What is an LLC Operating Agreement – Complete Guide

Last Updated on November 15, 2023 by Dr. Gabriel O’Neill, Esq.

In the dynamic world of business, an LLC operating agreement stands as a powerful compass, guiding entrepreneurs through the complexities of running a Limited Liability Company. Picture it as a customized roadmap outlining the rules, rights, and responsibilities of LLC members. 

This document serves as a binding contract that fosters harmony, protects individual interests, and mitigates potential disputes. Join us as we unravel the intricacies of an LLC operating agreement, uncovering its role in shaping the destiny of businesses and enabling seamless collaboration. 

Whether you’re a seasoned entrepreneur or just dipping your toes into the entrepreneurial waters, this blog post is your gateway to understanding the pivotal significance of an LLC operating agreement. Prepare to embark on a journey that unveils the hidden secrets behind this essential legal document, empowering you to navigate the thrilling yet uncertain realm of business with confidence and clarity.

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What Is an LLC Operating Agreement?

LLC stands for “Limited Liability Company” and is the most popular structure for small businesses in the United States. The designation was created largely to increase small businesses’ access to the protection from liability afforded to corporate shareholders.

An LLC operating agreement identifies the company, states its ownership, defines member duties, and lays out other structural features of the business. 

It usually includes basic information about the LLC and its owners (known as members), the company’s elected tax treatment, and guidelines for how certain key procedures will be handled. 

Operating agreements function as a legal contract between or among members of a multi-member LLC, though even single-member LLCs can benefit from one, too.

Most LLCs won’t need to file or provide proof of an operating agreement in fact, a business can keep these documents confidential among members if preferred. The agreement can be updated as necessary as a source of guidelines both for normal operations and for helping resolve any disputes that may arise.

Which States Require an LLC Operating Agreement?

If you’re forming or have formed an LLC in California, New York, Missouri, Maine, or Delaware, state laws require you to create an LLC operating agreement.

While all states do not explicitly mandate LLCs to have operating agreements, having one in place is highly recommended to establish the internal structure, rules, and regulations governing the LLC’s operations and the relationships among its members. 

Operating agreements help clarify ownership rights, responsibilities, profit distribution, decision-making processes, and other important aspects of running an LLC. It’s essential to consult specific state laws and regulations or seek legal advice to determine the exact requirements for operating agreements in a particular state.

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What’s Included in an LLC Operating Agreement?

While the structure and content of LLC operating agreements vary, here are some of the types of information they most often include:

Basic Information About the Business

An operating agreement further solidifies some of an LLC’s most basic decisions and premises, many of which may already be laid out in the company’s “articles of organization,” another document important to forming an LLC. 

These typically include the LLC’s official name, its principal place of business, its duration, its management structure, its statement of purpose, and the identification of its registered agent.

Tax Treatment Preference

LLCs typically enjoy a “single layer of taxation.” They are by default exempt from a business tax, meaning profits are only taxed at the individual level, or “layer,” when members report their share of income and expenses on their personal tax returns.

LLCs also have the ability to be a bit of a chameleon when it comes to tax treatment: depending on the type of business, LLCs may value certain incentives to elect corporate status, which they can do by selecting to file as either a C-corp or an S-corp. 

An operating agreement can state the LLC’s initial tax status and outline the procedure for changing the tax classification in the future.

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Member Information

One of an operating agreement’s most critical functions is to specify how the business’s profits and responsibilities are distributed among members. 

The agreement often lays out basic member information such as names, addresses, and roles within the business and includes the amount and nature of a member’s contributions (often financial, but not always) to the LLC. 

Expectations about compensation, which are often based on this shared assessment of member contributions, may be described along with ownership percentages.

Management Structure

An LLC will have one of two management structures. A “member-managed LLC” allows members to be “agents” acting on behalf of the company and relies on members for day-to-day management. 

