Browse any introductory textbook on economics or corporate finance and you’ll find a section that looks at three legal structures, sole proprietorships, partnerships, and corporations, under which businesses typically operate. However, these introductory textbooks often exclude a more recent fourth structure, the Limited Liability Company or, for short, the LLC.
Limited Liability Company Overview
The Limited Liability Company is, in a sense, an entity that is a hybrid of a Partnership and a Corporation and, as a result, is one that provides its organizers with some of the benefits of both. Like a partnership, a limited liability company is generally created as a transfer entity. This means that all profits and losses of the business are incorporated into the individual state and federal income taxes of their owners. If you were one of the owners, for example, your LLC’s profit or loss would show up on your 1040 as income and would be taxed at your individual tax rate.
This transfer-of-profit nature allows you to avoid the double tax problems commonly associated with a corporation. Another important benefit of an LLC is that it literally limits the responsibilities of each owner. The owners of a limited liability company are not responsible for the debts and other obligations of the company, nor are they legally responsible for the debts and obligations of the other owners. Investors and owners risk only losing the capital they contributed.
The Operating Agreement
The Operating Agreement is simply an agreement between the founding members that specifies the obligations and rights of each member, the way in which the company will be governed and, among other things, the distribution of profits and losses among the members. The following is an overview of the main sections of an operating agreement.
Organizational matters
This section (a) provides for the formation of the company, (b) specifies the restrictions on the name of the LLC, (c) specifies the registered agent and registered office of the company, (d) specifies the corporate headquarters of the company , (e) discusses your purpose and any restrictions on your purpose, and (f) describes the duration of the business. Given the uncertain nature of start-ups, it should be explicitly stated that there are no limitations on the type of business the LLC can conduct. Often times, the idea that you start with will not be the idea that makes your business solvent.
Members and capital structure
This section specifies (a) the name and address of each of the members, (b) the percentage of ownership of each member in the LLC, (c) the initial capital contribution made by each member and whether the members must make from time to time additional capital contributions, (d) whether the loans or services are considered capital contributions, (e) the terms under which new members are added, and (f) whether the members have limited responsibilities and whether they are personally responsible for the obligations of other members.
Company governance
This section specifies (a) whether the company should be managed by its members or if day-to-day management should be delegated to employees, (b) the rules and procedures governing formal company meetings, (c) actions, such as a sale of the company, which requires the unanimous approval of the members, (d) the amount of time each member must dedicate to the company, and (e) the rules governing the use and withdrawal of company funds.
Accounting and records
This section determines how often and for how long financial records are available for inspection by members. More importantly, the section specifies whether the LLC is classified as a transfer entity, which member is responsible for tax-related matters, and what the company’s fiscal year will be (usually January 1 to December 31).
Allocations and distributions
This section specifies (a) the allocation of net income, net losses or capital gains, (b) the distribution of capital, if there are restrictions on these withdrawals and how often the available cash will be distributed, (c) if the company can withhold a portion of the cash distribution to comply with federal and state laws, and (d) if members are liable for incorrect or erroneous distributions.
Restrictions on withdrawal and transfer of ownership interests
This section specifies (a) the terms and conditions under which a member may withdraw from the company, (b) the restrictions on the transfer of a member’s ownership interest, and (c) how the purchase price is determined for the transfer of ownership interest.
Dissolution and liquidation
This section specifies (a) the terms under which the company may be dissolved, (b) how the company will be wound up, (c) and how the company’s assets will be distributed once the business is terminated.
Long, but not complicated
Phew! As you can see, the Operating Agreement is a lengthy document. However, it is not terribly complicated. Just remember the need for legal protection and rules for virtually every what-if scenario imaginable. What happens if a member decides to leave? What happens if one, God forbid, dies? What if you want to bring in a new co-owner? All of these and many other questions are covered by the Operating Agreement. While you can get a simple agreement through a company like LegalZoom, you shouldn’t operate a Limited Liability Company without one.