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Disaster Could Strike Your LLC without an Operating Agreement

Once you have decided to set up your Limited Liability Company (LLC), it is advisable to create an LLC operating agreement. This enables you to structure your working and financial relationships with any joint owners that are best suited to the needs of your business. In the operating agreement, you and the LLC joint owners will have to decide on what percentage each of you owns and how your profits are to be shared, or losses if it ever comes to that. You will also have to include the rights and responsibilities each of you has and what should happen to your LLC if one owner decides to opt out.

Anything Could Happen without an Operating Agreement

Just imagine your spouse forces a divorce on you and you have no signed financial plan to cover the distribution of your assets. This dilemma could cost you a lot in legal fees sorting out the mess. The same applies to an operating agreement. Without one in place, it could not only damage your LLC's reputation if your co-owners cannot agree on an important matter, but far too much time would be spent on arguing and not running your LLC, let alone costly legal fees if arguing fails to resolve the problem.

An LLC Operating Agreement Protects its Limited Liability Status

The presence of an operating agreement helps to ensure that the courts will recognize your personal limited liability. This is typically important in a single-person LLC where, if an operating agreement is not present, the LLC will resemble a sole proprietorship. With this formal agreement, your LLC’s individual existence will have its own limited liability status.

Your Management and Financial Structure May Face Chaos without an LLC Operating Agreement

Jointly owned LLCs should document their joint decisions on decision-making and profit sharing, as well as the measures they use to handle the arrival and departure of members. If there is no operating agreement, you and the co-owners will not be suitably equipped to reach any settlements concerning misunderstandings over management and finances. Worse still, your LLC will be required to follow any of your state’s default operating conditions. This could be far more of a burden than setting aside time to fill in the necessary forms to set up an operating agreement.

State Default Rules Can Seem Alarming

All U.S. states have laws that determine the basic rules for operating an LLC. Some of these will play a role in the governing of your business unless you have ensured your operating agreement states its own wishes. These state rules are typically called default rules.

An example of a default rule used in a lot of states is the requirement for any profits or losses (if it comes to that at any time) to be divided equally between the owners without considering how much each member has invested in the business. Most businesses would not like to see this happen, especially if some owners had invested more than others.

The way to handle this is quite straightforward. By ensuring your business has an operating agreement, you have added details concerning how you and your business’s co-owners have decided to divide any profits and losses.

Your state’s default rules may not be of particular concern to you; however, in some situations, following them due to an irreconcilable situation in your business may cause a breakdown if you haven’t drawn up an operating agreement in the first place.

Comparing Your LLC Management Structure with an Operating Agreement and Your State's Default Provisions

Typically, all your LLC members could take part in its management, or its members could delegate management power to a manager or managers. Many states do not require that an LLC has to include the structure of its management when it files its articles of formation.

In most states, the default management follows the member-managed structure. This means that all LLC members have to reach an agreement on any business decisions. Your LLC operating agreement may override the default by affirming the management type and indicating the degree of authority accorded to the management team. This means you run your LLC according to your members’ wishes, not your state’s default.

You may be a small LLC and your state’s default laws work fine for you, but things do change and you could be harnessed with more than you bargained for by opting out of an operating agreement. There have been some changes made in both Florida and California that have benefitted LLCs that have an operating agreement in place, but it is not so good for others.

Your LLC In Florida May Have a Hard Time without an Operating Agreement

Under Florida’s old LLC statute, it allowed managing members. This covered both the two possible scenarios of member-managed or manager-managed structures.

The recent introduction of a new statute affects new LLCs but also applies to any LLCs formed after December 31, 2014. This no longer allows manager-managed LLCs.

Any current LLC operating with that management type will find it can only use the default management style, which is “member-managed,” unless it goes through the process of altering its operating agreement.

What You Must Include in Your LLC's Operating Agreement

  • Your members’ interests by percentage in your LLC
  • The rights and responsibilities of your members
  • The voting powers of your members
  • Your method of allocating your LLC’s profit and loss amongst your members
  • The management provisions for your LLC
  • The rules used when holding meetings and the taking of votes
  • The provisions for a buy-sell or buyout. This will determine what takes place when one of the LLC members dies or becomes disabled, or simply wishes to sell off his or her interests.

These decisions may seem obvious, but without them being written into an LLC operating agreement, all sorts of problems could unexpectedly erupt when a vital business decision has to be made.

