Two important objectives of business owners like you are liability protection and favorable tax treatment. Unfortunately, the two don’t co-exist in most types of business entities.
For example, C corporations provide liability protection for all shareholders but create earnings that get taxed twice. S corporations dodge double taxation but have restrictive ownership rules and must allocate pass-through income proportionately to the shareholders.
Partnerships provide pass-through taxation and can allocate pass-through income disproportionately to the partners. But general partners have no liability protection, and limited partners forfeit their protection if they are active in managing the business.
Sole proprietorships avoid double taxation (since there is no separate entity) but provide zero liability protection and generally self-employment tax than necessary.
This is where limited liability companies (LLCs) come in. LLCs provide liability protection for all owners (known as members), regardless of their managerial involvement. And multimember LLCs automatically qualify for the favorable partnership-tax rules.
But as in most things tax, the benefits that LLCs provide can be lost or curtailed if you don’t take the right action.
LLCs Are Creatures of State Law . . .
There is no federal LLC statute, tax or nontax. Rather, LLCs are created under and governed by state LLC statutes. All 50 states have passed LLC legislation, and all permit single-member LLCs.
A Uniform LLC Act exists and has been enacted by some states, although in differing forms.1 So much for uniformity!
In most cases, you’ll form an LLC in your home state. But if your LLC engages in interstate commerce, another state’s laws may apply unless you specify which state’s laws should apply.
. . . But Their Tax Treatment Depends on Federal Law
The check-the-box regulations govern the federal tax classification of LLCs. Under those regulations, if the LLC is a corporation under state or federal law, it remains so for tax purposes.
Otherwise, a single-member LLC is taxed as a sole proprietorship, while a multimember LLC is taxed as a partnership. Or, either one can elect corporate status by filing IRS Form 8832. The
Articles of Organization Are Not Enough
To form an LLC, you need to draft articles of organization that comply with the state’s LLC act and file the articles with the appropriate state office. Typically, the articles are broadly worded and don’t address the members’ rights and responsibilities.
Furthermore, most state LLC acts provide default rules that can be overridden or altered by agreement of the member(s). Odds are the act doesn’t provide what you want, and even if the default rules are acceptable today, they may be unacceptable tomorrow if the act is revised by the state’s lawmakers.
Relying on the default rules may be an easy way to get your LLC going, but hardly ensures that your business goals will be met.
Enter the Operating Agreement
A written operating agreement, which is akin to a partnership agreement, provides operational rules for running the business and can override or alter the default rules in your state’s LLC act.
Since state LLC laws vary, it’s important to verify whether your state requires an operating agreement for all, none, or some LLCs. It’s also important to verify whether the agreement must be written to be enforceable.
(Hint—don’t rely on oral agreements.)
For example, New York Consolidated Laws Section 417 says that
the members of [an LLC] shall adopt a written operating agreement that contains any provisions not inconsistent with law or its articles of organization relating to the business of the [LLC]; the conduct of its affairs; and the rights, powers, . . . or responsibilities of its members . . .
Let’s assume you own an equal interest in an LLC with two other folks. If you don’t have a written operating agreement, the state’s default LLC laws may allow the others to
- welcome new members into the LLC without your consent;
- change which law governs if business crosses state lines;
- incur debt or sell assets without your consent;
- add, remove, or revise the terms of the agreement;
- or dissolve the LLC without your consent.
You can see why you want an operating agreement. The agreement should be drafted simultaneously with the articles of organization and signed as soon as possible by all members. It need not be filed with the state and so is not a public document.
Two Good Reasons to Have an Operating Agreement
- The beginning of this article listed two important objectives when forming and operating a business. How does a written operating agreement help you with your liability protection and favorable tax treatment?
- Loss of limited liability has long been a concern of closely held corporations (i.e., “piercing the corporate veil”). Although this is still an open question for LLCs, it seems reasonable that similar rules will apply to your LLC.
- One of those rules is the corporation/LLC should be operated in a business-like manner. Having a written operating agreement lends credibility to your LLC’s business purpose and separate existence.
- An operating agreement can also prevent the unwanted dissolution of the LLC and the resulting distribution of assets to the members (former members after dissolution). Once that happens, the assets no longer have the LLC shield from creditors’ claims.
- With the multimember LLC, you likely created some favorable tax treatment. But not having a valid operating agreement may allow the other member(s) to
- change the date or amount of any required distributions,
- alter how the LLC’s pass-through income is allocated,
- cause a technical termination of the LLC for tax purposes, or
- convert the form or type of business under the state’s LLC law or the federal check-the-box regulations.
Even Single-Member LLCs Need an Agreement
A written operating agreement supports treatment of your single-member LLC as a separate legal entity. That’s why you created the LLC in the first place: for the legal protection. Your written operating agreement helps ensure that protection.
Plus, your death or the transfer of all or part of your interest (think divorce) can result in the addition of members with no prior involvement in your business. The operating agreement can address those factors and others.
Takeaways
Each state’s LLC act provides default provisions that apply absent an agreement to the contrary. However, the odds that the defaults provide exactly what you want are very small.
Luckily, the defaults can be overridden by an operating agreement that gives you more workable and desirable rules.
In particular, an operating agreement can help you meet two big objectives—liability protection and favorable tax treatment for you (and the other members, if there are other members).
You really want your operating agreement in writing. While you can create an agreement using online fill-in forms, you’re far better off hiring a knowledgeable advisor or attorney. And you can immediately write off up to $5,000 for federal tax purposes when you incur fees to get your LLC in place with its operating agreement.