#9 in my 27 Point Checklist for corporate and LLC formalities ask if you have adopted the operating agreement (or bylaws in a corporation) that should have been written up first thing when you decided to start a business.
#10 asks whether you understand what is covered by that operating agreement and what protection it gives you.
Your operating agreement is the playbook for how to run your company. It isn’t some form that you fill out and file away; it should be easily accessible and its outline followed in your daily and yearly business interactions.
In order to do what it needs to, your operating agreement can’t be 5 pages long. Publicly traded companies have bylaws that run 150-200 pages long, but a small LLC probably needs an operating agreement about 25-30 pages long.
(If you haven’t downloaded it yet or want to get it again, a free copy of my sample Operating Agreement is available here. A paid version comes with over two hours of step-by-step audio explanation so you can know what each section is and how it works for in your company. This can be purchased by itself or as part of any of my LLC Wizard Packages.)
Your operating agreement gives you a great opportunity to name your own rules to play by. If you play by your own rules and do what the operating agreement says you are going to do, the big courts will say you followed them. Your liability shield will remain in place because you treated your company like a company. If you don’t have a rule book or your rule book doesn’t address the situation you find yourself in, the state has a set of default rules that will govern your LLC.
A short online 5-page form leaves far too much to the state default rules, which will serve the interests of the state rather than your interests. You have the chance to write your own rules, and the courts will generally uphold whatever you have written as long as you followed it.
It is great to have all your rules written down, but if the owners/members never adopt the operating agreement officially as the company rulebook, they won’t do much good. You need to make sure to adopt your customized operating agreement in your first company meeting. Everyone needs to sign the agreement in each of their capacities, whether it be as member, as manager, or both.
Your operating agreement needs to detail the duties of the managers and the duties of the members–and if you are both a member and manager, you need to make sure you are acting in one or the other capacity when you perform certain functions. It needs to cover who the member owners are, what will happen if one of them dies or wants to buy out another member, how taxes will be paid, how often company meetings will be held, and how to resolve disputes. It needs to address the tax structure of the LLC. It should address the relationship of the members to each other. If you are the only member, this becomes less important, but it needs to be there to satisfy the courts that you have a real company and not just an alter ego.
The LLC operating agreement will define what the members do and what the managers do. Use it as a checklist to determine what the responsibilities of the members and managers are. For example, who has to approve debt incurred by the company? Who approves leases and contracts entered into by the LLC? If the LLC operating agreement says that the members have to approve these things, then you need to keep a minutes record, and each time the LLC enters into a contract or authorizes a note for debt, there needs to be a minute entry in the minutes of the LLC. The members then need to periodically approve the actions and minutes.
If you just ignore the requirements of the LLC operating agreement, when you get sued the argument will be, “This isn’t a real company. It’s just your alter ego.” Unless you can show the judge that it is a real company, you will lose your “corporate shield.”
What about a S.Corp? What kind of operating agreement if any do I need and do you have that template?
Jami,
An S-Corp is a tax identity while an LLC is a legal identity. You can be an LLC taxed as an S-Corp. The operating agreement does have language in it that you can select which would allow your LLC to be taxed as an S-Corp. The other thing that must be done is a you have to file an S-Corp election with the IRS on form 2553, which can be found at: https://www.irs.gov/pub/irs-pdf/f2553.pdf.
Hello, going through your sample operating agreement I had a question. Under 3.3P the clause states that the manager is to furnish monthly financial statements. If as the manager I have to mail a copy to myself, the owner, monthly, that could turn into a lot of hassle and papers to file. Is an electronic statement generated by the likes of Quickbooks sufficient? Or could the clause be changed to quarterly or annually?
Lee,
You don’t have to mail the report to yourself, but you do need to have some type of paper trail that shows that the report was created and delivered. You can switch the time to quarterly. Some see this as a hassle and so remove this provision. The problem with that is even though you are the only one in your company, you still need to run the company like it is a larger company.
A larger company will send reports to the share holders monthly or quarterly. By doing this you are creating a paper trail that can be used if there is ever a problem and you have to prove to the court that your company is a legitimate company.
You don’t have to mail the report to yourself but you do need to have some type of paper trail that shows that the report was created and delivered. You can switch the time to quarterly. Some see this as a hassle and just remove this provision. The problem is that even though you are the only one in your company you still need to run the company like it is a larger company. A larger company will send reports to the share holders monthly or quarterly. By doing this you are creating a paper trail that can be used if there is ever a problem and you have to prove to the court that your company is a legitimate company.
Can we remove that entire provision and manager not do financial reporting ? or is it a legal requirement ?