Making sense of the operating agreement of a limited liability company
Browse any introductory textbook on economics or corporate finance and you’ll find a section that discusses three legal structures—sole proprietorships, partnerships, and corporations—under which businesses typically operate. However, these introductory textbooks often exclude a fourth, newer structure, the Limited Liability Company, or LLC for short.
Limited Liability Company Summary
The Limited Liability Company is, in a sense, an entity that is a hybrid of a Partnership and a Corporation and, as a result, is one that provides its organizers with some of the benefits of both. Like a partnership, a limited liability company is generally created as a transfer entity. This means that all profits and losses of the business are included in the individual federal and state income taxes of its owners. If you were one of the owners, for example, your LLC’s profits or losses would appear on your 1040 as income and would be taxed at your individual tax rate.
This nature of transferring profits and losses allows you to avoid the double taxation problems commonly associated with a corporation. Another important benefit of an LLC is that it literally limits the liabilities of each owner. The owners of a Limited Liability Company are not responsible for the debts and other obligations of the company, nor are they legally responsible for the debts and obligations of the other owners. Investors and owners only risk losing the capital they contributed.
The Operating Agreement
The Operating Agreement is simply an agreement between the founding members that specifies the obligations and rights of each member, the way in which the company will be governed and, among other things, the distribution of profits and losses among the members. Here’s a quick overview of the main sections of an operating agreement.
organizational issues
This section (a) sets forth the formation of the business, (b) specifies any restrictions on the name of the LLC, (c) specifies the registered agent and registered office of the business, (d) specifies the corporate headquarters of the business, (e) discusses its purpose and any restrictions on its purpose, and (f) describes the duration of the company. Given the uncertain nature of start-ups, it must be explicitly stated that there are no limitations on the type of business the LLC can conduct. Many times the idea you start with will not be the idea that makes your business solvent.
Members and Capital Structure
This section specifies (a) the name and address of each of the members, (b) the percentage ownership of each member in the LLC, (c) the initial capital contribution made by each member and whether the members must, from time to time, make additional capital contributions, (d) whether loans or services are considered capital contributions, (e) the terms under which new members are added, and (f) whether members have limited liabilities and whether they are personally responsible for the obligations of other members.
Company Governance
This section specifies (a) whether the company will be managed by its members or whether day-to-day management will be delegated to employees, (b) the rules and procedures governing formal company meetings, (c) actions, such as the sale of the company, which require the unanimous approval of the members, (d) the amount of time each member must dedicate to the company, and (e) the rules governing the use and withdrawal of company funds.
Accounting and Records
This section determines how often and for how long financial records are available for member inspection. More importantly, the section specifies whether the LLC is classified as a transfer entity, which member is responsible for tax-related matters, and what the company’s tax year will be (generally January 1 through December 31).
Allocations and Distributions
This section specifies (a) the allocation of net income, net loss, or capital gains, (b) the distribution of capital, whether there are restrictions on these withdrawals and how often available cash will be distributed, (c) whether the business can withhold a portion of the cash distribution to comply with federal and state laws, and (d) if members are liable for incorrect or erroneous distributions.
Restrictions on withdrawal and transfer of ownership interests
This section specifies (a) the terms and conditions under which a member may withdraw from the company, (b) the restrictions on the transfer of a member’s ownership interest, and (c) how a purchase price for the company is determined. transfer of ownership interest. .
Dissolution and liquidation
This section specifies (a) the terms under which the business may be dissolved, (b) the manner in which the business will be wound up, (c) and how the assets of the business will be distributed upon winding up of the business.
Long, but not complicated.
Phew! As you can see, the Operating Agreement is a long document. It’s not terribly complicated though. Just remember the need for legal protection and rules for virtually every what-if scenario imaginable. What happens if a member decides to leave? What happens if one, God forbid, dies? What if you want to bring in a new co-owner? All these and many other topics are covered by the Operating Agreement. While you can get a simple agreement through a company like LegalZoom, you shouldn’t operate a Limited Liability Company without one.
