Newland's Business Notes

LLC Operating Agreements

Volume 10 Issue 2 -- March/April 2006

What is an operating agreement and why might you need one?  A Limited Liability Company (“LLC”) is a form of business entity that has become popular in the last 15 years, and if you’re involved in one you may want to use an operating agreement.

In many ways an operating agreement is similar to a partnership agreement. Operating agreements exist for the same reason that partnership agreements exist – to document the understanding of the members or partners of the business as the case may be.

Although LLCs have some similarities to partnerships, especially for tax purposes, LLCs have some fundamental differences from partnerships, such as limited liability for all members. In plainer English, LLCs, like corporations provide limited liability to its owners, usually called “members.” This primary attribute is what makes LLCs a much better entity for many than a partnership.

To learn more about LLCs you may want to visit our Web site, where there is a three-part series of newsletters beginning in July/August 1999 discussing LLCs, what they are and why one might pick that form of entity. 

One of the advantages of partnerships and LLCs is the ability to separately allocate profits, losses, credits and deductions among the principals. In many cases, these attributes are allocated according to the percentage of ownership, but it need not be done that way.

Let’s say that Charlie A. (“Cas”) Slump and Uline A. Lead form a new LLC, using their initials, called “ CAS - UAL , LLC,” with each contributing the same amount of capital.  Cas also owns an interest in a wrecking business called Wipeout LLC, from which Cas receives large amounts of income; therefore, even though he is a 50% owner of CAS - UAL , he is interested in taking a larger share of losses from the LLC.  Unfortunately, CAS - UAL ’s procedures were just that – casual – and there was no operating agreement documenting the agreement that Cas is to receive 75% of the losses generated by CAS - UAL , LLC. 

As is far too common, the members of CAS - UAL , LLC failed to document their understanding in an operating agreement.  Later, when there is a disagreement between them, there is no evidence of what they agreed to when the entity was formed. If Cas claims 75% of the losses the IRS will likely disagree when Cas is audited and determine that Cas is only entitled to 50% of the losses. For tax purposes, an operating agreement may be essential to achieving the members’ objectives.

It has often been said that oral agreements are not worth the paper they’re written on.  The same is true of operating agreements based upon oral understandings or, even worse, upon no understanding.  

In addition to recording important decisions about how profits and losses should be allocated, there are other important reasons for the use of operating agreements.  To list but a few of these, they could and should cover items such as the initial capital contribution, voting procedures, admission of new members, and special fee or compensation arrangements.

If the LLC has a single owner, as is often the case, a formal operating agreement is not needed. Some states, including Virginia , however, have laws stating that any written document by the sole owner of an LLC relating to the operation of the LLC may constitute an operating agreement.

If there are multiple members, especially those outside the immediate family, it is probably always advisable to have an LLC operating agreement.  Statutes governing LLCs provide many default rules which a well-prepared operating agreement may override.

Few people would think of buying a new car without getting the owner’s manual, yet an operating agreement is the “owner’s manual” of an LLC and many LLCs do not have one. In most cases it make sense to have one.

If you need help with the preparation of an operating agreement, call Newland & Associates.

Copyright 2006

Published by the law firm of Newland & Associates, PLC
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Manassas, VA 20110
Call us at (703) 330-0000 for a full range of business law and tax-related services.

While designed to be accurate, this publication is not intended to constitute the rendering of legal, accounting, or other professional services or to serve as a substitute for such services.

Redistribution or other commercial use of the material contained in Newland's Business Notes is expressly prohibited without the written permission of Newland & Associates, PLC.

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