This is desirable for small or streamlined LLCs with relatively few members and is the more popular of the two designations. With a “manager-managed LLC,” members instead elect a smaller number of people to manage the company (while they maintain passive ownership and voting rights on major decisions). 

The choice in structure usually comes down to the size of an LLC’s membership and how open it wants to be to investment from outside of management. Whatever the choice, an indication of management structure is an important part of an operating agreement.

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Operating Procedures

Business procedures important to running an LLC include voting, holding member meetings, approving manager actions, adding new members, facilitating member exits, and even dissolving the LLC with wind-down procedures if the situation demands. 

These types of procedures, along with many more that might be relevant only to specific kinds of businesses, can be addressed in a variety of ways.

A Liability Statement

One of the main benefits of choosing an LLC as a business structure is the distinction that it makes between the company and its individual members. 

While corporate stockholders are personally shielded from their business’s liability, sole proprietors or members of a partnership are not legally distinct entities from their business and assume full personal responsibility for the risks of the operation. 

LLCs combine the best characteristics of both structures, enjoying a corporation’s limited liability without shouldering its level of tax and regulatory burdens. LLCs need to properly define limited liability status with a clear liability statement in case this status is ever challenged. An operating agreement is one traditional place to declare this.

Additional Provisions

Operating agreements aim to proactively address bumps in the road ahead. As such, they often include provisions that describe what happens in the event of unplanned events such as a member’s death, a member’s withdrawal from the business, disputes between or among members, a need to edit the operating agreement, and further issues particular to the business’s industry. 

Many agreements close out with a “severability provision” stating the rest of the operating agreement remains in effect if one part proves contrary to state or federal law or otherwise unenforceable.

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5 Ways an Operating Agreement Benefits Your Business

1. It Strengthens Your Corporate Veil

Without an operating agreement, courts might not take as seriously the limited liability status a business claims. The legal separation, or “veil,” between a business and its members or owners is central to limiting personal liability and is strengthened by the inclusion of a liability statement in an LLC operating agreement.

2. It Solidifies Central Agreements Between Members

As part of forming their business, members of an LLC must agree upon a division of rights, duties, ownership, compensation, and more. Going forward, LLCs may find few, if any, other ways to enforce these initial guidelines other than an operating agreement. 

Without proper documentation, members might not find any legal disincentive to later disregard a company’s foundational agreements. An operating agreement may be the only document addressing the company’s ownership percentages.

3. It Defines Key Business Procedures

Articles of organization (sometimes called a “certificate of organization”) filed with the state are what actually makes an LLC official, but these describe little about how the company actually functions. 

An LLC operating agreement gets into the nitty-gritty of procedures such as voting, holding meetings, key communications, conflict resolution, and more. Businesses, especially young ones, benefit from having internal procedures clearly defined, making it easy for members to stick to them.

4. It Keeps State Default Laws at Bay

Most states have “default laws” governing how an LLC must operate and be treated legally if no operating agreement already exists. By having its own agreement, an LLC can be free from these types of generic regulations and has a much greater agency in defining and regulating itself.

5. It Adds Legitimacy to Your Business

Entities may view a professional operating agreement as a proxy for a trustworthy business. By design, it’s relatively easy to form an LLC, especially when compared with starting a corporation. 

An effective operating agreement, however, shows a company has taken the additional steps to get organized and to operate as legitimately as possible. It demonstrates the LLC is conscious of its legal standing, intentional about its organizational structure, and prepared for the challenges ahead.

Lending institutions are a great example of an entity with a vested interest in confirming a company’s trustworthiness and competence: some banks may want to see an operating agreement before opening an account for a business.

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Affordable Ways To Create an LLC Operating Agreement

By legal standards, creating an LLC operating agreement tends to be pretty straightforward. The agreements do, however, include what many would consider “legalese” and can go on for dozens of pages. 

Without a legal background, it’s not recommended to try and write your own from scratch, and of course, an operating agreement’s legally binding nature means you won’t want any mistakes. 