How to Include the Percentages of Ownership in Your LLC Operating Agreement

The owner(s) of your LLC typically make(s) contributions in the form of services, property, or cash to a new business so that it can get off the ground. In return, each of the LLC members will expect to receive a percentage of the ownership in the LLC’s assets. It is common for members to receive ownership percentages which equate to the proportion of their capital contribution. An LLC is not tied to this, however, and you have the freedom to make your own decisions. It does not take much to realize how important it is to include this information in the LLC operating agreement.

How Distributive Shares Are Allocated Should Be Included in the LLC's Operating Agreement

As well as being apportioned ownership interests as an exchange for capital contributions, the owners of LLCs also gain shares of any of the profits and losses of the LLC. These are referred to as "distributive shares.” It is quite usual in an operating agreement for the distributive shares belonging to each of the LLC’s owners to equate to the percentage he or she owns of the LLC.

For Example...

Jean owns just 35 percent of the LLC, so she only receives 35 percent of any profit or loss. However, Jasper is allowed 65 percent of the profit and loss of the LLC because he owns 65 percent of the LLC.

Your LLC may wish to allocate distributive shares that do not represent the percentage interest that the owners have in that LLC. There are special allocation rules set by your state that need to be followed.

Other Details Needed in Your LLC Operating Agreement Regarding Profit and Loss

  • How much of your LLC's allocated profit (your members' distributive shares) has to be handed out to your LLC members annually?
  • Can your members expect their LLC to pay out to them a sufficient amount that will cover any income tax they are likely to owe on the year's allocation of the LLC’s profits? (Any LLC owner is similar to a partner who is part of a partnership, and is required to pay the required income tax on the full value of any profits that have been "allocated" to him or her and not only on profit that is paid out. When any profit is fed back into a business and is not paid out, it is still treated as the owner’s taxable income, in relation to the allocated proportion.)
  • Will profit distribution take place on a regular basis or are owners entitled to take out money any time from the business’s profits?

Voting Rights Become a Vital Part of an LLC Operating Agreement

Usually, management decisions in an LLC are quite informal, but there are times when a decision becomes so important or possibly controversial that there is a need for a formal vote. This is when it is vital to ensure that voting rights are clearly outlined in your LLC operating agreement.

  • Members’ voting powers correspond to the percentage interest they each have in the business; or
  • Each member is given one vote which is referred to as "per capita."

Usually, an LLC determines the voting rights of their members in relation to each member’s ownership interests. Whatever you select for your LLC, you must ensure that your LLC operating agreement indicates the amount of voting power that has been given to each member. Another important feature that should not be missed out is whether a unanimous decision or a majority of votes is required to reach a decision or resolve an issue.

Ownership Changes Cannot Be Neglected, so Plan Ahead

Many owners who are new to the world of business often overlook what would happen if an owner dies, retires, or makes a decision to sell his or her interest in the LLC. An LLC operating agreement should include a buyout plan which encompasses the rules that determine what happens if a member exits the LLC for any number of reasons.

If you think an LLC operating agreement is not necessary, do not get a shock if you have to solve an LLC issue using your state’s default rules.

Your State's Statutes Define the Default Arrangement for an LLC

If your LLC members have decided against writing an operating agreement, or the agreement you have does not cover something that has cropped up in your LLC, then this is where your state’s default laws will be relevant. These provisions are able to take control over how your LLC is operated and structured. This means that your LLC may find that it is forced to operate under rules that its members never intended.

A well-researched and compiled LLC operating agreement can put an end to all these obstacles.

You Can Amend an Operating Agreement in Some States

California LLCs have changed their statutes too. The new law enforces requirements on an LLC manager’s authority so that any decisions that fall outside the usual running of an LLC need its members’ unanimous approval. California’s LLCs can opt out of these restrictions by either adopting or amending their operating agreement to state what authority their managers have and what they consider to be an extraordinary transaction.

An Operating Agreement Must Be Up to Date

Management of your LLC is just one of the areas where your state’s default requirements could come into conflict with your LLC members’ opinion of how the LLC should function. There is only one way that will guarantee that your LLC will function as your members would prefer, and that is to draw up an operating agreement which includes all the crucial areas, from financial to management. You should also remember to review your operating agreement every year so that it will reflect the wishes of its members and address all the areas where its members may want to circumvent the state’s default law.

If you don’t have a well-crafted, comprehensive operating agreement, it could end up in confusion and irreconcilable disagreement at a vital time in your LLC's life. Ensure all parties to the operating agreement sign it, even if it is not compulsory in your state. If you want your LLC to succeed, don’t delay. Organize it now and fill in the required forms before it is too late.

How To Create Your LLC Operating Agreement

Get started now and create your agreement in just minutes online using our LLC operating agreement template.