What Is An Operating Agreement And Why Do You Need One?

Here's why you need an operating agreement. Image: Flickr
Here’s why you need an operating agreement. Image: Flickr

The LLC is the most popular entity to create a business and an operating agreement is a very crucial part of forming an LLC.

The document delineates the structure of your working and financial relationships with co-owners, including loss and profit sharing, ownership percentages, and the method for a member or partner to leave the business.

Although an operating agreement isn’t mandatory in most states, it’s a prudent business practice, particularly if you’re beginning a multi-member LLC.

Numerous people don’t anticipate legal issues with family or friends in their business; however, lawyers will advise you to have an agreement in place. Here’s what you should know about an operating agreement.

What an Operating Agreement Includes

  • Responsibilities and Rights of Managers and Members

An LLC’s members are usually its owners, however; those members can appoint a manager to operate the company if they don’t want involvement in its daily management. The LLC’s certification of formation will probably include a section where you indicate whether a manager or member is directing the company.

Nevertheless, you’ll still need to identify the responsibilities and role of the members while operating the company. Furthermore, you should include a plan to help resolve any disagreements between members or managers and members.

  • Distribution of Losses and Profits

LLC owners receive shares of losses and profits or distributive shares. Operating agreements typically indicate that every owner’s distributive share matches their proportion of ownership in the LLC. If the LLC desires different arrangements, the company should follow regulations for special allocations.

Additionally, the agreement should specify the parameters of profit distribution and means of income tax payment because these areas will be particularly relevant to the daily and monthly working of every owner.

  • Voting Rights

Besides establishing the outcome needed for a vote to pass, the agreement must outline the distribution of voting rights between members. This typically occurs in two ways where every member obtains a single vote or the value of every member’s voting weight depends on the percentage of business interest. It’s important to establish these things in advance because in some instances, a formal vote may be necessary to resolve some issues.

Why You Need an Operating Agreement

  • Observing the Essential Formalities

Depending on the situations, failing to follow some corporate formalities will lead to the loss the restricted liability enjoyed by LLC business owners. The operating agreement is a significant step toward adopting the essential formalities because it will outline the formalities for you.

A well-drafted agreement will make it easier to differentiate your activities as an individual from your roles as a member. This is particularly true when it comes to a sole member.

If you comingle an LLC’s activities, particularly its banking activities with the activities of other individuals and entities, you face the likelihood of losing your protection of limited liability.

  • Status Protection

If your LLC faces a lawsuit, an operating agreement will make sure the court upholds the owners’ limited protection. This is particularly vital if the LLC is running as a single-member entity, to clearly differentiate the business as an LLC rather than a sole proprietorship, which doesn’t enjoy restricted liability protection.

  • Avoid Roadblocks and Management Disputes

One of the main reasons LLCs have gained popularity is the flexibility in implementing the business management. You can integrate management clauses that assign different managers varied authority.

For instance, if you are a business-savvy entrepreneur who has decided to collaborate with a tech professional, you can take up the management and financial aspect and assign your partner research and development. This way, neither of you will be responsible for an area in which you lack experience and knowledge.

  • Non-competes

An agreement also helps you protect the business by including a non-compete clause that can prevent the company members from competing with the LLC.

Final Thoughts

Although numerous states don’t require an operating agreement, it doesn’t mean it’s not important. You’ll discover it offers numerous benefits as outlined. If you don’t know what an operating agreement entails, this guide will prove invaluable.

Dailey Bookkeeping Services is a Xero Certified SILVER Partner and a QuickBooks Online Certified Advisor, so if we can help you with your LLC needs, just give us a call, we would love to help you!  The owner, Jacqueline Dailey is a Certified Public Bookkeeper, an Advanced Certified QuickBooks and QuickBooks Online ProAdvisor, a Sleeter Group Certified QuickBooks Consultant and a Xero Certified Silver Partner. We work remotely so we can work with any company located in the U.S. If we can help you with this process or provide you with custom reporting, please give us a call. If we cannot help you, we will refer you to someone who can!  Feel free to visit our website at http://www.daileybookkeeping.com.

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