operating agreements for llcs

In short

I once watched a friend of mine open a small bakery with his brother, and they shook hands and called it done. An operating agreement is the written version of that handshake, and it spells out who owns what and who decides what. If you own an LLC, or plan to, you can write one in an afternoon, and most states do not make you file it with anyone. The agreement matters most when something goes wrong, such as a death, a fight, or a buyout. Think about who puts in money, who puts in time, and how profits get split. Then write it down, sign it, and keep it where every owner can find it.

The whole of it

What it is

A friend of mine once said that a business without paper is like a barn without a latch. It may hold for years, but the first strong wind will test it. An operating agreement is the paper. It is a contract among the owners of a limited liability company, called members, and it sets the rules for how the company runs.

An LLC is a business form created by state law. It can shield the owners' personal property from most business debts. The state gives the company its basic shape, but the owners can change much of that shape by contract. That contract is the operating agreement.

You may be wondering if the state already has default rules. It does, and they apply when owners write nothing. Those default rules can surprise people. Each state writes its own default rules for profits and for decisions. Your state's LLC statute says what those rules are, and they may not match what the owners pictured. So the plain truth is that writing your own rules usually serves you better than leaning on the state's.

The agreement is an internal document. The state does not approve it, and in most places the owners do not file it. Banks, though, often ask to see it before opening a business account. Lenders and investors may ask too.

How it works

If you are holding a freshly formed LLC, the agreement is the next thing to build. It usually covers a handful of plain subjects. The first is ownership. It names each member and states the percentage each one holds, based on what each put in. The second is money. It says what each member contributes and whether anyone must add more later.

The third subject is profits and losses. Owners do not have to split these by ownership percentage, though many do. The agreement says how and when money gets paid out to members. These payouts are called distributions. The fourth is management. In a member managed LLC, the owners run the daily business together. In a manager managed LLC, one or more chosen people run it, and the other owners stay out of the daily work. The agreement says which style applies and how votes are counted.

The fifth subject is the hard one, which is what happens when someone leaves. The agreement can say how a departing member gets paid, how the share is valued, and whether the other owners get the first chance to buy it. This is often called a buy sell clause. It also covers death, divorce, and disability, which nobody likes to discuss on a sunny day.

A court may look past the LLC shield if owners mix personal and business money or ignore the company's own rules. A signed agreement, followed in practice, helps show the company is a real and separate entity.

The numbers, and where to find yours

I once sat with a woman who thought the filing fee was the whole cost of an LLC. It was only the start. Each state sets its own formation fee, and many charge yearly or biennial report fees too. Your state's Secretary of State website, or the office that handles business filings, lists the current amounts. The figure is the current figure, which the official source publishes each year, and it varies by state.

Taxes come next. The Internal Revenue Service explains that a single member LLC is taxed by default as part of its owner, and a multiple member LLC is taxed by default as a partnership. An LLC can also choose to be taxed as a corporation by filing the proper form with the IRS. The IRS page titled Limited Liability Company (LLC) lays out these choices. Any self employment tax rate is set by law and is the current figure, which the official source publishes each year.

Another number to find is the ownership percentage of each member, and that one is yours to set. Write it as a percent and make the percentages add up to 100.

A worked example

A friend of mine named Dana and her neighbor Carl started a lawn care company. Dana put in $8,000 for a truck and mowers. Carl put in $2,000 and said he would also do most of the daily work. They agreed to base ownership on money put in.

The total put in was $8,000 plus $2,000, which is $10,000. Dana's share is $8,000 divided by $10,000, which is 80 percent. Carl's share is $2,000 divided by $10,000, which is 20 percent.

Then Carl spoke up. He felt that his labor was worth something too. So they wrote a second rule into the agreement. Carl would get a payment of $1,000 a month for running the crews, treated as a cost of the business. After that, the leftover profit would be split 80 percent and 20 percent.

Say a good year leaves $30,000 in profit after Carl's pay. Dana's piece is 80 percent of $30,000, which is $24,000. Carl's piece is 20 percent of $30,000, which is $6,000. Add them and you get $30,000, so the books balance. Carl also earned $1,000 times 12 months, which is $12,000 for his work.

Now suppose Carl wants out. Their agreement says the company must offer his share to Dana first, at a value set by a simple formula they wrote down. Because they settled this early, no one had to fight about it later. Nobody enjoyed writing that clause. Everybody was glad of it.

Where it goes wrong

I have seen good people get hurt by good intentions. The first trouble is silence. Owners skip the agreement because they trust each other, and then trust runs into a real disagreement with nothing to guide it. The state's default rules fill the gap, and those rules may not match what anyone pictured.

The second trouble is vagueness. A line such as "profits will be shared fairly" sounds kind, but fair means different things to different people. Use numbers and plain steps instead.

The third trouble is a copied form that does not fit. Online templates are a fair place to start, but a template written for another state or another kind of business can miss your needs. State law differs, so the agreement must fit the law where the LLC was formed.

A fourth trouble is a single member LLC with no agreement at all. The owner may think there is no one to agree with. Still, a written agreement can show a bank or a court that the company is run as its own entity. It also names who takes over if the owner dies or cannot work.

The last trouble is not following your own document. If the agreement says a vote is needed for big purchases and no vote ever happens, the paper loses its weight. Keep short written records of major decisions.

Questions to answer before you leave this page

Have you and your co owners talked about who puts in how much money and how much time, and does the written percentage match that talk? Do you know whether your LLC will be member managed or manager managed, and who signs for the company? How will profits be paid out, and how often? What should happen if one owner dies, gets divorced, becomes disabled, or simply wants out, and who gets the first chance to buy that share? Have you checked what your state's default rules say, and would they suit you if you wrote nothing? Do you know where your state lists its formation and yearly fees, and what the IRS says about how your LLC will be taxed? Has every owner read the agreement, signed it, and received a copy?