An LLC operating agreement is an agreement that governs the operating of a limited liability company (“LLC”). An LLC is a hybrid business form that combines the advantages of a corporation with that of a sole proprietorship or partnership. An operating agreement allows the owners to structure an LLC business in a manner that suits them best.
LLC Agreement Protections
An LLC agreement protects the owners of an LLC and is important even if there is only one owner. The presence of an LLC agreement lends credibility to the claims that an LLC is a limited liability company, not a sole proprietorship.
An LLC agreement protects owners by ensuring that they enjoy limited liability for debts and liabilities of the LLC.
State Default Rules
Each state has its own rules that apply by default to LLCs. If the owners of an LLC wish their LLC to be governed differently, the agreement must indicate this in the agreement. For example, an operating agreement may distribute profits to owners in a manner that differs from the state law rules.
Elements of an LLC Agreement
There are certain elements that should be present in an LLC agreement to maximize its effectiveness. The LLC agreement should define the percentage of ownership for each owner, how decisions are made, how profits and losses are attributed, and how members can join or leave the LLC.
The agreement should also outline the owners’ voting rights, the LLC’s management, meeting and voting rules, and any other owner rights and responsibilities.
How Ownership is Allocated
The agreement should outline how much of the LLC each owner owns. While owners usually receive a percentage of ownership in relation to how much capital they initially contribute to the LLC, a different percentage may be set under the agreement.
Each owner receives a distributive share, or a percentage of the LLC’s profits and losses. As with ownership percentages, the owners are free to designate in the LLC agreement the amount of profits and losses distributed to each owner. A distributive share that is not proportionate to an owner’s percentage of ownership is known as a “special allocation.”
Profit and Loss Distribution
The LLC agreement should outline how much of the profits should be distributed each year, whether the LLC will pay each owner’s income taxes, and whether distributions will made on a schedule or randomly upon request.
Formal voting occurs for those decisions that are critical to the business, although many LLCs are managed on an informal basis. Voting rights can be distributed according to an owner’s percentage of ownership interest or each owner can be assigned one vote.
Addition and Departure of Owners
An LLC operating agreement should provide for the possibility that an owner may want to leave the LLC or a new owner may want to come into the LLC. As well, the agreement should cover the possibility that an owner may die or become disabled and unable to participate in the LLC. The agreement should have a buyout option provided so that owners know what to expect if they wish to leave the LLC.
An LLC operating agreement governs the management, voting, profit and loss sharing, and ownership rules for an LLC. The agreement should cover the percentage of ownership each owner enjoys, the percentage of profits and losses to be distributed to each owner, the frequency of distribution, owner voting rights, and how the addition or departure of owners will be handled.