LLC operating agreement: what it must cover, and when a template isn't enough

The articles of organization create your LLC. The operating agreement decides how it runs. It's the document that says who owns what, who makes which decisions, how money comes out, and what happens when an owner wants to leave, dies or falls out with the others.

Most states don't make you file it, and many don't require you to have one at all. Have one anyway. Without it, your state's default rules fill the gaps, and they rarely match what the owners would have chosen.

What an operating agreement is for

An operating agreement is a contract between the LLC's members, and between the members and the LLC. It does three jobs.

• It replaces your state's default rules. Every state's LLC law includes default terms that apply when the members haven't agreed otherwise. Those defaults might split profits by headcount rather than investment, or require everyone to agree to decisions you'd rather leave to one manager.
• It supports your liability protection. Courts sometimes ignore an LLC's separate existence when the owner treats it as a personal piggy bank. A signed agreement, followed in practice, is evidence that the LLC is a real, separate business.
• It settles disputes in advance. Disagreements are far easier to resolve when the answer was written down while everyone still got along.

Which states require one

The rules vary. A few examples show the range.

• New York requires the members to adopt a written operating agreement before, at the time of, or within 90 days after filing the articles of organization.
• Delaware defines an LLC agreement broadly as any agreement of the members, written, oral or implied. That's flexible, but an unwritten agreement is hard to prove.
• Many other states don't require one, and simply apply their default rules if there isn't one.

Whatever your state says, banks often ask to see an operating agreement when you open a business account, especially for a multi-member LLC. The IRS doesn't need it, but your accountant may want to read it to understand how profits are allocated.

What every operating agreement should cover

These sections appear in nearly every agreement, whatever the number of members.

1. Formation details. The LLC's name, state, principal office, registered agent and the date it was formed.
2. Purpose. Usually broad, such as "any lawful business," so you don't have to amend it every time the business changes direction.
3. Members and ownership. Who the members are and what percentage each owns, often in a schedule that's easy to update.
4. Capital contributions. What each member put in, whether more can be required later, and what happens if someone can't pay.
5. Allocations and distributions. How profit and loss are allocated for tax, and when and how cash is paid out. These don't have to match ownership percentages, but if they don't, an accountant should check the wording.
6. Management. Whether the LLC is member-managed, with every member able to act for it, or manager-managed, with one or more managers running it.
7. Voting. Which decisions need a majority, which need everyone, and how votes are counted.
8. Transfers. Whether a member can sell or give away their share, and to whom, usually with the other members' consent or a right of first refusal.
9. Dissolution. What ends the LLC, and how its assets are divided when it winds up.
10. Indemnification. Whether the LLC covers members and managers for costs they incur acting in good faith on its behalf.

The single-member operating agreement

With only one owner, there's nobody to disagree with, so the agreement is shorter. It still earns its place.

The main job is showing that the LLC is separate from you. The agreement should say that the LLC owns its own assets, keeps its own bank account and records, and that you act on its behalf as its member or manager. Then live up to it: pay business expenses from the business account, and record money you take out as distributions.

The second job is continuity. Say who can step in to run the business, or wind it up, if you die or become unable to act. Without that, your family may need a court's permission just to access the business account.

A template works well here. Several formation services include one, such as the agreement in Northwest's $39 formation package, and legal document services like Rocket Lawyer include operating agreements in memberships that start at $149 a year or $34.99 a month.

The multi-member operating agreement

With two or more owners, the agreement becomes the most important document the LLC has. These are the clauses that matter most.

What happens when someone leaves

A buy-sell clause decides what happens when a member wants out, dies, becomes disabled, divorces or goes bankrupt. It sets who can buy the departing member's share, how the price is worked out, and how it's paid, often in installments so the business isn't drained. Without one, the remaining owners can end up in business with a former partner's heirs or ex-spouse.

How the price is set

"Fair market value" sounds fair but invites an argument. Many agreements use a formula, an agreed annual valuation, or an appraiser chosen by a set method. Whatever you choose, decide it now.

Deadlock

Two equal owners who disagree can paralyze the business. Common solutions include a tie-breaking vote for a named person, mediation, or a "shotgun" clause where one owner names a price and the other must either buy or sell at it.

Vesting for founders

If one founder might leave early, consider having ownership vest over time, the way startup equity often does, so someone who walks away after three months doesn't keep half the company.

Non-compete and confidentiality

Whether members can run competing businesses, and how they treat confidential information. These clauses are enforceable to different degrees in different states, so they're worth an attorney's look.

This is where templates fall short. Each of these choices depends on the owners, the business and the state, and a dispute over any of them costs far more than having them drafted properly.

The tax clauses worth including

A multi-member LLC is taxed as a partnership by default, and a few tax provisions belong in its agreement.

• The partnership representative. Under the IRS's partnership audit rules, every partnership names one person to deal with the IRS in an audit, with power to bind the partnership. The agreement should say who that is and how they must keep the other members informed.
• Tax distributions. Members owe tax on their share of profit whether or not cash is paid out. Many agreements require the LLC to distribute at least enough to cover each member's tax on that share.
• Tax elections. If the members might later elect S corporation status, the agreement should say who can make that decision and how. Our guide to when to elect S corp status covers the trade-offs.

Mistakes owners make with operating agreements

• Signing a template without reading it. Templates include clauses written for someone else's business, such as a manager-managed structure you don't use or transfer rules that don't fit.
• Equal splits by default. Two founders who put in different amounts of money or time often split 50/50 to avoid an awkward conversation, then have it later at a worse time.
• Never updating it. A member leaves, a new one joins, or the business takes on a loan, and the agreement still describes how things were on day one.
• Ignoring it in practice. Taking money out informally, making decisions the agreement reserves for a vote, or mixing personal and business funds undermines the very protection the agreement is meant to support.

Template or attorney?

• Single member, simple business: a template is fine. Read every clause and fill in the continuity section.
• Two or more members: have an attorney draft it, or at least review your draft, with particular attention to buyouts, valuation and deadlock.
• Outside investors, unequal contributions, or members in different states or countries: an attorney, without question.

Expect to sign the agreement when the LLC is formed, and to update it whenever ownership changes, a member joins or leaves, or the way you run the business changes in a way the agreement doesn't cover.

Keeping it useful

An operating agreement only protects you if you follow it. Keep a signed copy with the LLC's records, give each member a copy, and record major decisions in writing, even as a short email to all members. When the business changes, amend the agreement rather than letting practice drift away from it.

If you're still forming the LLC, our guide to starting an LLC shows where the agreement fits in the order of steps, and our comparison of LLCs, S corps and C corps covers whether an LLC is the right structure in the first place.