A business operating agreement is a legal document that explains how a business will be owned, managed and operated. In the United States, the term usually refers to an LLC operating agreement, which is an internal contract between an LLC and its members.
The U.S. Small Business Administration's cited guidance was published in 2016. An operating agreement can govern an LLC with 1 member or 2 or more members. It sets rules for ownership, voting, management authority, profit distributions, member responsibilities, ownership transfers, disputes and business closure. A signed agreement puts those rules in writing instead of leaving them to informal promises.
Business Operating Agreement at a Glance
| Question | Answer |
|---|---|
| Usually used by | Limited liability companies, or LLCs |
| Main purpose | To establish the LLC's internal ownership and operating rules |
| Who signs it | The LLC's members and, where relevant, its managers |
| Filed with the state? | Usually no. The company generally keeps it with its business records |
| Required? | Requirements vary by state. Many states do not require a written agreement |
| Does it create the LLC? | No. The articles of organization or certificate of formation creates the LLC |
| Does it determine tax treatment? | Not by itself. Federal tax classification generally depends on the LLC's membership and tax elections |
What Does an LLC Operating Agreement Do?
An LLC operating agreement sets the internal rules for the LLC, its members and, where applicable, its managers. It lets the owners use terms that are more specific than the default rules supplied by state law.
Common subjects include:
- Ownership percentages and member contributions
- Voting rights and approval thresholds
- Member-managed or manager-managed operations
- Duties and authority of members and managers
- Profit and loss allocations
- Distributions
- Admission of new members
- Ownership transfers and buyouts
- Dispute and deadlock procedures
- Amendments and dissolution
The U.S. Small Business Administration lists ownership percentages, voting rights, management duties, profit and loss distributions, meetings and buyout rules as common operating agreement provisions.
Why Is a Business Operating Agreement Important?
A written operating agreement gives the owners rules for making decisions and handling conflict.
Without one, the LLC may fall under the default rules of the state where it was formed. Those rules may not match the owners' plans. They may determine how votes are counted, how profits are divided or what happens when a member wants to leave.
The agreement can also document that the LLC is a separate business with its own financial and management procedures. It does not, by itself, protect members from personal liability. The owners must also follow applicable laws and keep personal and business affairs separate.
Is an Operating Agreement the Same as Articles of Organization?
No. The two documents have different roles.
| Document | Main function |
|---|---|
| Articles of organization | Public formation document that creates the LLC under state law |
| Operating agreement | Internal contract that sets the LLC's ownership, management and financial rules |
| Employer Identification Number, or EIN | Federal tax identification number issued by the IRS |
| Business licenses | Government approvals required for particular activities or locations |
The articles of organization usually include basic details such as the LLC's name, address and registered agent. The operating agreement covers the more detailed rules for ownership, management and financial decisions.
Does Every LLC Need an Operating Agreement?
No. Whether an LLC must adopt a written operating agreement depends on the state where it was formed.
Many states do not require an LLC to file or adopt a written agreement. State laws also differ on whether they recognize oral or implied agreements. Even when a written agreement is optional, most LLCs benefit from having one.
A written agreement is especially useful when an LLC has:
- Two or more members
- Unequal ownership or financial contributions
- Passive investors
- Different voting and profit-sharing arrangements
- Intellectual property or real estate
- Plans to admit additional owners
- A significant risk of disagreement among members
Operating agreements generally are not filed with the Secretary of State. The company usually keeps the signed agreement with its internal records.
Does a Single-Member LLC Need an Operating Agreement?
A single-member LLC can benefit from an operating agreement even though it has only one owner.
The agreement can document:
- The LLC's separate legal existence
- The identity of its sole member
- The member's authority to make business decisions
- How company records and finances will be maintained
- What happens if the owner dies or transfers the business
- How the LLC can be amended or dissolved
A bank, investor, lender or other third party may also request the agreement as evidence of who controls the company.
