What Is an S Corp Operating Agreement?
With respect to the S corporation as an entity, the underlying document(s) that establish and govern the affairs of a corporation is its bylaws. However, the bylaws are often not sufficient for an S Corporation, especially in instances where there are multiple individual shareholders with other business interests (multiple trusts, partnerships or C-corporations). Because the S Corporation often has multiple owners who have other business interests, it is vital to have a separate operating agreement that will address and govern the terms of operation for the S corporation .
The Operating Agreement of an S corporation is a contractual agreement between the shareholders and is used to define or clarify shareholder rights. Use of an S corporation operating agreement ensures that the S corporation will not be in violation of S corporation rules and regulations. Running an S corporation without a clear operating agreement can have costly consequences. Internal Revenue Code Sections 1373 and 1374 simply is not adequate for many closely-held S corporations. S corporation owners can use an operating agreement to create their own unique contractual agreements and rules and should consult their CPA and business attorney for guidance.
Essential Elements of an S Corp Operating Agreement
An operating agreement is a critical document for controlling the structure and operation of any company, and this is no different for S Corporations. However, S Corps operate on a shareholder basis much more akin to corporate bylaws and stockholder agreements than they do by LLC operating agreements or partnership agreements which govern the internal affairs of members or partners. This conceptual difference has important ramifications on what needs to be contained in the operating agreement for an S Corp.
Some of the key elements that should be included in an operating agreement of an S Corp may include:
Ownership Structure
While the operating agreement should contain stock ownership structure information, including voting rights and transfer restrictions, the best information about ownership for an S Corporation will generally be found in the full corporate records together with a list of all stockholders, organized by the number of shares owned by each in the company. A separate stockholders agreement, like bylaws or a corporate code of ethics which apply when the S Corp operates in a corporate format, may also be helpful and often goes hand-in-hand with a corporate operating agreement.
Management Roles
The management of the S Corp may be limited to a small group of shareholders or be open to voting shareholders and non-voting shareholders alike. Including information about voting rights, powers of the board of directors, or committee members may be helpful. As with any other business organization, this information should also make it clear who will handle the internal management, and how the development of corporate policy and direction will be handled.
Decision-Making Processes
How are decisions made concerning the company and by whom? Including provisions for the appointment of officers, committees, and other decision-making bodies will create for the shareholders a set of rules with which they must comply in order to properly run the business.
Succession of Shareholders
At some point in the future, shareholders may wish to pass their shares to someone else (whether voluntarily or involuntarily). Therefore, any restrictions throughout the S Corp operating agreement should be laid out in such a manner that shareholders understand how to remove shares from one person and give them to another.
Dispute Resolution
The decisions made by shareholders could be disputed, and shareholders may encounter situations where a shareholder is not fulfilling their duties or carrying their weight. Including an agreement to arbitrate any disputes, or other manner of resolving internal conflict, will provide shareholders with information about how to straighten out disputes efficiently without involving the court system.
S Corp Operating Agreements vs Other Business Entities
Since the S Corporation is a pass-through entity like an LLC, there is naturally a lot of confusion about the S Corp operating agreement and how it compares to an LLC operating agreement. An LLC operating agreement may be simple or complex, depending on the needs of the members and the complexities of the company. The S Corporation operating agreement is similar to that of the LLC in that the members are allowed to craft procedures that fit their specific needs. However, there are some differences regarding naming conventions, tax designations, and IRS requirements.
For example, an operating agreement for an S Corporation will reference "Stockholder" and "Shareholder" rather than simply "Partner." The Federal government requires that S Corporations follow specific requirements when it comes to taxation and IRS filings. That is, how many shareholders a company is allowed to have and still qualify as an S Corp. An S Corporation cannot have more than 100 shareholders. This is much different than an LLC whose membership can be unlimited.
With an LLC, the members are liable for the LLC debts to the extent of their capital contribution. Shares are often issued in an LLC operating agreement but those shares do not usually give the shareholder or member any voting rights. Your typical LLC membership interest does not get you a say in who runs the company and how decisions are made. In an S Corporation, the shares are much more formal and are actually the official certification of ownership in the company. That is not to say you cannot use shares for an LLC membership interest. But typically people do not. Again the intent of this blog post is not to teach you how to create an S Corporation operating agreement. But rather show you how they differ from an operating agreement for other business forms.
The S Corporation is a hybrid entity. It has some similarities to corporate structures and some similarities to LLC membership. This means that you have to be cognizant that some of the same rules for corporations also applies to your S Corp. For instance, the board of directors; Corporations have a board of directors. While most states require that an LLC be member managed or manager managed, they do not require that they have a board of directors. Generally the S Corp board of directors can be managed by one person or more, depending on the needs of the corporation. That is not to say that an LLC cannot also have a board of directors. The operating agreement for any entity is about determining how the company will be managed and how decisions will be made. Unfortunately, there is no cookie cutter operating agreement for S Corporations.
