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A Limited Liability Company (LLC) operating agreement allows you to structure your
financial and working relationships with your co-owners in a
way that suits your business. In your operating agreement, you
and your co-owners establish each owner's percentage of
ownership in the LLC, his or her share of profits (or losses)
and his or her rights and responsibilities, as well as what
will happen to the business if one of you leaves.
Why an Operating Agreement Is Necessary
While many states do not legally require your LLC to have an
operating agreement, it's foolish to run an LLC without one,
even if you're the sole owner of your company. An operating
agreement helps your LLC by guarding your limited liability
status, heading off financial and management
misunderstandings, and making sure your business is governed
by your own rules -- not the default rules of your state.
Protecting Your Limited Liability Status
The main reason to make an operating agreement is as simple as
it is important: It helps to ensure that courts will respect
your limited personal liability. This is particularly key in a
one-person LLC, where, without the formality of an agreement,
the LLC will look a lot like a sole proprietorship. Just the
fact that you have a formal written operating agreement will
lend credibility to your LLC's separate existence.
Defining Financial and Management Structure
Co-owned LLC's need to document their profit-sharing and
decision-making protocols as well as the procedures for
handling the departure and addition of members. Without a
thorough operating agreement, not only will you and your
co-owners be ill-equipped to settle misunderstandings over
finances and management, but you will also be subject to the
rules of your state law (see below).
Overriding State Default Rules
Each state has laws that set out basic operating rules for
LLC's, some of which will govern your business unless your
operating agreement says otherwise (these are called
"default rules"). Many states, for example, have a
default rule that requires owners to divide up LLC profits and
losses equally, regardless of each member's investment in the
business. Unless you and your co-owners invest equal amounts
in the LLC, it's doubtful you'll want profits allocated this
way. To avoid this, your operating agreement must spell out
how you and your co-owners want to split profits and losses.
In this same way, many state laws regarding LLC's will not
be favorable to your business. Don't be tempted to rely on
them to structure your LLC; instead, decide on the best rules
for your situation and put them in a written operating
agreement.
What to Include in Your Operating Agreement
There's a host of issues you must cover in your operating
agreement, some of which will depend on your business's
particular situation and needs. Most operating agreements
include the following:
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the members' percentage interests in the LLC
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the members' rights and responsibilities
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the members' voting power
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how profits and losses will be allocated
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how the LLC will be managed
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rules for holding meetings and taking votes, and
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"buy-sell" provisions, which establish a
framework for what happens when a member wants to sell his
interest, dies or becomes disabled.
While these items may seem fairly straightforward, each is
rife with details. Make sure you fill out the particulars in
the following key areas.
Percentages of Ownership
The owners of an LLC ordinarily make financial contributions
of cash, property or services to the business to get it
started. In return, each LLC member gets a percentage of
ownership in the assets of the LLC. Each member is usually
given an ownership percentage that's in proportion to his
contribution of capital, but LLC's are free to divide up
ownership in any way they wish. These contributions and
percentage interests are an important part of your operating
agreement.
Distributive Shares
In addition to receiving an ownership interest in exchange for
his investment of capital, each LLC owner also receives a
share of its profits and losses, called a "distributive
share."
Most often, an operating agreement will provide that each
owner's distributive share corresponds to his percentage of
ownership in the LLC. For example, because Tony owns only 35%
of his LLC, he receives just 35% of its profits and losses.
John, on the other hand, is entitled to 65% of the LLC's
profits and losses since she owns 65% of the business. (If
your LLC wants to assign distributive shares that aren't in
proportion to the owners' percentage interests in the LLC,
you'll have to follow rules for "special
allocations.")
Distributions of Profits and Losses
In addition to defining each owner's distributive share, your
operating agreement should answer these questions:
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How much -- if any -- of the allocated profits of the
LLC (the members' distributive shares) must be distributed
to LLC members each year?
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Can members expect their LLC to pay them at least enough
to cover the income taxes they'll owe on each year's
allocation of LLC profits?
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When will distributions of profits be made?
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Or are the owners entitled to draw periodically from the
profits of the business?
Because you and your co-owners may have different financial
needs and marginal tax rates (tax brackets), the allocation of
profits and losses is an area to which you should pay
particular attention.
Voting Rights
While most LLC management decisions are made informally,
sometimes a decision is so important or controversial that a
formal vote is necessary. There are two ways to split voting
power among LLC members: either each member's voting power
corresponds to her percentage interest in the business or each
member gets one vote -- called "per capita" voting.
Most LLC's mete out votes in proportion to the members'
ownership interests. Whichever method you choose, make sure
your operating agreement specifies how much voting power each
member has as well as whether a majority of the votes or a
unanimous decision will be required to resolve an issue.
Ownership Transitions
Many new business owners neglect to think about what will
happen if one owner retires, dies or decides to sell his
interest in the company. These concerns may not be on your
mind now, but such situations crop up frequently for small
business owners, and it pays to be prepared. Operating
agreements should include a buyout scheme -- rules for what
will happen when one member leaves the LLC for any
reason.
How to Create an Operating Agreement
Obviously, you'll need help beyond this article to make your
own operating agreement. There are many sources for blank or
sample LLC operating agreements, but you must be sure that
your operating agreement is drafted to suit the needs of your
business and the laws of your state.
Law libraries are a good source of state LLC law as well as
technical material on preparing an operating agreement, but
since the material is written for lawyers, you may find it
more confusing than helpful.
It is recommend that you can pay a business lawyer for assistance,
especially with LLC's with more than five owners, or for
those that opt to have a special manager or management group
run the LLC. Lawyers typically have several types of standard
agreements on hand that can be customized for your LLC.
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