What is an Operating Agreement?
An operating agreement is a contract among the owners of an LLC that specifies the rules and expectations for management and operations of the LLC. Specifically, an operating agreement will specify how the business will be managed, what happens when an owner sells their interest, when and how profits will be distributed, how ownership percentages are determined, and how major decisions are made.
The operating agreement is important in that it will govern the relationship between the owners. If there is no operating agreement, or if the operating agreement is not adequate, the LLC will be governed by state law and court decisions interpreting state law. This could be problematic because an operating agreement could specifically include provisions desired by the owners, while state law could dictate actions that are not desirable to the owners.
For example , in some states the operating agreement can provide for the distribution of profits to be dictated by the owners based on percentages agreed to by the owners. If the owners did not agree to a specific distribution plan, then the default would be that profits would be allocated evenly among the owners. If the owners of the LLC own unequal percentages, this could lead to a very different result than if the owners specifically signed an operating agreement.
Another example could be if an owner passes away or wishes to sell their interest in the LLC, if there is no operating agreement specifying what happens with those interests upon this kind of event or what happens to a deceased owner’s interest, the LLC would be governed by default provisions in the state laws and the courts’ interpretations, which again could be a very different result than what was intended by the owners. These are just several examples of the importance of an LLC’s operating agreement.
Articles of Organization Explained
Articles of organization are the documents that you will file with the state government office responsible for registering businesses to form an LLC. Respective state offices and departments often have different names, from state to state. In California, for example, they are called "Articles of Organization." In Minnesota, they are called "Articles of Organization." In other states, they might be called "Articles of Affiliation" or something else. These documents are the building blocks of what is essentially a newly independent business entity. After you file your articles of organization and receive government approval for your new LLC, you will be able to apply for any necessary business licenses, hire employees, and pay start-up costs from the business’s revenue.
The information typically required in articles of organization includes:
State governments need specific information to register your LLC as a distinct entity. This information includes:
Articles of organization can also include information about registered agents and which members are authorized to manage the LLC—for example, one owner might wish to handle contract negotiations or financial matters. As noted, these documents are formal; they contain basic information about your business and legal protections for you personally that are unavailable if you simply form a partnership or other informal business entity.
Operating Agreements vs. Articles of Organization: Key Differences
The initial filing required by the Secretary of State is the Articles of Organization. The articles typically only require the name of the LLC (must include the words limited liability company or some abbreviation), the address of the LLC, the registered agent’s name and address, and the organizer’s signature. There are a few more requirements in the Iowa Code for the articles, but those can get complicated. Iowa Code 489.201(1). The articles do not need to include any of the information that may be used for the operating agreement. It is worth noting that if you do specify anything in the operating agreement about management or members, that cannot conflict with the operating agreement. Iowa Code 489.204.
Many states, including Iowa, have a statutory model operating agreement that will be applied if one is not adopted. Iowa Code §489.110(1). The important aspect of an operating agreement is that it is not filed with the Secretary of State. In fact, it is intended to be used as an informal document that you simply keep with your personal records. Instead of making a contract with another party, you’re essentially entering into an agreement with yourself. Because of this, you can modify the terms as you see fit. Of course, it’s always a good idea to check with a business attorney before making changes as there are certain provisions that should always be included.
State Requirements and Legal Implications
State regulations commonly govern both the formation of limited liability companies (LLCs) and the formation of limited liability partnerships (LLPs), but requirements for LLCs and LLPs often differ from one another. Articles of organization are not always mandatory. Depending on state results, LLPs are required to file a certificate of registration or a certificate of incorporation with the state in which they are formed. All states require an LLC to file articles of organization, but a few states also require an LLC to draft an operating agreement. For example, New York mandates an operating agreement for all limited liability companies. Conversely, New Jersey and California do not require members to draft an operating agreement, but do require them to abide by the terms of their operating agreement. Beyond whether or not operating agreements are required, state laws may vary in regards to what an operating agreement must contain. For instance, as previously mentioned, New York does not require an operating agreement, but if it is drafted, the document must adhere to the requirements set forth in New York Limited Liability Company Law (NYLLCL) Section 417.
