All About the Operating Agreement
When forming a Limited Liability Company (LLC) in Virginia, a primary requirement is to file Articles of Incorporation with the Virginia State Corporation Commission. However, if you ask a local lawyer about an operating agreement, you may be surprised by the answer. In fact, many people are surprised to learn that there is no legal requirement in Virginia for an LLC to have an operating agreement; however, it is highly recommended. The Virginia LLC Act merely states that "unless otherwise agreed", the members can determine the "conduct of the business and the rights and liabilities among the members".
LLCs are popular structures for small business owners because they offer both personal liability protections and taxation benefits. However, not having an operating agreement places these protections in jeopardy and potentially create negative tax consequences. Therefore although it’s not legally necessary to create an operating agreement when forming an LLC, if you don’t, you may not get the protections you think you are getting.
Liability Protection
When you fail to comply with the law, you risk losing the LLC protections that the law provides you. Filing the paperwork to create the entity is only the beginning. When you create an LLC and choose to not have an operating agreement, you are giving no guidance on how the business should be run. For example, without an operating agreement, any member may be able to use the powers of the company to commit wrongful acts. In the event of a lawsuit, the court is left with very few choices if there is not an operating agreement . As part of its judgment, the court may issue orders and injunctions on the business that removes the business owner’s ability to run the company, while the legal battle plays out. Without guidance from an operating agreement, the court may even appoint a receiver to run the business for the duration of the suit.
Tax Consequences
Even if your LLC is a single-member LLC, the IRS treats the single-member LLC as a disregarded entity. This means that your business activities are reported on Schedule C of your personal income tax return. Because of this, any self-employment tax issues, such as excessive self-employment tax, will pass through on to the business owner and become subject to the self-employment tax. If you have a multi-member LLC, all profits, losses and distributions will pass through to the members and be subject to tax on each member’s personal income tax return.
An Operating Agreement helps ensure that the members are treated fairly, regardless of how the profits and losses occurs. For example, what do you do if one member invests $50,000 and another member invests $5.00, but they both receive 50/50 profits and loss distributions? You damages the business, you setup your LLC to fail. Having an operating agreement ensures an operating legitimacy of the company, and fairness amongst the members.
After reading the above, why would you forego preparing an operating agreement, especially when it is not that cost prohibitive? An operating agreement will help provide organizational clarity to your LLC and ensure the protections afforded to it. You’ll be glad you did.
What to Include in your Virginia LLC Operating Agreement
The framework of your Virginia limited liability company is established in its articles of organization, but it is the operating agreement that defines the rights and responsibilities of the LLC’s members and managers. An operating agreement is often considered an internal document because it does not need to be filed with the Virginia State Corporation Commission. Still, having a carefully crafted operating agreement is important because it will hold up in court should a dispute arise between company members.
A Virginia operating agreement typically includes the following essential elements:
Members. The LLC operating agreement should identify the company’s members and spell out their respective roles within the business.
Capital Contributions. The operating agreement usually details how much capital each member has contributed to the LLC.
Allocation of Profits and Losses. A Virginia LLC operating agreement will typically specify how profits and losses will be allocated to each member.
Management Structure. If the Virginia LLC will be managed by a small group of people (rather than having all members participate in management), the operating agreement should include provisions for management and for appointing and removing managers.
Change of Membership. The most common changes of membership in a Virginia limited liability company are when a member sells his or her interest in the LLC, or when a bankruptcy trustee seizes a member’s interest. Some LLCs require unanimous consent before transferring membership; others will allow members to unilaterally assign their interests. An operating agreement should detail the process for adding new members, buying out departing members, and removing members from the LLC.
Dissolution and Liquidation. The operating agreement should provide for the dissolution of the Virginia LLC and the distribution of any assets remaining after creditors have been paid.
Virginia Factors Affecting Operating Agreement
Virginia, like many states, has specific provisions that may be included in an operating agreement for a Virginia limited liability company. Some of these provisions may be unique to Virginia and reflect state law or characteristics of the Virginia limited liability company statute.
For example, Virginia law permits a limited liability company member to waive his/her right to notice and a copy of the LLC’s annual financial statements and certain tax returns. In addition, a limited liability company may require a member to waive the right to receive tax-related information (such as IRS Schedule K-1 or its equivalent) by unanimous consent of the members. As a result, a waiver provision could be included in the operating agreement for each member, with the LLC stating that it will maintain this information in its records if no member opts out of receiving the information once provided. A provision could also be inserted directing the manager(s) or members, as applicable, to provide copies of all federal, state, and local tax returns to the other members. Whether such provisions are needed in your Virginia LLC will depend on the overall size and complexity of the limited liability company. Where possible, however, it is always good practice to include such provisions so that the members know (i.e., through the operating agreement) exactly what to expect when it comes to information flow from the limited liability company.
