Why Your LLC Needs an Operating Agreement

Congratulations! You have decided to form a limited liability company (LLC) to run your business. After completing your state formation process, your LLC needs to have the right documentation in place. An operating agreement, sometimes called a company agreement, is a legal document that describes and outlines how an LLC will run, and is an essential document for owning and operating an LLC. Operating agreements are not required in most states; however, that should not dissuade you from creating one. Having an operating agreement can provide your business with many benefits and can help you avoid significant problems.

• An operating agreement allows you to customize how your business operates. A key advantage of LLCs is the ability to create flexible business structures. However, when you fail to create an operating agreement, you subject your business to the default rules set out in your state’s LLC statute. On the other hand, if you draft an operating agreement, you can customize a variety of provisions related to the management and ownership of your business. LLC owners, referred to as members, can customize and identify

  1. how profits and losses are split among members,

  2. restrictions on the transfer of ownership interests,

  3. methods for paying for business taxes, and

  4. signatories for business accounts.

This is not an all-inclusive list. In general, most aspects of an LLC can be designed to reflect the members’ desires, unless the state statute that governs the LLC specifically prohibits contractual alteration of a specific right or duty.

• An operating agreement may help maintain members’ limited liability. An important benefit of LLCs is that LLC members have limited liability—that is, they will not be held liable for the LLC’s obligations. However, limited liability may be lost if steps are not taken to maintain the business as an entity that is separate from its owners. One practical step is creating and implementing an operating agreement. Evidence that an LLC adheres to an operating agreement has supported the recognition of the limited liability of its members in the past. Steps to clarify the legal separation between business and owner are especially crucial for single-member LLCs, which have only one owner. When there is only one member, the limited liability veil is more easily pierced. Intentional planning, including the drafting of an operating agreement, is required to strengthen the shield and preserve the limited liability of the member.

• An operating agreement identifies how decisions will be made. Another critical part of the operating agreement is the provisions that address how decisions are made. These clauses provide immense value, particularly for multimember LLCs and manager-managed LLCs, where multiple people may be involved in making management decisions. In those instances, it is vital to identify who has the power to make certain decisions. For example, if you have multiple LLC members, you may want to create two or more ownership classes with varying degrees of voting power. Additionally, if you have a manager-managed LLC, you may want to identify certain decisions that LLC managers are authorized to make while leaving other decisions for LLC members. Finally, you may also want to determine how matters like voting deadlocks will be addressed. Will the LLC provide tie-breaking powers to specific managers or members in the LLC, or will they consult with an independent third party? These issues should be addressed in your operating agreement.

• Other institutions may require an operating agreement. Even though most states do not require LLC operating agreements to be created or filed, some institutions or individuals may impose such a requirement before engaging in a business transaction with your LLC. Some banks require a copy of the operating agreement before opening business accounts for an LLC. Some investors and similarly situated institutions have also required copies of operating agreements when evaluating whether to invest in a business. These institutions or individuals may want extra reassurance and proof of how the company operates, which can be provided by the LLC operating agreement. It is essential to have an LLC operating agreement in place to enable your LLC to take full advantage of business opportunities when they arise.

Call Summa Business Law Today

Utah business attorney, Paul Sparks, understands how to draft operating agreements that will help your business operate efficiently and avoid expensive litigation. A conversation with him will enable you to identify the key features your LLC needs. Call Summa Business Law and schedule a virtual appointment today.