Common Misunderstandings
Many forming an LLC are not familiar with either or both of these documents as they are primarily setups for new businesses and the formation of new entities. Common misconceptions concerning operating agreements and articles of organization arise when people assume that one or the other is optional when in reality both are needed to protect your business and its owners, and to meet state requirements for your new entity. You will need an operating agreement no matter how simple or complex you plan on your owning business to be. If you plan on having partners or multiple owners in your business than an operating agreement is essential. An operating agreement will cover how you and your partners want the business to function and provide ground rules for decision-making , how and when a member can leave the company, and what happens in the event of your death. Articles of organization are also essential to the formation of your new entity. You will prepare and file these papers with your Secretary of State in order to formally register your new business as a Limited Liability Company (LLC). You cannot form an LLC that is recognized by your states where you want to do business without articles of organization.
How to Write an Operating Agreement and Articles of Organization
Much like the articles of incorporation that corporations file when they’re formed, limited liability companies (LLCs) create articles of organization to tell the state specific information about them, mostly about the ownership. LLC members can look up this information publicly on the state’s website. If you’re the owner of an LLC, it’s not likely that employees, customers, or even vendors care too much about the specific ownership, so the articles of organization do not need to be something you worry about too much.
For example, if you want to form a limited liability company in California, you’ll need to fill out Form LLC-1: Certificate of Organization and return it to the Secretary of State’s office. However, the specific details of what you need to include on your articles of organization – your name, address, and business purpose – will vary from state to state.
The rules governing how to create an operating agreement vary from state to state. For example, you can find California requirements for an operating agreement at CalCorporationCode.org and Texas requirements at TexasLLCFormation.com. Again, once your operating agreement is complete, you will keep it for your own records and show it to the state in the event of an audit or legal action against your business.
In most states, an operating agreement need not be complex to be effective. The single most important function of an operating agreement is to specify how the owners of the LLC will share profits. The second most important function is to describe how important decisions are made. Other functions of an operating agreement could include:
When you research requirements for an operating agreement in your state, pay particular attention to what isn’t required. For example, some states only require basic member information, such as names and addresses. Others require LLCs to provide a description of the business. Still others require a more detailed distribution of ownership, a buy-sell agreement, and specific anti-dilution language. Because there’s variation in every state, and because of the high cost of litigation, you’ll want to ensure your operating agreement is complete.
An operating agreement isn’t filed with a state agency, and doesn’t even need to be filed with the business records that are kept by your accountant or filed under lock and key in the back office of your business. It’s simply a private document that can be changed at any time, either formally or informally, by the owners of the LLC.
Obtain a Sample Agreement
Many businesses, particularly those just starting out, copy a sample operating agreement and modify it to suit their own needs. There are hundreds of free sample operating agreements available online, but keep in mind that not all are written by lawyers or based on law. Additionally, copying an operating agreement used by another business is generally not a good idea, as it can have unintended consequences.
It’s best to use an operating agreement that is compliant with state law and best practices for your industry. You can either:
Finally, if you want to do your homework before hiring a professional to prepare an operating agreement for you, consider consulting the The Corporation Sole Checklist. It contains a list of the components you should include in an operating agreement. You’ll need to know the specific requirements for your state, but even if you make test deletions and addins, you’ll have a solid understanding of the elements that should be included.
Why LLCs Need an Operating Agreement and Articles of Organization
For all the reasons mentioned above, operating agreements and articles of organization are important. I would also add that both documents, especially the operating agreement, are essential for maintaining limited liability. Operating agreements are especially important in limited liability protection. There are several legal cases in Illinois where loss of limited liability protection occurred because the members (or LLC owners) failed to get an operating agreement done. Failure to keep accurate records and a good operating agreement can not only lead to a loss of liability protection but also subject the LLC to IRS income tax penalties. In Illinois , LLCs are one member delinquent annual report filings away from being administratively terminated.
Internal governance issues are also important reasons to enter into an operating agreement right away. All parties need to understand their role in the LLC. Together the articles of organization and the operating agreement are more than enough to comply with your statutory requirements in Illinois.