How Do You Distinguish a Good Operating Agreement from a Bad Operating Agreement?
A good Operating Agreement is well-written by a competent business lawyer, accounts for the latest laws (including tax, asset protection and dispute resolution), and written specifically to address the unique tax, partnership and business circumstances of your LLC. A well-drafted Operating Agreement could be great for one LLC, and horrible for another.
You can determine whether an Operating Agreement is good or bad for your LLC, by asking yourself some questions:
Was the Operating Agreement Created Specifically for You?
We're not talking about a template that was given to you when you hired a service to create your LLC.
We're talking about an Operating Agreement that was drafted to specifically meet and address your tax status, partnership needs and business circumstances.
Was the Operating Agreement Created Using the Latest State and Tax Laws?
Much of our competition boasts that their Operating Agreements are "created by attorneys." Okay, but how long ago? Do they address the latest changes in the tax code and state law?
Are you (or do you want to be) taxed as a S-Corp?
S-Corporations require very specific language in the Operating Agreement. If you're not careful, the IRS will kill you in an audit, claiming your LLC is actually a C-Corporation for tax purposes, subjecting you to significant penalties, fines and double-taxation for previous tax years.
How can you tell if your Operating Agreement is properly drafted for S-Corp tax treatment?
S-Corporation status is specifically mentioned.Profits and losses are allocated and distributed pro-rata.There should be language designed to protect and preserve the S-Corp tax status.There should be no mention of “Capital Accounts”.There should be no reference to any Section in the 700’s of the Tax Code.There cannot be more than one class of ownership, and all owners must meet S-Corp ownership requirements.
Are you (or do you want to be) taxed as a Partnership?
Most Operating Agreements you find on the Internet (or those that are used as templates), are for Partnership tax treatment. However, most are old and don't account for the latest changes in the tax code.
Language identifying and managing a “Partnership Representative” should be specified.“Capital Accounts” should be defined with reference to Sections in the 700’s of the Tax Code.It should have language specifically indicating it is not to be treated as a “partnership” (for legal purposes, only tax purposes).“Tax Matters Partner” means you have an old Operating Agreement. This has been replaced in 2017 with “Partnership Representative”.
Are you (or do you want to be) taxed as a Disregarded Entity or C-Corporation?
While disregarded entities and LLC's electing C-Corporation tax treatment are common, it's hard to find an Operating Agreement that treats these tax treatments properly.
If your language is not precise, you could lose your tax status or lose your liability protection.
Language identifying the tax status should be specified.There should be no reference to “Capital Accounts”.There should be no reference to “Tax Matters Partner” or “Partnership Representative”.There should be no reference to “allocations” or “distributions”.
Are Important Issues Addressed for You and Your Business?
There are a frightening number of issues that can crop up during the lifespan of your LLC. A well-written Operating Agreement can mean the difference between bankruptcy and a successful enterprise.
A very small sample of issues includes:
Are there appropriate safeguards for spousal issues in a community property state?How is Intellectual Property (IP) handled for original works of authorship?Is voluntary withdrawal permitted or not permitted?Are owners restricted by non-compete, non-solicitation or must otherwise work full-time for the LLC?Can an owner be removed for bad behavior or other circumstances?How is power allocated by the owners versus the Company versus a Manager (if Manager Managed)?How are disputes resolved or settled between the owners?Is a “deadlock” provision needed as a tie-breaker when the owners cannot reach consensus?How are assets protected and preserved?