One other possible Virginia-specific issue: Virginia’s limited liability company statute expressly authorizes the governor to issue a certificate of cancellation if a Virginia LLC fails to file the requisite documents after administrative dissolution. This means that if your LLC is administratively dissolved (typically because it has failed to file its annual report/timely pay related fees), a Virginia judge is not the only person who can reinstate the LLC – the governor of Virginia can do this as well. This is an important fact to keep in mind as it may provide a very cost-effective (and simple) way to turn things around.
Writing Your Own Custom Sample Agreement
Once you have a solid understanding of how an operating agreement works and what yours will need to include, it’s time to create a new, customized sample agreement using the template from the previous section as a guide. Below is a detailed method for doing exactly that, tailored to the context of a Virginia LLC.
- Start with the LLC name and the effective date of the agreement. As in the template agreement, include a sentence to the effect that the agreement is being entered into between the members (owners) of the LLC and will be binding until amended or dissolved by law.
- Include a statement of purpose that outlines the reasons the LLC was formed and the types of business activities the members intend to engage in.
- Specify the extent of the member’s personal liability for debts and whether that liability is limited to the amount they invested in the company. If the LLC is structured to provide protection from creditors, make this clear in the agreement.
- Specify what happens to all of the assets an LLC member has at the time of their death. Do they belong to the surviving members, or are they divided among the deceased’s heirs according to established law? Set forth the process for passing along assets and stipulate whether they must be sold to a third party .
- Spell out what happens to the LLC interests held by members that want to leave the company. Do departing members lose their rights to remaining profits, or are those profits disbursed according to a specific formula? Also, clarify how and when departing members can receive their ownership share value.
- Specify whether the LLC will be taxed as a corporation or a sole proprietorship, the latter of which is possible in Virginia and many other states.
- Indicate what will happen if the LLC is dissolved and how the members will go about restarting a new LLC.
- Specify whether meetings will be held on a regular basis and how records will be kept.
- Clarify things like the registered agent’s name and address so they’re easy to find. This section should also establish who will be responsible for keeping the operating agreement updated and who will make corrections to it if errors are discovered.
- Sign the operating agreement. It’s a good idea to sign and date the operating agreement at the very end to show that the signatures weren’t added to an incomplete agreement that could otherwise cause disputes down the road about whether the LLC is being properly run.
Mistakes to Avoid in an LLC Agreement
When starting a new business, it is crucial to protect the personal assets of the owners by not exposing any of those assets to the potential liabilities of the business – this is why it is important for a new business entity to be formed under state law, probably as an LLC. However, that entity recognition under state law does not protect the entire personal don’t mix up easily. That there are separate and distinct actions that must be taken to establish an "operating agreement" for the LLC, a way to recognize the relationship between co-owners of the LLC, as well as the outside people who may want to have dealings with the LLC.
There are two very common mistakes that the new business owner can make due to a lack of knowledge of the way business entities work. The first is to be careless in the drafting of the operating agreement. The operating agreement needs to provide for what happens in all areas of the business, and should be as thorough as possible. The second mistake is to assume that once an operating agreement template is put into place at the time of the formation of the LLC, that the operating agreement need not be revisited. Both of these mistakes need to be avoided at all costs, because they are easily done but are also easily fixed if you take the time to do so.
The mistake that is made by many new business owners when drafting an operating agreement is to not think through every aspect of their business. While it might be tempting to only focus on the topics that are known at the time of formation of the LLC, they need to understand that there are many future contingencies that arise in every operating business that cannot be predicted. As a result, the operating agreement needs to discuss how the newly formed LLC should respond to each of those potential issues that could arise, even if those issues are not present at the time of formation of the LLC. The way more established businesses deal with potential future contingencies is to include language that says in the event that such-and-such occurs, we will respond in such-and-such a matter.
The second mistake that is made is that operating agreements are often not revisited during the life of the LLC. It is very important that all owners of the LLC not only look at the operating agreement upon its original formation to make sure that it provides sufficient protection of their personal ownership, but that they also spend time going over the agreement at least once per year to see if there are additional contingencies that need to be addressed, and have the agreement be amended to reflect those additional issues.
In this day and age, it is also important to regularly check on whether your LLC is staying within the bounds of your agreement. The issues or actions that you needed to address in your operating agreement years ago may expand over time, and your operating agreement may need to be changed for these new issues. If you discover that your LLC is not within the bounds of your operating agreement, you may want to break down your LLC into a set of new, distinct and separate business entities that can be either treated separately by investors or that can more easily be transferred to new members. If necessary, you can also return to the original entity and set up a new operating agreement, but still retain and operating agreement for the other entity.
Professional Assistance is an Option
Given the technical nature of an operating agreement, it is wise to hire a professional to take the lead in drafting this document. For a reasonable fee, you can provide the attorney with the relevant details about your new business: who your partners are (if you have partners), what the expected salary and profit share for each partner is, what other rights and privileges they should have, and what happens upon someone leaving the company, and any other issues that are important to you . A skilled business attorney has written many operating agreements and knows what clauses each business entity might need. He or she can quickly suggest what clauses need to be added to the document to cover unique situations or concerns that you have. An experienced attorney can also word each clause more clearly and concisely than you could on your own.