Requirements and Legal Considerations
When creating an S Corp, at least nine areas in your operating agreement are legally required. Each of these must be considered and addressed in your S Corp operating agreement. The list below, found in Internal Revenue Code 1361-1379, is in the order they appear in the tax code, but not in the order you should address them.
- Organizing the company: You must specify which state you organized the business under and where the registered office and registered agent for the business is.
- Eligibility requirements: The business must be organized as a corporation, comprised of shareholders who are individuals (with some exceptions), citizens and residents of the U.S., and it must offer one class of stock to all its shareholders.
- Election to be taxed as an S Corp: The shareholders must agree to elect to be taxed as an S Corporation, and the tax year of the corporation must be the calendar year.
- The taxation of shareholders: It must be spelled out that income and losses from the business will be passed through to each shareholder on a pro-rata basis and taxed to them at their personal tax rates. This is not an issue until the 2018 tax year, but that doesn’t make it less important.
- Limitations on ownership: You must indicate how many shareholders the business may have maximum, how the number of shares of stock issued to each shareholder will be counted (typically by percentage), whether the shares can be redeemed by the corporation and under what circumstances that might occur.
- Distributions of income: This must be spelled out and may be changed periodically. If profits are not distributed, then if a liquidating event occurs, the prior un-distributed income can be included as part of capital gains.
- Shareholder loans: The agreement must indicate under what circumstances the shareholders or their spouses are permitted to lend money to the corporation.
- Accounting methods: Include how the company will account for depreciation, inventory, bad debts and uncollectible receivables.
- Liability protection issues: In order to comply with federal law, the business structure must be set up as a corporation and be operational as a corporation. The shareholders must avoid commingling funds and other matters that are not clearly personal versus business-related.
Example S Corp Operating Agreement
A well-drafted S Corporation Operating Agreement is a critical element in promoting the business and protecting the owners of the S Corp. In the preceding section, we will identify and describe the key terms and conditions that should be addressed in the S Corp Operating Agreement. Once you understand and prioritize the terms that must be included in S Corp Operating Agreement, the next step is to craft the form. It is important to search for a quality form to customize in drafting your S Corp Operating Agreement . When researching for sample S Corp Operating Agreement templates, make sure the template includes the following sections: Name of the Corporation, Date of Incorporation, Signature of the Organizers, Purpose, Number of Common Stock Shares, Sub-S Corporation Election, Board of Directors, Officers, Bank Account, Accounting Books, Fiscal Year, Annual Meeting Schedule, Voting Requirements, Liability Insurance, Indemnification, Authorized Capital Stock, Distributions Policy, Dividends and Director and Officer Liability. You can easily find sample templates for S Corp Operating Agreement on various legal template websites.
S Corp Operating Agreement Mistakes to Avoid
When it comes to drafting an S Corp operating agreement, there are some common pitfalls that businesses face that can lead to more problems than they’re worth. Avoiding these issues can save you time and money in the long run, and make the process far smoother.
Neglecting the Operating Agreement
One of the biggest mistakes many business owners make is thinking that the operating agreement is a ‘one and done’ document that will be in effect for the life of the company. As your business grows and changes over time, your operating agreement should reflect those changes. Always consult with an attorney to make sure your S Corp operating agreement is up-to-date and properly drafted.
Vagueness
If a clause or section of your S Corporation operating agreement is unclear or worded poorly, it can lead to confusion among members and shareholders. When crafting your operating agreement, be as specific as possible to alleviate any chance of ambiguity.
Neglecting Members’ Rights
Many businesses will hammer out the details of their operating agreement and then move on, forgetting about other important aspects of the business entity itself. It’s crucial to understand all the rights and privileges of the S Corp for each member to ensure everyone is on the same page and in agreement.
Leaving Out Tax Matters
Understanding how taxes impact the distribution of profits is one of the most challenging aspects of an S Corp. How the various shareholders are taxed, and the rights and responsibilities they bear, will be laid out in the operating agreement and should be done clearly.
Not Having Everyone on Board
An S Corporation requires all members to sign off on the operating agreement. If any member doesn’t agree, it can’t be used for the business. Make sure before you draft the operating agreement that all members and holders of shares agree to the terms.
When Is a Lawyer Necessary
It is important to consult a legal professional before crafting an operating agreement, or at least having the final document reviewed prior to signing. Laws differ by state and any deadlines for filing or required elements before signing, differ by jurisdiction.
No one would bake a cake without tasting it or a sculptor without standing back to assess the dimensions. Similarly, a business owner who does not have a clear understanding of the consequences of an Operating Agreement, may find a poorly-written document causes unexpected headaches in the near future. An Operating Agreement may also not contain other necessary documentation that protects the officers , shareholders and company itself.
If the Operating Agreement fails to include any required elements, or does not follow necessary timelines for filing of other documents, not only can it lead to unanticipated personal liability, but it can also result in lost tax benefits.
A corporation with fewer than 100 shareholders may request the IRS for Subchapter S status, which allows small corporations to pass income through to shareholders, without use of the double taxation requirement. Specific requirements must be met to qualify for S-status and if those requirements are not properly included in the Operating Agreement, tax write-offs may be lost.