Should Your LLC Have an Operating Agreement?
In the past two or three years (which interestingly coincides with the Covid pandemic), I have received more frequent inquiries from clients seeking legal and tax advice regarding problematic situations among owners of multi-member LLCs. Though the specifics of these scenarios differ greatly, typically a well-drafted operating agreement could have prevented much of the dissatisfaction among ownership that tends to arise over time. But does every LLC need an operating agreement? I don’t aim to answer that question for your particular LLC in this article, but do want to provide some things that small business owners should consider.
What Happens When an LLC Doesn’t Have an Operating Agreement?
LLCs have become so easy and inexpensive to form that people oftentimes create them on the basis of an idea that has not yet become a business. It is contemplated in the laws of each state that LLCs will be created that have no formal arrangement among ownership for how that entity will be governed. For this reason, each state has default provisions governing LLCs in the absence of an operating agreement. When an operating agreement does exist, it generally supersedes these default state law provisions.
Most LLC owners do not look at the state statutes in the jurisdiction of formation—they pay the approximate $200 fee and form the entity without regard to the laws to which their entity is subject (and to which they are subject as the owners of that entity). This can create quite a bit of surprise in situations where circumstances go awry down the road.
Why Is Having an Operating Agreement Beneficial?
Establishing an operating agreement can be beneficial for even the owner of a single-member LLC who owns 100% of the company. Why is this? Because if another owner or investor comes along, there are already guidelines established for how the entity will be governed. Furthermore, the better the corporate formalities of the entity, the less likely the corporate veil can be pierced by potential plaintiffs and/or creditors of the LLC.
When an LLC has more than one member, having an operating agreement is paramount. Sometimes in circumstances where the only owners of the entity are spouses there is no operating agreement because the owners are within the same household and typically are accustomed to successfully making decisions together (though I still see it as a best practice for spouses who co-own an LLC to have an operating agreement). Spouses have the advantage of divorce proceedings that generally split assets in an equitable manner as approved by a court if circumstances don’t work out long-term. But when businesses are not co-owned by spouses, making decisions and dissolving the business can be significantly more difficult. In businesses that involve more than one owner, whether it is seen as right or wrong, at least one of these individuals is typically operating in his or her own self-interest. Given that, there are situations that will inevitably arise where one LLC member feels he is not receiving enough of the benefits of ownership and/or where he may be enduring too much of the burdens of ownership. Usually, at the LLC’s formation stage, everyone is on good terms and more agreeable than they may be down the road. Getting the terms ironed out in the formation stage can result in significantly less hassle, financial loss, and legal fees down the road.
Should an Attorney Draft the Operating Agreement?
Generally, when small businesses start, budget is one of the primary concerns of the owner(s). Most are aware that you can purchase a standard operating agreement on LegalZoom or peruse the internet and find one. While those options might save money at the initial formation of the entity, that decision can result in catastrophic consequences down the road. Standard form agreements, or custom operating agreements created and tailored for a different business entity, do not consider your particular type of business; the relationships among the parties; the personalities involved; the risks, benefits, and opportunities involved; and the concerns of the owners. Additionally, oftentimes small business owners aren’t aware of the tax consequences of some of their formation choices as well. Hiring an attorney to put the agreement together can result in a more comprehensive agreement that contemplates your specific circumstances and protects you a lot better in the event that things go wrong down the road.
If you need a consultation regarding whether to create an operating agreement, how to handle an LLC membership that has gone awry, or need assistance drafting or reviewing an operating agreement, feel free to contact me using the form below.
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