LLC Operating Agreements for Beginners

A Basic Overview of the Importance of LLC Operating Agreements

LLC Operating Agreement
An LLC operating agreement is the document or contract that serves as the rules by which a business is run. It must be signed and approved by the LLC members and it is always advisable to consult an attorney. Getty Images

All limited liability companies, or LLCs, are supposed to be governed by a contract that the investors sign amongst themselves known an LLC operating agreement. In practice and theory, an LLC operating agreement is essentially identical to the limited partnership agreement that governs limited partnerships.

What Are Some Common Provisions in LLC Operating Agreements?

Many, if not most, LLC operating agreements are going to contain important provisions and information including, but not limited to, the following:

  • LLC operating agreements will contain ownership information about members of the limited liability company.  Specifically, the percentage, or "proportionate interest", of each member of the company.  (In an LLC, owners are referred to as members, not stockholders, since the equity is made up of membership units, not common stock shares.)
  • LLC operating agreements will explain the breakdown of the profit and loss allocation that will be used by the firm.  Unlike a traditional corporation, an LLC operating agreement doesn’t have to require that profits and losses are divided by ownership. Special arrangements can be made, such as letting one investor bear the burden of all the losses or having another get paid a performance incentive bonus based upon the company’s results. This provides tremendous flexibility, especially for the structuring of hedge funds and family investment companies or family limited partnerships.
  • LLC operating agreements will provide an overview of how, and under what conditions, dividends of distributions can and will be paid to members.  An LLC operating agreement can call for regular, required dividend payouts, no dividends at all, or dividends sent solely at the discretion of the managers if it is a manager-run limited liability company.  (If an LLC has opted for partnership taxation rather than corporate taxation, the LLC would pay distributions, not dividends.  Distributions are taxed differently depending upon what funded them.  Each year, the LLC is required to give members a form K-1 in such a situation, which the members will then file with their personal taxes.)
  • LLC operating agreements will explain any required meetings the managers or members must regularly schedule or attend  This can include an annual meeting, a quarterly review, or almost anything else the parties involved want to work out between themselves during the establishment or modification of the agreement.
  • LLC operating agreements will place restrictions on the business.  The members of a limited liability company can set restrictions on the manager or managers' authority including limiting the industries in which a company can do business, requiring a certain dollar amount of working capital to reduce risk, forbidding specific types of investments such as publicly traded common stock, or even requiring that the company never engage in the selling of certain types of products or services such as tobacco. Anything that is legal and can be put in a contract is fair game for an LLC operating agreement.
  • LLC operating agreements will explain the dissolution dates, plan, and procedures.  Some firms only need to be in business for a specific span of time.  The limited liability company can explicitly acknowledge its termination date in the operating agreement.  It can also include performance-based terminations such as calling for the end of the firm if it fails to meet required build-out dates or targets for sales, profits, or other financial ratios.

    There is a lot more but you get a general idea.  LLC operating agreements will often include processes for handling or forbidding shares of membership units without the prior approval of a certain percentage of other members; perhaps giving them the right of first refusal.  It might include details about a guarantee payment (salary) for certain managing members.  It could grant authority to the manager or managers allowing him, her, or them to issue "side pocket" allocations so only certain members participate in the acquisitions of specific assets.  Short of something that is illegal or otherwise prohibited by law and regulation, there's almost no end to the imagination you can bring to a well-crafted limited liability company operating agreement.

    Make Sure To Work With a Good Attorney When Drafting or Reviewing an LLC Operating Agreement

    The trick is to make sure you work with the best, the most qualified lawyer you can find.

     Small details in the wording or structure of the firm can mean the difference between a peaceful, low-stress resolution and a multi-year extended battle that drains time, money, and goodwill.  The more Machiavellian can even structure their LLC operating agreements to protect the family against unforeseen family strife by turning the firm into a weapon against outsiders.  My own attorney once told me a story about a client who left his stake of the family holding company to his mistress and did so in a way that the other members, his children, couldn't block the transfer.  Instead, as the controlling members, they removed the provision in the LLC operating agreement requiring annual tax distributions.  Each of the kids was financially independent and could afford the look-through tax bill they incurred.

    [Side note if you are unfamiliar with partnership tax rules.  For limited liability companies that opt to be taxed as a partnership, the IRS views the individual member as the economic unit.  This means the member must pay taxes on his or her share of any income or gains even if the LLC does not distribute any cash to cover it.  If your cut of an LLC generated $100,000 in operating profit and you're in the 25% bracket, all else equal, you have to send $25,000 to the IRS even if the LLC doesn't distribute any of that $100,000 in earnings.  As a practical matter, most LLC operating agreements include a tax distribution clause to avoid a situation where the managers won't pay a distribution and the members suddenly owe huge taxes they don't have the liquidity to cover.]

    The mistress, on the other hand, was not.  Her sole asset consisted of the millions of dollars in membership equity she had been left in this firm.  As the profits piled up, the tax bills grew larger, and she couldn't cover the Federal, state, and local debts that were going unpaid, the financial stress of living as if she were bankrupt despite being rich on paper caused her to wash her hands of the family and sell out to the kids at a severely depressed price.  Right or wrong, fair or unfair, the LLC operating agreement is what made that possible.  Had a tax provision been in place, the mistress would have been protected.  Had a right of first refusal on inherited shares been in place, the kids would have been able to buy her off and avoid her having any role in the family for the years of which she remained a stakeholder.

    More Information about Limited Liability Companies or LLCs

    For more information, read our New Investor's Guide to Limited Liability Companies or LLCs.