First off, an Operating Agreement is the controlling document for the members of a Limited Liability Company (LLC). The instructions contained within the Operating Agreement determine how the business is run, how much earnings a member gets, what rights and responsibilities the members have, and much more. This article will only outline the most common terms in an Operating Agreement, but the possibilities are endless.
You’ve probably seen this in statutes, contracts and all sorts of legal documents, so an Operating Agreement is no different. Since it is such a controlling document, it is important that every member is clear on what a term means. An Operating Agreement is only as effective as it is clear to the members; therefore, this is one of the more important sections when interpreting all the other parts of the agreement.
This section is important when considering profits and losses later on as well as a place to illustrate how you value each member’s contribution. Contributions can be labor, assets, cash and promises, and they can be valued in any way that the agreement states. There are some separate rules when it comes to recognizing labor as a capital contribution in the tax planning aspect, but that’s not an issue for allocating profits and losses.
Arguably one of the most important clauses in the Operating Agreement, this is where you determine who owns what share of the LLC. There are numerous ways you can divide up the company from basing it on contribution amounts to setting a strict percent value to each member. What matters is having a clear method to determine how much each member owns and illustrating how much each will still have if additional members are included in the LLC at a later date.
Distributions of Profits and Losses
This is the section that members care the most about because it determines how much they get paid. This is also how you determine how much you have to report you earned on your taxes or how much you can subtract as a loss. Often times, the profits and losses are either divided equally amongst the members or divided based upon how much each member contributed.
How Ownership Can or Cannot Be Transferred
First and foremost, the ability to transfer ownership is limited in most Operating Agreements to avoid certain SEC rules as well as unwanted owners dictating the way the company is run. From my experience, I’ve found that most people like to generally limit the ability to transfer ownership and create preemptive rights as well as rights of first refusal when a member passes away, files for bankruptcy and many other situations where he or she may lose ownership.
This is also the portion of the Operating Agreement where the determination of company or unit value is determined, if any, because this area can be very complex and litigation heavy if there is a dispute.
There are numerous tax sections that can be utilized when starting a small business. In order to take advantage of these provisions, your company must elect to do so, in many cases. Therefore, it is important to make that election and the requirements to obtain that election be clearly stated in the Operating Agreement.
When a Member Leaves
This clause is often overlooked, but it is a heavy one. Members leave sometimes, and it is important to have a plan in place for what the company will do if a member does leave. Sometimes, the other members can buy his share of the company from him. Other times, he is allowed to sell it on his own. What happens isn’t as important as having a plan for when it does.
Another crucial part of an Operating Agreement. Members need to know what their rights are, from voting rights to management rights. If it is clearly outlined in the Operating Agreement, it is less likely a member will overstep her authority and cause trouble for the LLC. Commonly associated with this section is the member’s duties section where each member is required to do something as part of the ongoing company. If one member is tasked with the technical side of a company and the other is in charge of the business side, they should know that and have some form of duty imposed in the agreement.
It is common to outline in the Operating Agreement when and how meetings are held. This clause seems less important than the others, but can help with scheduling later if the members were on notice from the start when the meetings were to be held. In this section, you may also outline how voting works, what quorum is, what percent vote is needed to pass resolutions and election of company positions.
The larger the company, the bigger this issue becomes. Records are the memory of the company, so it is important to keep the records in a manner that professionals can comprehend. To do this, you need to be organized from the start, and one good way of being organized is following general practices while ensuring they are required in your Operating Agreement. Getting audited is bad enough, but getting audited when you have poor record keeping methods could be fatal to the company.
Companies close down. It happens, and when it does, it is important to have a plan in place on how to sell off assets or distribute assets to the members. The last thing a failing company wants is to have the members suing each other over who gets which assets.
When A Member Joins
Also important if the LLC ever plans to expand. In this section, the agreement would outline how a member joins, what share he would be entitled to and how his entrance affects the rights and duties of the other members.
Arbitration and Claims by Members
This section is included in nearly every complex Operating Agreement. It ensures that each member knows how to make a claim against the company or another member and that he or she is required to use binding arbitration to settle that claim. This saves time and money for all parties involved.
Other General Provisions
Other sections will be needed depending on the nature of the company. If it isn’t already mentioned in the Articles of Organization, it would be useful to outline how to amend or modify the Operating Agreement and the purpose of the company.
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