Paper Details
Paper Code: RP03V12023
Category: Research Papers
Date of Publication: December 06, 2023
Citation: Mrs. Shamim Mohammad Anwar Sheikh, “Operating Agreement: A Cornerstone of Your Business Structures in the United States of America”, 1, AIJIPCA, 21, 21-26 (2023).
Author Details: Mrs. Shamim Mohammad Anwar Sheikh, Advocate, Bar Council of Goa and Maharashtra
ABSTRACT
Legal documents are written instruments that outline legal rights, obligations, and relationships between parties. These documents serve as authoritative records and guides in various legal matters, they encompass a wide range of materials, like contracts, agreements, wills, deeds, licenses, affidavits, pleading, and more. These legal documents are meticulously crafted to ensure accuracy, compliance with relevant laws, and clear communication of terms. The effectiveness of legal regulations and Laws designed to enhance certainty in contractual relationships only achieve their purpose when communicated to the public. Ambiguities in the legal frameworks often lead to uncertainty. This article narrows its focus to the doubt surrounding the effectiveness of statutes of fraud in the context of LLC (Limited Liability Company) operating agreements. Examining case law from both the LLCs and Partnership context uncovers how applying statutes of fraud to otherwise adaptable and familiar entity forms often yields inequitable outcomes. When considering a new business structure offering personal protection with minimal formalities, opting LLC could be wise. With your specific chosen Business structure, the essential paperwork like an operating agreement holds significance. The operating agreement spans 5-20 pages and covers ownership, voting rights, powers, profit distribution, and more. Although some states don’t mandate it, not having one is unwise. Keep it with core records for confidentiality.
KEYWORDS
Agreements; Business Structure; Legal Documents; Legal Rights; LLCs; Operating Agreement
Introduction
Imagine, two friends want to start a cookie shop, and both have different roles and responsibilities. To make sure everyone knows what they need to do, both created a set of rules on a small piece of paper. It’s like a set of instructions for how the cookie shop will work and what each member should do. This way, there won’t be any confusion and everyone will know how to play their part to make the shop successful. When this paper becomes legally binding on the shop’s owner it is called an Operating agreement to make sure everyone knows their roles and how the business will run smoothly. Operating Agreement is like a rule book for a special business called a limited liability company. In this rulebook, the owners/ members of the company write down how they will work together, make decisions, share the money they earn, and run the business. it's an important document that helps the members understand their roles and keeps everything organized so the business can be successful.
Research Methodology
This research paper is a combination of both primary and secondary research methodologies. The primary research includes the analysis of case law of the high court and supreme court Judgements involving the utilization of reliable legislation books to gather provision and statutory information.
Review of Literature
The Limited Liability Company is a business structure in the United States that combines the Pass-through taxation of a partnership or sole proprietorship with the limited liability of a corporation. The business trend in the United States is constantly evolving, and technological advancements and government regulations significantly shape the changing business landscape in the USA. Over the years, the dynamic market has given rise to various innovative business structures[1]. The Limited Liability Company (LLC) in the USA is a new and dynamic structured business.
For an LLC establishment, two vital documents[2] are required. The first is the ARTICLE OF ORGANIZATION- a prerequisite for legitimizing your business through submission to the respective state. This outlines the essential information such as legal business name, purpose, registered agent, and expected duration and proposes management structure. The second Critical and most crucial document is the OPERATION AGREEMENT, a contractual arrangement among LLC members, akin to partnership or shareholders agreements that outlines the organizational framework, detailing the roles of individuals involved, and delineates members’ roles, rights, and obligations in the LLCs operational and financial aspects. Of utmost significance, it addresses the protocol when a member decides to exit the business, as well as the processes and timing for transferring or selling their stake in the LLC.
Need for an Operating Agreement
Once the Operating agreement is signed it has a binding effect on its members and here are some requisites to have the needfulness of an Operating agreement:
· Operating agreement protects the owner’s liability within the LLC, by distinguishing the business from its owners for the LLC’s debts and obligations.
