leaves.

Necessity of LLC Operating Agreements

Depending upon the state that you are running your business in, you may or may not be required by law to write out an operating agreement for your limited liability company. However, even if you state does not require it, it is still a good idea to make an operating agreement for your LLC.

By having an operating agreement for your LLC in place, you have a line of protection that guards the status of your limited personal liability for your business' dealings, and can also avoid or alleviate misunderstandings between owners of the LLC. Lastly, each state has default laws you may want to avoid that will govern the running of your LLC if you choose not to make an operating agreement.

Limited Liability

One of the primary reasons for organizing your business as a limited liability company is to gain the limited liability status that comes with this business structure. Having an operating agreement in place can protect this status when and if courts begin looking at your assets to satisfy an obligation of your business. It may be hard to protect this limited liability status, especially if you are the only owner of the business, without some kind of documentation to back it up. A court may look more favorably on your limited liability status if you have an LLC operating agreement in place for your business.

Laying out the Ownership and Management

If you are a part owner of an LLC that has multiple owners, you will want to ensure that the operating agreement for your LLC lays out the profit- (and loss-) sharing breakdown between all of the owners. In addition, the operating agreement should also clearly define the managerial structures, laying out procedures for decision making about the business as well as what will happen in the event that one of the owners decides to leave the business. If your LLC does not have an operating agreement in place that takes care of these two issues, you may run into problems when your business makes record profits for a year, or when your long-term business partner decides to leave.

Avoid State Default Rules

As mentioned above, each state has default rules that will govern the running of your LLC unless you have an operating agreement that says differently. For example, many states have default rules that say that losses and profits should be divided equally among all the owners of the LLC, regardless of their respective ownership interests. If you create an LLC operating agreement, however, you can avoid this default rule by agreeing that the share of losses and profits will be split according to the percentage ownership of each member.

By writing your own operating agreement for your LLC, you will ensure that your business is run in the way that you choose, not the way the default rules are set up.

Elements to Include in LLC Operating Agreements

Although each LLC operating agreement will probably be a little different, depending upon the needs of each business, there are few essential terms that are contained in a majority of operating agreements. These terms include:

  • A breakdown of the ownership percentage of each member
  • The rights and responsibilities of the members
  • A detailed plan showing how losses and profits will be distributed
  • The voting rights of members
  • A management plan for the business
  • Rules for meetings and voting, and
  • Buyout or buy-sell rules that govern when a member's sale of an interest, or a member's death or disability.

Ownership Percentage

Generally speaking, owners (members) of LLCs are determined by who gave money, property or services to the business when it started. Owners are rewarded for their contributions in the form of a percentage ownership in the business. Most of the time, the ownership percentage is determined by the amount a member gave at the start of the business compared to the total amount given by all members. If you choose to do so, however, you do not have to follow this ownership percentage scheme and can allocate the ownership of the LLC in any way you wish so long as you include the scheme in your operating agreement.

Shares of Profits and Losses

This is often called the distributive share. Under most LLC operating agreements, a member's distributive share is often just a simple calculation under their ownership percentage. Perhaps an example is the easiest way to make this clear. If Dave owns 25% of ABC LLC, and the operating agreement of ABC LLC dictates that a member's distributive share is equal to his or her ownership share, Dave would take 25% of ABC LLC's losses or profits. If ABC LLC made $100,000 in profits for the year, Dave would be entitled to $25,000.

If you would like your members to all receive and equal distributive share without regard to ownership percentage, you can make this arrangement within your LLC operating agreement.

Profits and Losses Special Considerations

In addition to determining the distributive share within the operating agreement, you may also want to make some special arrangements within the operating agreement that deal with unique situations.

For example, the operating agreement should dictate how much of the distributive share a member is allowed to take each year. If, for example, the business is new, you may want to consider limiting each member to only taking half of his or her distributive share each year. So, to follow the above example, Dave would only be allowed to take $12,500 of his distributive share, leaving the remainder in the business to help with growth.

In addition, if an operating agreement limits the amount of a distributive share that a member can take out of the business each year, consider whether you want to ensure that this amount is enough to cover the income taxes that the member is required to pay. A member of an LLC is required to pay income taxes on his or her entire distributive share, not just the part of the share that the owner takes out of the business.

Lastly, are members allowed to withdraw their distributive share at any time, or will the operating agreement set up one, or a few, certain days throughout the year where members are allowed to withdraw some, or all, of their distributive share? If all of the members are struggling financially, it may make sense for the business to allow withdrawals from the business only once a year so that the members do not bleed the business dry.

Meetings and Voting Rights

The LLC operating agreement for your business should lay out details about meetings and voting rights. For example, the operating agreement could dictate that a meeting can only be held whenever there is a quorum present. A quorum could be defined as at least 50% of the ownership base, or at least 50% of the members.

Voting rights should be laid out as well. In general, there are two voting rights schemes that LLCs commonly use. The first is where each member votes his or her membership percentage. Under this scheme, a person with a 40% ownership share has a much larger voting power than a person that only has a 1% ownership share. The other option is where each member gets one vote, no matter the size of their ownership shares. Your operating agreement could also specify that a vote can only be taken when a quorum is present.

Transitions of Ownership

Your LLC's operating agreement should also lay out the procedures required for transitions of ownership. Often, operating agreements have different procedures for this depending upon the circumstances (such as death, selling, disablementetc). Most often, operating agreements include simple buyout schemes that allow continuing owners to buy out the ownership share of a member that is leaving the company.

Creating an Operating Agreement

Hopefully this article has helped you see some of the more important points to consider when creating an operating agreement for your LLC. You still need to sit down and create the actually document, however. You may need professional help for this step. You may not need to hire an attorney to assist you, though, as many state governments offer "fill-in the blank" operating agreements that LLCs commonly use.

If your LLC's operating agreement is going to exceed the basics that these blank documents can help you with, you may have to consult with a business lawyer. This is even more true for LLCs that are going to have several different owners, as the relations between members can be strained when it comes time to draft the operating agreement. It may be expensive to hire an attorney to help you create this document, but the benefits in the long run will probably outweigh the upfront costs.

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