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What is a Bad Operating Agreement?

I bet you could guess that most of our revenue as a law firm, comes from expensive litigation. But, did you know that most of that expensive litigation is due to partnership disputes involving a bad Operating Agreement?

What is a Bad Operating Agreement?

An inadequate Operating Agreement is either a free template you found on the Internet, an old document that hasn’t been updated or revised for 10 years or more, or the template you received from a non-lawyer, like some Internet company that formed your LLC.

What makes an Operating Agreement defective? It is one that is not customized for your business, your tax status, or your circumstances.

An inadequate Operating Agreement glosses over tax issues. It doesn’t address important circumstances, such as when a partner dies or becomes incapacitated. It also does not address the latest changes to the tax code.

How Can You Figure Out if You have a Bad Operating Agreement?

Conduct an “audit” on your LLC’s current Operating Agreement. Use these helpful tips to determine whether you have a bad one or not:

  • Is your company taxed as a Disregarded Entity, S-Corporation or C-Corporation?
    1. Search for “Capital Account”. If there is any language regarding “Capital Accounts”, you have a bad one.
    2. Search for “Section 70”. If there is any language regarding the tax code in the 700’s, you have a bad one.
    3. Search for “allocation”, “distribution” or “profit”. All these terms are irrelevant for a disregarded entity and C-Corporation. You may have a bad one.
    4. Search for “Partnership Representative”. If there is any language about “Partnership Representative”, you have a bad one.
    5. Search for “Tax Partner” or “Tax Matters Partner”. If there is any language about “Tax Partner” or “Tax Matters Partner”, you have a bad one.
  • Is your company taxed as a Partnership?
    1. Search for “Partnership Representative”. If it’s MISSING, you have a bad one.
    2. Search for “Tax Partner” or “Tax Matters Partner”. If you have it, you have a OLD Operating Agreement, and it’s a bad one.
  • Is your company taxed as a S-Corporation?
    1. Search for “S-Corp”. If there is no language indicating your LLC is to be taxed as a S-Corporation, you have a bad one.
    2. Search for “profits” and read the language. If it depends on “Capital Accounts,” you have a very bad document. If it doesn’t mention “pro rata distributions,” you have a bad one.
  • Does your Operating Agreement have language dealing with ALL of the below? (If not, you have a bad one):
    1. Spousal ownership if the LLC or any owners are located in community property states?
    2. What to do, if a partner dies or is incapacitated?
    3. Preventing or allowing voluntary withdrawal?
    4. What powers are reserved to the Members (or Managers, if Manager Managed)?
    5. Owner restrictions, if important to your business, such as non-compete, non-solicitation and/or language indicating whether an owner is expected to work full-time for the business?
    6. What to do, when the owners are deadlocked?

There is No Excuse for Bad Operating Agreements

This helps to illustrate why we put together a sophisticated, AI-based Operating Agreement tool. For just $29.95, you can create a high-quality, highly customized document for your business. It utilizes the latest laws and tax rules, and provides over 100 different options to select from in customizing your Operating Agreement. We call it the Couture Operating Agreement, and it’s available free to clients who form a LLC or Anonymous LLC with us.

Law 4 Small Business, P.C. (L4SB). A little law now can save a lot later. A Slingshot company.

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