· These written operational agreements contain some conditions and business arrangements that provide a reference point in case of conflict and avoid miscommunications between the members
· This agreement provides the organizational structure for the LLC which defines the rights, and duties and outlines the protocol for the inclusion of new members
· It can serve as a preventive measure against potential conflicts among business owners just by explicitly defining the financial and operational choices of the LLCs.
· It empowers to establishment of personalized procedures and governing guidelines for the LLC, granting the freedom to shape its functioning as per the owner's preferences.
· This agreement is a fundamental document that delineates the management, operation, and structure of the LLC, demonstrating to both internal and external parties that the business is well organized, serious, and operates professionally.
· To avoid any conflicts between business partners, the operating agreement clearly defines the duties, obligations, and anticipated outcomes of each member’s involvement.
· Establishing rules and procedures that can adapt to changes in laws and regulations is a smart move that future-proofs the companies. It provides a solid framework and allows you to address potential issues or misunderstandings that may arise in the future with confidence.[3]
What Happens if You don’t have an Operating Agreement?
Operating agreement holds many important reasons to sign it between the members:
· The LLC might become subject to state default regulations that might not align with the member's interests.
· With NO Operating Agreements, State default Rules will apply to the businesses
· NO written agreement may lead to friction or misunderstanding between LLC members that may leave them vulnerable to legal trouble and conflicts.
· Without an operating agreement, it may create challenges for its members in safeguarding the LLC’s Limited Liability status and may raise ambiguity in the management and financial misunderstanding, ultimately jeopardizing the adherence to the chosen rules and protocols by the members.
· In the absence of an operating agreement, every member will possess equal rights irrespective of their capital contributions
· Rule about withdrawal and expulsion will not be defined for members and the transfer of membership interest will only be permissible with the unanimous consent of all other members
· Not having the operating agreement may result in potential trust issues within the LLC. Depriving it of potential tax benefits and legal protection, Moreover, a deficiency could deter potential investors and undermine the legitimacy of the business entity, fostering ambiguity that could result in legal disputes.
While most other states do not insist on including it, it is always considered wise to draft an operating agreement, as it protects the status of a company, comes in handy in times of misunderstandings, and helps in carrying out the business according to the rules set by the members[4].
Drafting an effective[5] Operating agreement for their LLCs
· Consult with the business lawyer to ensure that the operating agreement is tailored to the specific needs of the LLC and complies with state laws and regulations.
· As per the industry in which the LLC operates, there may be specific regulations that must be addressed in the operating agreement. Such as;
- Healthcare industry - may require addressing the regulations related to patient privacy,
- Legal Industry – may require regulations related to the ownership and management of law firms that need to be addressed in the operating agreement
- Financial industry – may require regulations for anti-money laundering that need to be addressed in the operating agreement
- Technology industry - may require regulations for the ownership and protection of software patents that need to be addressed in the operating agreement, etc.
· The basic information of the members must be mentioned such as their names, addresses, ownership percentages, designated rights, responsibilities, or compensations of each member.
· The operating agreements should establish guidelines and rules for the LLC, providing clarity and guidance in the event of a conflict.
· LLC operating Agreement varies and is influenced by numerous factors, yet typically include[6]:
- The tax treatment of the LLC – how this is going to be taxed; as a partnership or corporation;
- The specification of the number of members and their ownership percentages;
- The management structure such as the roles and responsibilities of each member;
- The contributions of each member such as cash, property, or services
- How the profits and losses will be allocated among the members
· The operating agreement must be updated regularly to reflect changes in the LLC's ownership structure, management, or operations. And also try to review and update the operating agreement at least once a year.
An operating agreement is a very crucial document for LLCs that should be drafted with care and attention to detail. Regular updates for better effectiveness and all the required provisions as per the member's choices must the noted in the agreement to avoid any future conflicts.
Single Member or Multi-members Operating Agreement
An LLC may be owned by a single owner or multiple owners and accordingly, the operating agreements are to be created. The operating agreement for a single owner is simpler than the multi-owner LLC.
Irrespective of whether an LLC is single-member, multi-member member-managed, or multi-member-managed, it remains an essential document for one’s business. Among the various reasons for creating an Operating Agreement, the most conspicuous one is establishing ownership. Creating the Operating agreement between a business and the single owner can help[7]:
· To override the default rules imposed by the state and provide the flexibility to modify these rules to align with the proposed terms,
· To separate and safeguard the member and business-related lawsuits and the LLC from personal liabilities.