There are several options:

Do It (Almost) Yourself

Short of relying on one’s own legal expertise, the simple, free DIY option for writing an operating agreement is to follow a blank template or step-by-step instructions. 

Many different variations of these can be found online via legal help sites and law libraries. The main trouble you might encounter is being sure the directions you choose to follow provide an agreement that’s appropriate for your specific business.

Interactive Services

Many websites with business formation resources, such as ZenBusiness or Legal Zoom, offer services specifically geared toward LLCs. 

These include interactive templates that will ask questions and solicit your business information before providing a finished operating agreement. Many of these are also free. 

These automated services can be a better way to produce an agreement that’ll provide a good fit for the specifics of your business but may still not always produce optimal results, especially for businesses with unique considerations such as foreign transactions or members already a separate business entity and not an individual.

Professional Services

For those LLCs with unique considerations, above-average complexity, or more than a couple of members, hiring professional legal help becomes more worthwhile. 

Plenty of lawyers and legal services specialize in projects such as LLC operating agreements and offer to price for individual documents rather than hourly rates. Some sites have users post a “project” so different lawyers can offer bids.

Before agreeing to anything, be clear about whether you’re actually going to be consulting a lawyer (with the possibility of asking questions and doing rounds of revisions) or simply paying to have a real person write a draft based on submitted information.

If you’re working with a lawyer online, make sure the person is licensed to practice in your state and familiar with its LLC laws.

Operating Agreement Costs

Legal expertise is expensive, but so are the costs of the legal issues likely to arise with a subpar operating agreement. Along with filing fees, professionally created operating agreements represent one of the major potential costs of starting an LLC. 

It’s possible to have a draft written by a legal expert for a couple of hundred dollars or less, though some companies spend many thousands of dollars working on a custom-tailored agreement. Lawyers and other legal services commonly offer free consultation and quoting services.

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Member-Managed vs Manager-Managed LLC – Frequently Asked Questions

Can You Make Changes to an LLC Operating Agreement?

Your LLC’s operating agreement needs to remain up to date at all times, so anytime there’s a change within your LLC, you need to amend the operating agreement. 

These changes can include changes in membership, managers, the name of the LLC, address or other physical information, financial information, or how the LLC operates. 

You create these amendments, and once approved by your membership, you can file the amended documentation with the secretary of state that the LLC is founded in as needed. They should also become part of the LLC’s official record.

Is It Possible to Set up an LLC for Free?

While the cost to register an LLC varies by state, there’s a fee to register a business in every state. 

So, while there are some companies that advertise “free” LLC formation, what this really means is that the company will fill out the LLC paperwork for you for free. But again, you will still be responsible for the state’s filing fee.

Does My Single-Member LLC Really Need an Operating Agreement?

It’s strongly recommended. Even though single-member LLCs can be relatively simple entities, operating agreements help the business with credibility and help ensure LLC status. 

Without documentation of certain defining information, proving the legal distinction between an LLC and its sole member can be more challenging in the event, it’s ever litigated. Don’t forget all LLCs, regardless of size, are required to have some form of operating agreement in California, Delaware, Maine, Missouri, and New York.

Bottom Line on What is an LLC Operating Agreement?

In conclusion, an LLC Operating Agreement serves as the backbone of a limited liability company, offering structure, protection, and clarity to its members. 

By defining ownership, management, and decision-making processes, it sets the stage for successful collaborations and minimizes conflicts. This crucial document provides a solid foundation for the smooth operation of the business, safeguarding individual interests and outlining the path to growth. 

Whether you’re starting a new venture or seeking to strengthen an existing LLC, taking the time to craft a comprehensive operating agreement is an investment well worth making. 

Remember, it’s not just a legal requirement but a powerful tool that empowers entrepreneurs to build thriving businesses while ensuring transparency, accountability, and long-term success.

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