Why Every Small Business Needs an Operating Agreement
The fact that an LLC offers flexibility, provides limited liability to its owners, and is treated favorably for tax purposes attracts many entrepreneurs in the United States. Surprisingly, many small business owners fail to make an operating agreement.
Although an operating agreement isn’t required by law in every state, it forms the basis of the organization’s rules for your business. Treat it as the basic set of rules for your LLC.
What Does an Operating Agreement Mean?
Members (owners) of an LLC are connected by a legal contract called an operating agreement. It governs:
- Ownership percentages
- What a member is required to do
- Profit distribution
- Voting rights
- Management structure
- Provisions for coming to an agreement and dissolving the company
Under U.S. state laws, operating agreements play a crucial role in governing a business. Although filing an operating agreement with the Secretary of State is rare, California, New York, and Missouri require all LLCs to have an operating agreement on file, even if it’s not filed with the state.
Is It Required by Law?
| State | Operating Agreement Required? | Must Be in Writing? |
|---|---|---|
| California | Yes | No (can be oral) |
| New York | Yes | Yes |
| Delaware | No | No |
| Texas | No | No |
| Florida | No | No |
| Missouri | Yes | No |
Even in states where it’s not mandatory, U.S. courts recognize operating agreements as enforceable contracts that help avoid default statutory rules.
What Happens Without Having One?
If your LLC doesn’t have an operating agreement, the rules for your business will come from your state’s LLC Act. Often, these guidelines are as follows:
- General and fitting for all things
- Multi-member LLCs often run into problems because of this rule.
- No clear rules for giving out goods, making decisions, or having a vote
Unless otherwise mentioned in an agreement, most state laws give equal ownership and voting rights to all partners regardless of how much they invested.
Example:
Your partner added just $10,000 when you put in $90,000 of your own to start the business. If you don’t have an operating agreement, some states will assume that you and your partner each hold 50% of the business. Such a situation may lead to huge disputes in the days ahead.
Benefits of an Operating Agreement
Let’s break down the key reasons why every small business in the U.S. should have an operating agreement, even if it’s a single-member LLC.
- Supports the personal safety of the owners
The biggest benefit of an LLC is that it protects individuals from debts or lawsuits involving their business. In a single-member LLC with no operating agreement, the courts may view your company as an unnoticed business and expose you to personal liability.
- How State Law Defaults Can Be Changed
The laws’ default rules about LLCs in every state may not be what you want. Through an operating agreement, you can decide how your LLC operates.
- Avoids conflict among people in the organization.
There will always be times when members have conflicting opinions. The document tells everyone their responsibility, voting rules, and how their rewards will be divided—this helps prevent conflicts and makes everything consistent.
- Examines the Intended Way of Distributing Profit and Loss
You have the freedom to share profits differently than the ownership percentages, as long as it’s in the agreement and is not questioned by the IRS.
- Makes Succession Plans
By adding buy-sell provisions, death policies for members, and exit plans to the operating agreement, it can ease the way members leave the business.
What Should Be Included?
| Section | Purpose |
|---|---|
| Company Details | Name, business purpose, principal address, formation date |
| Ownership Structure | Members, ownership percentages, capital contributions |
| Management Structure | Member-managed or manager-managed; responsibilities |
| Voting Rights | How decisions are made, and vote thresholds |
| Profit/Loss Distribution | Who gets what and when |
| Dispute Resolution | How internal disputes will be handled (mediation, arbitration, etc.) |
| Transfer of Interest | Rules for selling or transferring ownership |
| Dissolution Procedures | What happens if the business shuts down |
What About Single-Member LLCs?
Even if it’s just you, an operating agreement still provides:
- The act of designating your business as an entity on its own
- Assistance in situations where the IRS audits or lawsuits occur
- Detailed instructions if you are not able to manage because of incapacity or death
A lot of companies in banking and finance will also want to review your operating agreement to check your legitimacy and ensure you have proper procedures.
Law & Banking Compliance
Needed by Banks and Lenders
Most banks generally want an operating agreement before they open a business account. If there is no such law, you cannot be certain of your rights.
- Find a financial institution to manage your business banking.
- Check if you’re eligible for a small business loan.
- Get resources for the company
IRS Compliance
The Internal Revenue Service considers LLCs as pass-through entities by nature (unless someone chooses otherwise). An operating agreement can achieve several things.
- Determine the compensation amount for each member.
- Ensure that you support tax elections, such as an S corporation.
- Detail both capital accounts and how managers distribute money.
Begin with what your state wants from you, the rules are available on the Secretary of State’s website.
Decide if your LLC will be set up by a sole owner or multiple owners. Should corporate practices be directed by the membership or by employees?
Highlight the main elements—ownership, management, voting, how distributions are made, and the working procedures.
Be sure to mention what will occur in the event of disagreements and the death of the parties involved.
Make sure every member signs, regardless of whether state law demands it.
How to Create Draft One
You have the option of using templates, but it’s suggested that a licensed lawyer draft or examine the agreement for you.
Real-World Example
Two Co-Founders Created a Business, but Never Made an Operating Agreement
Alex and Jamie decided to launch a food truck. Alex gives $80K, and Jamie adds $20K. Alex and Jess discuss how Alex will take 80% of the profits.
If there is no operating agreement, state law requires their investment to be 50/50. Jamie is fighting against the current profit division in court. Since there is no formal paperwork, the court grants Jamie’s request.
As a result, Alex will be out thousands and has to handle tax issues. Lesson? Record the owner’s name and how profit will be handled.
Final Thoughts
An operating agreement should always be in place because it’s necessary. A written business plan benefits both single owners and partners by showing the business is legal, making its goals clear, and providing ongoing protection.
By signing an operating agreement, you both protect your business and set plans for its future, per U.S. law. Go through the process now to create or look over yours—it could mean you save a lot of trouble later on.