· To structure the details like investor inclusion, repayment terms, voting rights, and exit strategies, foreseeing expansion upfront grants control, prevents negotiation ambiguities, and positions your company favourably when seeking investments.
· To outline the authority, compensation, and exit provisions of managers, defining managerial roles and responsibilities.
· to ensure accountability, loyalty, and financial prudence, enabling seamless day-to-day operations while you focus on strategic vision.
An operating agreement typically includes provisions related to ownership, management, profit distribution, decision-making, and dispute resolution it is required to ensure that the operating agreement covers all necessary aspects and complies with state laws.
Addition of new members: If incorporating an additional member into the LLC it is necessary to revisit all the required documentation in alignment with the terms agreed upon between the owner and the new partner. This step ensures that the operating agreement accurately reflects the updated composition and responsibilities within the LLC.
Through operating agreements, businesses can work with credibility and help to ensure LLC status, without legal documentation and following the legal process, proving the legal distinction between an LLC and its sole members will be challenging, and therefore, California, Delaware, Maine, Missouri, and New York are the countries that require the LLC Operating Agreement either oral or implied. Even though operating agreements are not legally mandated for LLCs in the remaining 45 states, it is strongly advised to have one in place.
Operating Agreement Vs. Article of corporation
After the comprehensive understanding of the operating agreement in this article, it’s equally imperative to delve into the significance of the Article of Incorporation. Just as the operating agreement holds its crucial place, the article of incorporation stands as an indispensable document for any business. Both are crucial legal documents for any business they share some similarities and differences;
Similarities:
· Both documents are highly weighted and indispensable insights for the best functioning of the business
· They meticulously define the business's name, purpose, and operational protocols.
· The structure of ownership and management is intricately detailed in both documents.
· Irrespective of legal mandates, the presence of both these documents is a pivotal factor contributing to the triumph of the business.
Differences:
· Operating agreement adeptly crafts the legally binding professional relation between business owners, while the Articles of Incorporation delineate the legal relationship between business and state.
· Articles of incorporation are public documents filed with the state, while an operating agreement is for internal use.
· Articles of incorporation are required by law for corporations while operating agreements are not required by law in some states
In essence, comprehending these two documents, the operating agreement and article of incorporation is essential for the establishment and prosperity of the business.
Conclusion
An LLC is a flexible US business structure that blends partnership and corporation benefits, offering easy management and liability protection. Creating an operating agreement is not mandatory in many states still recommended for clarity in operations. This agreement outlines terms, protects status, and prevents misunderstandings. Without one, default state rules apply, potentially causing unsuitable regulations. An operating agreement also safeguards partners from personal liability and ensures fair profit distribution.
It's crucial to emphasize that the repercussions of lacking an operating agreement can vary based on the state of formation and the unique circumstances of the LLC. When an operating agreement is absent, the LLC becomes subject to the default regulations of its organizing state, which may diverge and not align with the members' intended arrangements. These default provisions can include aspects such as equal voting rights for all members, irrespective of their capital contributions. It's noteworthy that the specific default rules applicable to an LLC without an operating agreement may differ contingent on the state of formation. For the most precise and up-to-date insights into the default rules governing LLCs without operating agreements in specific states and industries, seeking guidance from a legal professional is recommended.
[1] Dharti Popat, Limited Liability Company In the USA, 2022.
[2]Chris Daming, 3 Reasons Why Your Single-Member LLC Must Have an Operating Agreement, 2023.
[3] Ijeoma S. Nwatu, Basic information about operating agreements, U.S small Business administration, 2016.
[4] The New York state senate. “Section 417.” Accessed Jan. 23, 2022.
[5] GouchevLaw ,10 must-haves in an LLC operating agreement,2023.
[6] Nellie Akalp,Score for the life your business, What Should Your LLC's Operating Agreement Include?,June 20, 2023.
[7] Jennifer Reuting,Limited Liability Companies for Dummies, 4 Reasons Why a Single Member LLC Needs an Operating, 3 March 2023.