What Is the Difference Between a Member-Managed and Manager-Managed LLC?
An operating agreement should identify who has authority to run the business.
Member-Managed LLC
In a member-managed LLC, the members generally participate directly in operating the business. The agreement can state whether every member may act for the company or whether certain decisions require approval from a defined percentage of the members.
Manager-Managed LLC
In a manager-managed LLC, one or more designated managers handle daily operations. The members may keep approval rights over major decisions, such as borrowing money, selling major assets, admitting a new member or dissolving the company.
The operating agreement should identify the managers, describe their authority and explain how they can be appointed or removed.
Does an Operating Agreement Determine How an LLC Is Taxed?
No. An operating agreement does not automatically determine an LLC's federal tax classification.
For federal income tax purposes, the IRS generally treats a domestic LLC with 1 member as a disregarded entity and a domestic LLC with 2 or more members as a partnership, unless the LLC elects corporate treatment. An LLC can generally make that election using IRS Form 8832, subject to applicable rules.
The agreement may include tax-related provisions covering profit and loss allocations, a partnership representative, capital accounts and tax distributions. These provisions should be coordinated with the LLC's tax adviser because the agreement and the company's conduct need to match.
What Should an Operating Agreement Include?
A practical operating agreement should address the following areas.
Ownership and Contributions
State each member's ownership interest and record what each member contributes. Contributions may include cash, property, equipment, intellectual property or services.
The agreement should also explain whether members must make additional contributions and what happens if a member does not contribute as promised.
Voting and Decision-Making
Specify:
- Which decisions require a majority vote
- Which decisions require unanimous approval
- Whether voting power follows ownership percentage
- How routine and major decisions are approved
- Whether written consent or electronic voting is permitted
Profits, Losses and Distributions
The agreement should distinguish between:
- How profits and losses are allocated
- When cash or property is distributed
- Whether the LLC must retain cash for taxes, reserves or operating expenses
Ownership percentages do not always determine every allocation or distribution. If the members want a different arrangement, the agreement should state it clearly and the arrangement should be reviewed for legal and tax compliance.
Transfers, Departures and Buyouts
The agreement should explain what happens when a member:
- Wants to sell an ownership interest
- Dies
- Becomes disabled
- Files for bankruptcy
- Gets divorced
- Leaves the business
- Violates the agreement
Buy-sell provisions can give the company or other members the right to purchase the departing member's interest. They can also establish a valuation method.
Dissolution
The agreement should explain when the LLC may be dissolved, who approves dissolution, how debts are paid and how remaining assets are distributed.
How Is an LLC Operating Agreement Different From Agreements Used by Other Businesses?
"Operating agreement" is primarily associated with LLCs.
| Business structure | Common governing documents |
|---|---|
| LLC | Operating agreement or limited liability company agreement |
| Corporation | Bylaws, board resolutions and shareholder agreements |
| General partnership | Partnership agreement |
| Limited partnership | Limited partnership agreement |
The U.S. Small Business Administration identifies bylaws as the internal governance documents commonly used by corporations, while LLCs generally use operating agreements.
How Do You Create an Operating Agreement?
To create an effective agreement:
- Identify the state law that governs the LLC.
- List every member, ownership percentage and contribution.
- Choose member-managed or manager-managed operations.
- Define voting rights and approval requirements.
- Establish profit allocations and distribution rules.
- Add transfer, buyout, dispute and deadlock procedures.
- Address dissolution and amendment requirements.
- Have all required parties sign the agreement.
- Store the signed version with the LLC's official records.
- Update it when ownership, management or major business terms change.
A generic template may work for a simple single-member LLC. An attorney should review agreements involving multiple members, unequal contributions, investors, real estate, intellectual property, professional services or customized tax arrangements.
Bottom Line
Read the agreement as a decision document, not a formality. If a clause would be unclear during a disagreement, revise it before anyone signs.