Learn what an LLC operating agreement is and how to create one for your business.
- An LLC operating agreement is a contract between LLC members, listing details of the organization's ownership, structure and finances.
- LLC operating agreements are not legally required in most states, but experts say that every LLC should create one.
- To create an LLC operating agreement, you can use free online templates, sign up for paid online services or consult an experienced lawyer.
- This article is for entrepreneurs and small business owners who are entering an LLC agreement.
An LLC, or limited liability company, is a popular legal structure for small businesses because it protects the owners' personal assets if the business is sued or declares bankruptcy. One of the documents you need for this is the LLC operating agreement, which clearly identifies the business's structural, financial and operational details. This document isn't only necessary for multimember LLCs, however; single-member LLCs need it too.
What is an LLC operating agreement?
A limited liability company operating agreement is a legal contract between LLC business members that clearly defines the organization's structural, operational, managerial and financial details. The agreement includes clear guidelines and protocols for each member to follow.
Dustin Ray, CEO of LLC formation company Incfile, says every LLC agreement should document the roles, responsibilities, rights, and relationships of the members, as well as their respective ownership percentages and their shares of profits and losses.
"These agreements also spell out what will happen to the LLC if someone leaves or if a new member wants to come on board," Ray told Business News Daily. "Not only does this increase an organization's efficiency and effectiveness, it also provides a clear protocol for disagreements and misunderstandings concerning decision-making and financial dealings."
Key takeaway: An LLC operating agreement is an internal document that outlines an LLC's division of ownership, operations, management and financing among its members.
Why are LLC operating agreements important?
Although only a few states (California, New York, Missouri, Maine and Delaware) legally require LLCs to create operating agreements, every LLC can benefit from one. An LLC operating agreement helps to identify several important aspects of a business, such as by classifying legal structure, setting rules and procedures, and clarifying levels of control and responsibility. It provides personal liability protection, operational clarification and disagreement resolution. It is an especially useful tool to have at your disposal when your company grows or membership changes.
Kelly Williams, founder and managing partner of Slate Law Group, said an operating agreement is especially important to distinguish how your LLC is to be operated in the eyes of the state, which is why even one-person LLCs need it.
"Generally, without an operating agreement, the state in which an LLC is filed has default rules that govern the LLC," said Williams. "However, these state default rules are generalized, and are not designed to adhere to the individual interests of business owners. Therefore, an operating agreement is important in order to custom-design the governance of your LLC in the way you see fit."
As your business makes (or loses) money, an LLC operating agreement can help you make financial decisions, like distributing ownership shares and allocating profits and losses. Informal and verbal agreements can get messy when it comes to money – these are details you want formally outlined and agreed upon beforehand.
"Each LLC member usually gets a percentage of ownership in the LLC that's in proportion to their contributions, but sometimes partnerships aren't always so neat," said Ray. "Operating agreements allow members to divide up ownership any way they see fit."
An operating agreement can specify how much of the LLC's allocated profits will be distributed to the members each year. Ray said an LLC member has to pay income taxes on the full amount of the profits allocated to them by the distributive shares specified in the operating agreement, whether or not those profits were actually paid to the member.
Key takeaway: An LLC operating agreement serves several purposes, including clarifying operational processes, determining the business's legal and financial structure, and resolving conflicts.
What is included in an LLC operating agreement?
An LLC operating agreement should include details about ownership, operations, management and financing. Williams said every LLC operating agreement should cover the following information:
- The percentages of each member's ownership interest
- Members' voting rights and responsibilities
- Powers and duties of members (and managers, if applicable)
- Procedures dictating how meetings are held
- Capital contributions of the members and procedures for distributing the company's profits and losses among members
- Procedures for transferring interest, including buyout provisions, buy-sell provisions, and rules governing ownership transfers in the event of a death
- LLC dissolution provisions
Be sure to check your state's specific requirements for LLC operating agreements, since they dictate varying levels of complexity and detail. Based on your state's guidelines, you may need to include additional detailed information in your operating agreement to best suit your business. For example, many states have default rules for LLCs that can be altered slightly by an operating agreement.
"Some states, for instance, have a default rule that requires LLC members to divide profits and losses equally, regardless of the level of each member's investment in the business," said Ray. "If all members did not invest equal amounts in the LLC, it's unlikely that all members will want to allocate the profits equally. To avoid this, operating agreements can spell out how members want to split profits and losses."
Key takeaway: An LLC operating agreement should include the key terms that govern the internal functioning of the business.
How do you create an LLC operating agreement?
The best way to create an LLC operating agreement is to consult an experienced attorney who can customize an operating agreement to fit your business's needs. Although this course of action is highly recommended, it is not your only option. Simple businesses that only need basic LLC operating agreements can seek online sources to build their own agreements.
When building an LLC operating agreement, according to Williams, you should include these six basic elements:
Organization: Outline the creation of the LLC, listing the official name and address of the business, its purpose, who owns it, what type of business it is, and the ownership percentage each founder and/or member has in the business.
Capital contribution: Outline which members made an initial capital contribution to starting the LLC and how additional money will be raised to fund the business.
Management and voting: Outline how the business is managed, and establish voting rights and procedures that members of the LLC must follow.
Distributions: Provide a procedure for how the LLC's profits and losses are distributed amongst members of the business.
Membership changes: Outline the process of adding and removing members to the LLC. This is where the transfer process for membership interest is established, along with buyout and buy-sell provisions. This section also dictates terms for how to transfer ownership interest in the event of death.
- Dissolution: Lay out the procedures of how to dissolve the company. This section is often known as "winding up" the LLC's affairs.
Key takeaway: You can use free or paid online templates to create a basic LLC operating agreement or work with an attorney to create an operating agreement tailored to your business.
LLC operating agreement templates and online services
If you cannot afford to hire an attorney to create a customized operating agreement for your LLC, you can access free online templates and paid online services to build a basic agreement.
Here are some free templates for LLC operating agreements:
There are also some online services that can help you create an LLC operating agreement for a fee:
- LegalZoom provides online legal services and can create an LLC operating agreement for you.
- Incfile offers LLC formation services, giving you the option to include an LLC operating agreement in its business formation package.
Before creating an LLC, you need to identify the details of the kind of business you want to build (management structure, members, tax structure, etc.).
"If you are just starting out as a new business owner, these kinds of considerations can often seem daunting," said Williams. "Seeking legal counsel to help business owners create their operating agreement allows them to be able to go through all of these components one step at a time, and establish a strong foundation for their business so that there are no unwelcome surprises in the future."