Three Reasons to Have an Operating Agreement

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Nexsen Pruet, PLLC

I get asked this question all the time. Why do I need an Operating Agreement? 

To keep your Limited Liability Company (LLC) in good standing, there’s one very important document you should have - an Operating Agreement. However, I can’t tell you how many entrepreneurs do not take this step and it can cause a ton of headaches later on. I’ll explain why.

For starters, an Operating Agreement outlines the structure of your company, the ownership of each member, helps protect your limited liability status, addresses how disputes are handled/ resolved, and, perhaps most importantly, creates the governing rules of your business. However, California, New York, Missouri, Maine, and Delaware are the only states that require operating agreements. Even though few states require them, it is merely good business practice to execute an Operating Agreement – whether you’re a single-member or multi-member LLC.

There are a number of reasons for doing so but here are just a few:  

Customize Your Business Structure

A great advantage of having an LLC is choosing how you’ll split profits, work-load, distribution of membership interest and more. In more rigid structures like S-Corps or C-Corps, you have less flexibility on how you design the structure. For example, in a C-Corp, if you’ve invested 20% of capital in the company, you’re likely to receive 20% of the profits or losses. An LLC allows you to set this up differently. For example, say that our hypothetical 20% owner actually does 80% of the work, whereas her partner invested 80% but does only 20% of the work. In their Operating Agreement, these partners could choose to split the profits and losses differently – say 50/50 or some other variation.

Guard Your Limited Liability

According to the IRS, a disregarded LLC refers to an LLC owned by a single member. In other words, for taxation purposes, the IRS classifies you as a sole proprietorship not an LLC. However, two of the main benefits of forming an LLC are  limited personal liability, and tax burden.

In an effort to maintain and limit your personal liability, in the event the business is involved in litigation, courts have viewed more favorably a single member LLC that has formalized the business by executing an Operating Agreement and has been operating accordingly. Therefore, the LLC is deserving of the liability protections afforded to it via state law. Thus, not doing so, could have consequences down the road and may even jeopardize your limited liability protection.

Avoid Your State’s Default Rules

If you do not create an LLC Operating Agreement, you will be subject to your state’s default LLC rules. These are one size fits all rules, not tailored to the wants and needs of your business. It is better to take the time and plan out the guidelines best suited for your LLC. No matter what you’re buying, selling, or trading, your company is unique. You worked hard and deserve the opportunity to shape the rules that support goals and objectives of your business. An LLC Operating Agreement allows you to do so. Assuming what’s included is not contrary to the LLC statutes in your state, you get to decide, instead of the state, how the business is operated and how issues are resolved. 

I can’t tell you how many disputes amongst business partners I’ve handled and one of the first documents any lawyer will request is – where’s the Operating or Partnership Agreement? And, in many cases, they do not have one or they purchased an online contract template which is devoid of a dispute resolution provision and other material clauses. Whether you’re just getting started in your new business or your business is doing well, if you haven’t done so already, put a solid agreement in place which can be scaled as your business grows.

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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