Why having an operating agreement should be at the top of your 2017 to-do list
By Mark Williams
Most states don’t require limited liability companies (LLCs) to have written operating agreements, but the story of a recent tragic accident underscores why they are so important.
A husband and wife, owners of a small business, were badly injured and killed, respectively, in a car accident. The couple’s family members took over the business, but with no operating agreement, they had nothing to guide them. They didn’t even know how to pay employees.
Even with the help of a trusted advisor, it took weeks for the family to sort out the paperwork. The complicated process came at a time when the family already was grieving the loss of one relative and helping another recover from serious injuries.
A simple document would have saved devastated family members from this unnecessary hassle: that written operating agreement.
For any business owner, especially among baby boomers considering retirement, it’s critical to put in writing an operating agreement to guide the business today and in the future. If your LLC doesn’t have an adopted document, it’s time to put signing one at the top of your 2017 to-do list.
What is an operating agreement?
Like corporate bylaws or a partnership agreement, an operating agreement spells out an LLC’s operating rules and the rights and duties of its managers. It can address everything from how the LLC is managed to how key business decisions are made and the procedure for transferring ownership interests.
Why do LLCs need one?
States typically don’t mandate that every LLC adopt a written operating agreement. But, if none exists or if it doesn’t cover every essential area of a business, then the one-size-fits-all provisions of a state’s LLC law kick in, controlling a business’ structure and operations, including the percentage of ownership, voting rights and the distribution of profits and losses.
Business owners should be wary even if they agree with their state’s LLC law, because those regulations are constantly changing. Consider these updates during the past few years to default provisions across the country:
- Alabama made changes to its LLC statutes that require LLCs to have an operating agreement — written, oral or implied. That means that if no written agreement exists, courts can infer members’ wishes simply from their actions.
- In California, a recent amendment to its LLC law says that decisions made outside the usual course of business must have unanimous approval from all members. LLCs can avoid this rule with a written operating agreement that lays out the power of each of the managers.
- In New Jersey, when members resign, they no longer have the right to receive fair value of the membership interest. With the appropriate provision in a written operating agreement, members who resign can cash out the membership interest.
Are they really necessary for single-member LLCs?
You might not have any members to argue with, but as a single-member LLC you should sign a written operating agreement. A state’s default LLC statutes will still apply to you if your business doesn’t have one. What’s more, you could lose out on the main benefit of an LLC: limited liability protection. Having a written operating agreement is an indication that the LLC is separate from its sole owner. If a court does not think the LLC is being treated as a separate entity it could consider your business a sole proprietorship, which means you face losing personal assets in a business dispute.
Three essentials for any written operating agreement
If you’re ready to get started on writing an operating agreement, it’s critical to work with lawyers and trusted advisors to ensure the agreement covers every aspect of the business, including any rules for making amendments.
Operating Agreements vary in complexity depending on the business, but there are three essential pieces to every adopted operating agreement.
- What are the LLC’s different kinds of ownership interests? The operating agreement should spell out the various ownership interests that govern, for instance, the allocation of profits and voting rights of each member.
- How are decisions made? By default, LLCs are member-managed, which means that all members must vote on all decisions. That’s fine when it’s a big decision, such as a merger, but it becomes cumbersome on day-to-day matters. An operating agreement can spell out who has the authority to make those smaller decisions.
- How is the money handled? An operating agreement should define how profits, losses and tax-related items are allocated among members.
Operating agreements also typically address the points at which members take specific actions, such as electing or removing members, and when and how an LLC might be dissolved.
In other words, a written operating agreement is all about controlling the future of a business — its operations and its continuity — in the case of a tragic accident or just the usual ebb and flow of business. An adopted agreement ensures that LLC members, not default state provisions, are in full command of their business’s destiny.
Mark Williams, customer service operations director at Wolters Kluwer’s BizFilings, leads a team of experts who help small businesses incorporate and stay in compliance.