What Is An Operating Agreement and Do I Need One?

An operating agreement is a very important part of starting an LLC. This document outlines the structure of your financial and working relationships with co-owners, including ownership percentages, profit and loss sharing, rights and responsibilities, and the exit method for a partner or member to leave the business. By outlining these technicalities ahead of time, you will be better equipped to guard your limited liability status and avoid misunderstandings related to finances and management.

It's important to protect your limited liability status, so creating an operating agreement helps establish that your personal liability is limited, should you be taken to court. This is particularly important in single-member LLCs that might be deemed a sole proprietorship if the formalities of an LLC are not followed. A formally-written operating agreement helps establish that the LLC is a separate entity.

The operating agreement should also define profit sharing and decision-making rights for LLCs with more than one owner. When financial or managerial conflicts arise, it is easier to refer to the operating agreement than to try to work out the problem when there might be hostility between the owners. An operating agreement can allow you to determine what happens with your company if a co-owner dies or becomes incapacitated. Many times, owners are forced to work with the spouses of deceased co-owners because they did not have a plan in place through the operating agreement.

If the operating rules of your company are outlined in your operating agreement, it will override some state "default rules," or state laws that define basic operating rules for an LLC. As an example, Oklahoma default rules require that, unless otherwise provided in the operating agreement, a majority vote is required to make changes to your company's operating agreement. This could have a huge impact on allocation of profit and loss, regardless of initial investment into the LLC. There are several other reasons to develop an operating agreement that works the best for your business from the start.

An LLC operating agreement will control many issues but the most common include the following:

  • Percentage of each member's interests in the LLC
  • Succession planning
  • Members' rights and responsibilities
  • Members' voting powers
  • Allocation of profits and loss
  • Management of the LLC
  • Rules for meetings and voting, and
  • Buyout, or buy-sell, provisions, which determine what happens when a member wants to sell his or her interest, dies, or becomes disabled.

Owners of the LLC also receive shares of profits and losses that are called distributive shares. Typically, operating agreements indicate that each owner's distributive share matches their percentage of ownership in the LLC. If different arrangements are desired, the LLC must follow rules for special allocations. Additionally, the operating agreement should indicate profit distribution parameters and method of income tax payment, as these areas will be especially relevant to the day-to-day and month-to-month working of each owner.

Another issue that the operating agreement will address is voting rights. In addition to determining the outcome required for a vote to pass (majority vs. unanimous), the operating agreement should outline how voting rights should be distributed between members. This is typically done in one of two ways where either, A) each member's voting weight is valued based upon the percentage of interest in the business, or B) each member gets a "per capita" or single vote. Each of these things is important to determine in advance because although the LLC business format lends itself to informal decision making, occasionally a formal vote may be required to resolve certain issues.