How to Create an LLC Operating Agreement

An LLC operating agreement is a legal document that outlines the ownership structure, financial arrangements, and operational procedures of a limited liability company. While articles of organization filed with the state create the LLC as a legal entity, the operating agreement governs how the business actually runs on a day-to-day basis. It establishes the rights and responsibilities of each member, defines how profits and losses are shared, and provides a framework for resolving disputes and handling major business decisions.

Every LLC, whether it has one member or twenty, benefits from a comprehensive operating agreement. Without one, the LLC is governed entirely by the default rules of the state in which it was formed, and those default rules may not align with the members' actual intentions. The Revised Uniform Limited Liability Company Act (RULLCA), adopted in various forms by many states, provides a set of default provisions that apply when an operating agreement is silent on a particular issue. However, relying on statutory defaults is risky because they were written for the general case and rarely reflect the specific needs of any particular business arrangement.

Why Every LLC Needs an Operating Agreement

Several compelling reasons make an operating agreement essential for every LLC, regardless of size or the number of members.

Protecting Limited Liability Status

One of the primary benefits of forming an LLC is the liability shield that separates personal assets from business debts. However, courts can pierce the corporate veil and hold members personally liable if the LLC is not operated as a legitimate separate entity. Maintaining a written operating agreement is one of the strongest indicators that the LLC is a properly structured business rather than a mere alter ego of its owners. Courts in many jurisdictions specifically consider the existence of an operating agreement when evaluating veil-piercing claims.

Overriding Unfavorable Default Rules

Every state has statutes that fill in the gaps when an operating agreement does not address a particular issue. For example, many states default to equal profit sharing regardless of each member's capital contribution. If one member contributed 80 percent of the startup capital and another contributed 20 percent, the state's default rule might still split profits 50-50 unless the operating agreement specifies otherwise. Similarly, some states' default rules grant all members equal voting power on every decision, which may not be appropriate when members have unequal ownership stakes.

Preventing and Resolving Disputes

Business disputes are inevitable, and the absence of a written agreement makes them far more expensive and difficult to resolve. When disagreements arise about management authority, financial distributions, or the admission of new members, a well-drafted operating agreement provides clear answers. Courts routinely enforce the terms of operating agreements in LLC disputes, and the document often determines the outcome of litigation.

Satisfying Bank and Lender Requirements

Banks and financial institutions typically require a copy of the operating agreement before opening a business bank account, extending a line of credit, or approving a commercial loan. Without one, the LLC may face difficulties accessing basic financial services. Investors and potential business partners also commonly request the operating agreement during due diligence.

Key Sections of an LLC Operating Agreement

A comprehensive operating agreement addresses every significant aspect of the LLC's governance and operations. The following sections are essential.

Member Information and Ownership Percentages

List each member's full legal name, address, and ownership percentage. The ownership percentage, also called the membership interest, typically determines each member's share of profits, losses, and voting power unless the agreement specifies a different allocation. For LLCs with multiple classes of membership interests, describe each class and the rights and limitations associated with it.

Capital Contributions

Document the initial capital contribution of each member, whether in cash, property, services, or promissory notes. Specify the agreed-upon value of non-cash contributions and describe any valuation methodology used. Address whether members are required to make additional capital contributions in the future and what happens if a member fails to fulfill a capital call. Include provisions for the issuance of additional membership interests in exchange for future contributions and describe how new contributions affect existing members' ownership percentages.

Profit and Loss Distribution

Define how the LLC's net profits and losses will be allocated among members. While many LLCs distribute profits in proportion to ownership percentages, alternative arrangements are permissible. Some agreements provide for preferential returns to certain members, guaranteed payments for services rendered, or special allocations that differ from ownership ratios. Be aware that the Internal Revenue Service requires profit and loss allocations to have substantial economic effect under Section 704(b) of the Internal Revenue Code. Allocations that lack economic substance may be reallocated by the IRS according to each member's interest in the LLC.

Management Structure

LLCs can be either member-managed or manager-managed. In a member-managed LLC, all members participate in the daily operations and decision-making of the business. Each member typically has authority to bind the LLC in ordinary business transactions. In a manager-managed LLC, one or more designated managers, who may or may not be members, handle day-to-day operations while the remaining members take a more passive role similar to shareholders in a corporation. The operating agreement should clearly state which management structure applies, define the scope of management authority, and identify any decisions that require member approval regardless of the management structure.

Voting Rights and Decision-Making

Specify the voting power of each member, which is often but not always proportional to ownership percentages. Distinguish between ordinary business decisions, which may require a simple majority vote, and major decisions that require a supermajority or unanimous consent. Major decisions typically include admitting new members, amending the operating agreement, selling substantially all of the LLC's assets, merging with another entity, incurring debt above a specified threshold, and dissolving the company. Define what constitutes a quorum for meetings and whether members may vote by proxy or written consent without a formal meeting.

Transfer of Membership Interests

Address whether and how members may transfer their membership interests to third parties. Most operating agreements include restrictions on transfers to prevent unwanted outsiders from joining the LLC. Common transfer restrictions include rights of first refusal, which require a selling member to offer their interest to the remaining members before selling to a third party, and outright prohibitions on transfers without the consent of a specified percentage of the other members. Include provisions for the valuation of membership interests in connection with transfers, buyouts, and other transactions.

