What is an Operating Agreement?
An Operating Agreement is a valuable tool specifically for a Limited Liability Company (LLC). An Operating Agreement provides the rules and regulations for an LLC and is a guiding force in its day to day operation. An Operating Agreement is not a requirement of forming an LLC, however it is important to have an Operating Agreement in place as part of the business operations.
There are some key components often included in an Operating Agreement . The first is a list of members, who own the LLC. The second is the allocation of ownership among the members. This component outlines how much each member owns a percentage of the LLC. Third is the governing structure of the LLC. This component addresses how members make decisions.
An Operating Agreement may also include components such as management, meetings, and details on distributions to the members. It may also discuss the dissolution of the LLC if desired.
What are Articles of Organization?
Articles of Organization are documents that, in certain states, are required for the legal formation of a limited liability company. They are typically filed at the time of establishment with the appropriate Secretary of State office. Articles of Organization contain basic information about a limited liability company, including its name, address, registered agent and organizer. Depending on the state, the Articles may also set forth the LLC’s business purpose, whether the business will have a limited duration and the name and address of the LLC’s managers or members. Certain states require additional information in the Articles of Organization. After the Articles are filed and accepted by the Secretary of State, the LLC is officially formed.
Eliminating the requirement to file Articles of Organization is not sufficient to subject an LLC to federal income taxation. Unless an LLC is a single-member LLC, it must file Form 8832, and elect to be classified as an S Corporation or C Corporation.
Differences Between Operating Agreements and Articles of Organization
So, how does the Operating Agreement differ from the Articles of Organization? Well, the difference is very clear. The former is an internal document that is not usually filed with the state. The latter is a public document that is always filed with the Secretary of State for the state where the LLC was organized. As can be seen, they play two very different roles in the LLC world, and are used at different stages in the formation process. The Articles of Organization are completed early on shortly before the LLC comes into being. The Operating Agreement is put together later on in the process once the LLC has already been formed.
State-Specific Statutory Requirements
States vary in terms of what they require for Limited Liability Companies (LLCs) operating in order to be compliant with the law. For example, Delaware requires all LLCs to have an Operating Agreement, however it does not govern the content of such a document. On the contrary, the majority of states require an Operating Agreement to be created, but at the same time provide LLCs with the option to create any necessary documents, whether by law or otherwise. In other words, some states enforce no guidelines for the creation of an Operating Agreement.
Whether or not a state requires you to have Operating Agreement, every state except Alaska demands that an LLC submit the Articles of Organization as part of the legal formation process of an LLC. This document is otherwise known as Certificate of Formation.
The Articles of Organization information varies on a state-per-state basis. On average, however, the following information must be submitted:
- Name of the LLC
- Registered agent’s name and address
- The principal address of the LLC
- The signature of the organizer(s)
An LLC that fails to comply with the Articles of Organization requirements may encounter issues with their legal formation and may be subject to penalties, including the restoration of an LLC’s limited liability.
Importance of Both for Your LLC
Both an Operating Agreement and Articles of Organization are important for an LLC. While there are some states (such as Alaska) that do not require a formal operating agreement for an LLC to be recognized, the default management rights under statute may not be in line with the limited liability goals sought by members and managers. In Alaska, the default provisions do not establish management in the hands of the board of managers as is often desired by many LLC members. In such cases, members of an LLC should create an operating agreement to capture the rights and obligations of the members and managers.
Some states allow for a simplified operating agreement to exist and file with the Secretary of State. For example, the Illinois Secretary of State allows the following simplified form to be filed with the Secretary of State and signed by all members. How’s that for simple and easy?
In other states, there are multiple layers of requirements to have an LLC formed properly. Ohio, in principle, does not require a formal operating agreement between members of an LLC. However, in order to be certified as a Minority Business Enterprise ("MBE") , the MBEs must have a written operating agreement covering their management structure. To be eligible for federal grants, small business classification/competing in set aside programs or to be eligible for perhaps an investment to be classified as a "QDRO" (Qualified Domestic Relations Order), an operating agreement may be required.
The Articles of Organization/Certificate of Formation is typically a short document that only requires minimal information regarding the entity’s name, address, principal place of business, general nature of business and names and contact address of the registered agent.
An operating agreement sets forth the management structure of the entity, identifies the LLC’s members, states when profits and losses will be allocated and determines what happens to a member’s ownership interest when the member leaves the company or dies, and so forth. An operating agreement provides a greater level of comfort for the protection of the members and the organization.
LLCs should never overlook the importance of making sure that the Articles of Organization and Operating Agreement are complimentary and address the same topics where needed, and do not conflict in any respects.
Frequently Deemed Misunderstandings
One of the most common misconceptions when dealing with an LLC is that an Operating Agreement and Articles of Organization are the same thing. They are not. The Articles of Organization are filed with the State to make the LLC an artificial person, but once created it is run by the members (or managers). The Operating Agreement governs how all decisions are made (including any dissolution), how distributions are made, what happens in the case of some kind of default, etc. Therefore, an Articles of Organization is never the last thing you need to form an LLC; the Operating Agreement is in many respects more important because it governs how the business is run and how decisions are made, which are both crucial to the success of the enterprise.
How to Draft and File the Two
When it comes to creating an LLC and ensuring it remains in compliance with state law, both an Operating Agreement and Articles of Organization are essential documents.
Drafting Operating Agreements
For single-member LLCs, the Operating Agreement is pretty straightforward. That said, single members should still consult with a legal professional to ensure their document contains important protections. Multi-member LLCs will likely require a more detailed Operating Agreement, as they need to stipulate how new members will be admitted, how profits and losses will be allocated, and how assets will be distributed upon dissolution.
And while LLC members are not required by law to have an Operating Agreement, this document may be requested by banks when applying for business financing. Without an Operating Agreement, the bank may issue a loan to any member of the LLC, increasing the risk that your bank funds will be mismanaged.
Filing Articles of Organization
Articles of Organization are usually easy to file online through a state-run Secretary of State website. Provided all required information is included (member names, LLC address, the registered agent, etc.), it is often processed and approved on the same day. However, this website cannot provide legal advice, so many business owners still choose to consult a business attorney.
Conclusion on Legal Framework of Your LLC
A legal foundation is critical to the long-term success of any LLC. Having an effective Operating Agreement and a solid Articles of Organization are part of that foundation. While the latter, oftentimes referred to as the "certificate of organization," is filed with a secretary of state , the former is not required to be filed with the state but is very important. The following section describes some important distinctions between these two critical documents and offers some final thoughts on the topic.
Having the correct documentation in place for your LLC is vitally important to the future growth (or survival) of your business. It’s not a good idea to try and cut corners here. Speak to an experienced business lawyer about whether you need an Operating Agreement — and if so, whether you’re using the right one for your particular type of business.