More and more people are turning to LLCs as their business structure choice. They like the flexibility they get with an LLC as far as taxes are concerned. An LLC, unlike any other business type out there, can choose how it wants to be taxed. Clients love the ability to start a business with a basic default tax structure and then upgrade later in the year, once they have an idea of the revenues and know which way they want to go to get the best tax breaks.
People also like the asset protection they get in an LLC. No matter what tax election you might make for your business, it’s still an LLC when it comes to legalities. That means your ownership isn’t generally attachable by creditors. Someone suing you personally doesn’t necessarily have the right to try and grab hold of the assets in your LLC to settle a claim. LLC owners enjoy the reverse protection, too. A creditor of the LLC can’t automatically sue an owner personally to cover the LLC’s debts.
But if you don’t put your fundamentals in place, your LLC can hurt you, not help you. I’m talking specifically about having an incorrect operating agreement or no Operating Agreement at all.
To an LLC, the Operating Agreement is the key document that sets out how it functions. It covers things like who the members are, and who the managers are. It sets out how the LLC is taxed. It sets out how and when the LLC distributes profits. It covers how owners may sell up and leave, or bring new blood into the entity. It goes through the process for removing managers. It also goes through how you settle disputes between owners. Basically it’s your go-to document for all things LLC.
There’s a surprising number of people who choose to run their LLC without an Operating Agreement, or who never bother finishing and signing the one they got with their LLC package. Or, they just grab one off the Internet, and figure it will work for them.
That can spell trouble in several ways:
- No Operating Agreement = No Choice. Without an agreement in place, your LLC is stuck with whatever state law dictates. If you intended your LLC to function on a 2/3rds vote (i.e., it takes 2/3rd of your owners to make a decision) and your state law says 51% is enough, guess what? You’re stuck with 51%. State law dictates how you settle disputes, and how members can come and go. You lose part of that very same control you wanted when you formed the LLC.
- Unsigned/Incomplete Operating Agreement. An agreement isn’t binding until it’s signed. You could thing you and your fellow owners had it all hashed out and were in agreement, but until that agreement is signed by everyone involved, it’s not binding. Of course, you won’t find that out until you are trying to rely on it to settle a problem and discover that you’re out of luck.
- Incorrect Operating Agreement. There are plenty of agreements you can pull from the Internet for free. Unfortunately, many of them have been written specifically for other companies and specific situations. Grabbing one and trying to modify it for your LLC can be problematic. It could be missing language you need. An LLC which will be owned by your pension, for example, needs some very specific IRS language in there. Or, maybe you want special language to deal with making an S or C Corporation tax election? Standard LLC agreements are written assuming partnership or Single Member taxation. They don’t have the right words in there to protect the LLC and its members from accidentally breaching IRS rules for S Corps. It could have language in there that you don’t need. Legalese can be hard to understand. You might accidentally give away rights that you didn’t want to. Or, you could wind up in tax trouble if the IRS audits the company and reclassifies the income, based on what the Operating Agreement says. There’s even a danger from third parties. Someone may try to claim your LLC is a sham LLC because it doesn’t have properly drafted documents.
If you’ve got an LLC, make sure your Operating Agreement is complete, accurate, and signed by everyone. You spent time and money setting it up. Why waste that by not completing the job?