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5 Reasons Your LLC Needs an Operating Agreement

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There are at least five reasons your LLC needs an operating agreement. Actually, there are  more than 5 reasons to have an operating agreement in place, but the top 5 reasons described below are strong incentives to make sure that your LLC and its members have the protection of an operating agreement.

An operating agreement is a document signed by the members of a limited liability company (an LLC) that establishes the “rules” for the operations of the LLC as well as the relationships between the owners (the “members”). Operating agreements are similar to the bylaws for a corporation. Although LLCs in Washington state are not required to have an operating agreement, the lack of an operating agreement may have dire consequences for the LLC and its owner or owners. At the very least, to the extent that Washington law applies to specific issue with the LLC, that treatment may not be how the member or members of the LLC want the legal issue resolved.

Before we discuss the top 5 reasons why every LLC should have an operating agreement, perhaps the most important reason to have an operating agreement is to open a bank account. Most (if not all) banks will require that the LLC have a written operating agreement in place before they will open a bank account in the name of the LLC.

Here are the top five reasons why every LLC in Washington state should have an operating agreement:

1. Management.

The operating agreement defines and sets the expectations for who will manage the LLC and exactly how it will be managed. This is most important for an LLC that has multiple members. The operating agreement should specify whether the LLC will be “member managed” or “manager managed,” meaning whether it will be managed by the vote of the members or if a designated manager (who does not need to be a member) will manage the LLC. Most operating agreements will also specify what type of decisions can be made by an individual manager (minor, or day-to-day decisions) without the need for further approval of the members as a whole (major decisions). An operating agreement can also provide a mechanism to resolve future management disputes.

Also, third parties dealing with the LLC will want to see an operating agreement that identifies who has the power to bind the LLC to contracts.

2. Death and Divorce.

Unfortunate things happen, and members of LLCs may die or get divorced during the life of the LLC. The operating agreement will describe the process for the winding down of the LLC in the event that its only member passes away, or how the surviving member can continue with the business of the LLC if so desired.

In the event that a member becomes divorced, the operating agreement can provide a process for resolution of the ex-spouses’s community property interest in the LLC membership interest (otherwise, the other member may have an unanticipated partner, the ex-spouse, who could end up with authority to participate in the management and affairs of the LLC).

3. Distribution of Profits and Losses.

Although not critically important for a single member LLC, for LLCs with multiple members it is very important that the allocation of profits and losses generated by the LLC be correctly specified, consistent with the expectations of the members as to how they will share profits and losses and consistent with the tax treatment of the LLC.  If the LLC wants  to be classified and taxed as a “Subchapter S” corporation, the profits and losses will have to be allocated in an equal (or pro rata) manner among the members. Failure to provide for the correct distribution of profits and losses  given the tax treatment of the LLC can create serious and negative unintended consequences, including the potential for double-taxation of income.

4. Protect Members and Managers from Liability.

During the life of a typical LLC, it will engage in dozens, hundreds or thousands of business transactions, each of which may give rise to potential liability. A properly drafted operating agreement will include “indemnification” provisions, which state that in the event a member or manager is sued with regard to business conducted on behalf of the LLC, then the LLC will step in and defend and hold harmless that member or manager. Although this is not required, it is highly recommended in order to protect and insulate individual member or manager’s assets from the business risks incurred by the LLC.

5. Restrict Transfers.

LLCs include characteristics of both corporations and partnerships. The shareholders of a large public corporation do not know each other and do not know each other a specific duty. The partners of a partnership, on the other hand, must specifically agree to be partners with each other and do owe each other certain duties. The stock in the corporation is freely transferrable while the partnership interests of a general partnership are not. In an LLC, the members must agree to be members with each other, but they may also sell their membership interests.

However, for most LLC members, it is very important that they have control over who controls the affairs of the LLC. An operating agreement can impose significant restrictions on the ability of a member to either leave the LLC or to sell his or her membership interest in the LLC. This is an important characteristics of LLCs and allows members to be careful about who will replace an existing member if he or she wants to sell his or her interest. With the right language in the operating agreement,  if a member tries to sell his or her membership interest without the permission of the other members, then the person buying the membership interest would hold an “economic interest” only, which means that he or she will not have any ability to participate in the management or affairs of the LLC (and would receive a distribution of profits and losses only).

This ability to restrict transfers and to impose negative consequences in the event that a transfer is made without permission, which would also apply to a creditor of an LLC member who seizes the membership interest, gives LLCs an important advantage over a standard corporation.

Conclusion

For LLCs without an operating agreement, we highly recommend that the member or members consider having an experienced LLC attorney draft an operating agreement, in order to prevent future unintended consequences which can have a devastating business and personal impact.