Dissolution and Winding Up

Specify the events that trigger dissolution of the LLC, which may include the unanimous consent of the members, the expiration of a stated term, the occurrence of an event specified in the operating agreement, or judicial dissolution. Describe the winding-up process, including how the LLC's assets will be liquidated, how debts and obligations will be settled, and how any remaining assets will be distributed to the members. Address whether remaining members have the right to continue the business following a dissolution event rather than winding up the LLC's affairs.

How to Create an LLC Operating Agreement: Step-by-Step

Step 1: Gather Essential Information

Before drafting the agreement, collect all necessary information including the LLC's legal name, state of formation, date of formation, registered agent, principal place of business, each member's full legal name and address, the amount and form of each member's capital contribution, and the agreed-upon ownership percentages.

Step 2: Choose the Management Structure

Decide whether the LLC will be member-managed or manager-managed. For small LLCs where all owners are actively involved in the business, member management is usually appropriate. For larger LLCs or those with passive investors, manager management provides a clearer separation between ownership and operational control.

Step 3: Define Financial Terms

Document how profits and losses will be allocated, when and how distributions will be made, whether members will receive guaranteed payments for services, and how capital accounts will be maintained. Address the tax classification of the LLC. A multi-member LLC is taxed as a partnership by default under the Internal Revenue Code, while a single-member LLC is treated as a disregarded entity. Either type may elect to be taxed as an S corporation or C corporation by filing the appropriate forms with the IRS.

Step 4: Establish Voting and Decision-Making Procedures

Determining which decisions require simple majority approval, which require supermajority approval, and which require unanimous consent. Set procedures for calling and conducting meetings, including notice requirements and quorum rules. Consider whether to allow action by written consent without a formal meeting.

Step 5: Draft Transfer and Buyout Provisions

Include restrictions on transferring membership interests, rights of first refusal, and a methodology for valuing interests in connection with buyouts. Address scenarios such as a member's death, disability, bankruptcy, or divorce, and consider whether the LLC or the remaining members should have the right or obligation to purchase the departing member's interest. Many LLCs carry life insurance policies on key members to fund potential buyouts.

Step 6: Address Dissolution Scenarios

Specify the circumstances under which the LLC will dissolve and detail the process for winding up its affairs. Include a provision allowing the remaining members to continue the business rather than dissolving the LLC when a member departs.

Step 7: Include Standard Legal Provisions

Add a governing law clause identifying the state whose laws will govern the agreement, an indemnification provision protecting members and managers from liability for actions taken in good faith, a severability clause, an entire agreement clause, and an amendment procedure specifying how the operating agreement may be modified.

Step 8: Execute and Store the Agreement

All members should sign and date the operating agreement. While most states do not require operating agreements to be notarized, some members may prefer notarization for added formality. Each member should retain a signed copy, and the LLC should keep the original with its other organizational documents. Operating agreements are internal documents and generally do not need to be filed with the state, though some states such as New York and California have their own specific requirements related to LLC formation that should be reviewed.

State-Specific Requirements

While an operating agreement is legally recommended for every LLC, state requirements vary considerably.

Delaware, often considered the most LLC-friendly state, grants maximum flexibility through the Delaware Limited Liability Company Act (Title 6, Chapter 18 of the Delaware Code). Delaware permits operating agreements to modify or eliminate virtually any statutory default provision, including fiduciary duties, giving members extraordinary freedom to customize their governance arrangements.

New York requires LLCs to adopt a written operating agreement within 90 days of filing articles of organization, as mandated by Section 417 of the New York Limited Liability Company Law. New York also requires LLCs to publish a notice of formation in two newspapers for six consecutive weeks.

California's Revised Uniform Limited Liability Company Act, effective January 1, 2014, recognizes both written and oral operating agreements but strongly encourages written agreements to avoid disputes. California also imposes an annual minimum franchise tax on LLCs registered in the state.

Missouri is the only state that legally requires LLCs to have an operating agreement, though as a practical matter, the enforceability of operating agreements in all states makes having one a near-universal best practice.

Single-Member vs. Multi-Member LLC Operating Agreements

A single-member LLC operating agreement is simpler in structure but no less important than a multi-member agreement. For a single-member LLC, the operating agreement primarily serves to document the separation between the member's personal finances and the business, reinforce the liability shield, establish the LLC's management procedures, and record the member's initial capital contribution.

A multi-member LLC operating agreement must address a much broader range of issues, including the relative rights of members with different ownership percentages, the process for admitting new members, procedures for handling deadlocks in decision-making, mechanisms for resolving disputes between members, and restrictions on competition by members.

Regardless of the number of members, every LLC operating agreement should be reviewed and updated periodically to reflect changes in the business, applicable law, and the members' circumstances. Using an online document generator like Forms Legal allows you to create a customized operating agreement tailored to your LLC's specific needs, ensuring compliance with your state's requirements and capturing the essential provisions that protect your business and its members.