Forming a limited liability company, or LLC, is a very appealing option if you want a business structure with less formalities and enhanced personal protection. They do, however, require a bit more paperwork, including a formal operating agreement. Here are the fundamentals of what every LLC owner needs to know regarding how LLC operating agreements work.
What is an LLC operating agreement?
An LLC operating agreement is a very important document that LLCs use since it clearly outlines both the functional and financial aspects of a business. The document's purpose is to govern the protocol and internal operations of a certain business in such a way that it meets the business owner's specific needs. Once the members sign the document, it serves as a legally binding formal contract.
Why is an LLC operating agreement necessary?
- To protect the limited liability status of a business. Formal operating agreements provide members 100% protection from any personal legal responsibility to the LLC. Without implementing that formality, the LLC is more like a partnership or sole proprietorship business structure that can put your personal liability at great risk.
- To make any verbal agreements perfectly clear. Sometimes misunderstandings can still occur even if all members have verbally agreed to specific terms. Therefore, it's in the best interest of everyone concerned to list the detailed conditions of how the business operates in writing. This way, if any discrepancies or conflicts arise, they can easily be referred to and evaluated based on the terms of the operating agreement.
- To protect your operating agreement regardless of the rules of your state. Each state has a default set of rules that govern LLCs without the need of a formal operating agreement. This means that every state has certain rules that apply to businesses that forego signing LLC operating agreements. Since the state's default rules are somewhat vague and general, it's better to have a formal operating agreement in place rather than relying on the general terms that each state offers.
What does an LLC operating agreement include?
The internal operations outlined in the LLC operating agreement include the following:
- Distribution of profits and losses
- Voting responsibilities and rights
- Percentage of each member's ownership
- Holding meetings
- Rules for buy-sell and buyout (e.g., protocol for transferring interest in the event of a death)
- Duties and powers of managers and members
Where should LLC operating agreements be stored?
LLC operating agreements should ideally be kept along with your primary business records. It's not necessary that they be filed, nor will your state accept them.
Are LLCs required to form an official operating agreement?
The specific state it was created in dictates if an operating agreement is necessary. While several states don't actually require operating agreements, some do, such as New York and Missouri. Check the website of your Secretary of State to find out more information.
Note: Even though the majority of states don't require a formal written document, it's still risky to operate a business without an official LLC operating agreement.
