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3 Reasons Why Your Single-Member LLC Must Have an Operating Agreement
Chris Daming, J.D., LL.M. : Apr. 18, 2023
When it comes to forming a single-member LLC, you’ve probably asked yourself: “Do I really need an operating agreement for my business?” "What’s the worst that could happen without it?” “Is this just more useless paper pushing? You’re saying I need to write a contract to myself?”
As lawyers, we get these kinds of questions regularly. And if you’re asking these questions, good. It means you’re thinking seriously about building a sustainable business. I’ll admit that it does seem strange at first to have to create an operating agreement when you’re the sole owner of your startup.
But there are a ton of good reasons why you’re going to want to get this agreement finalized, let me explain.
Single-member LLCs, or LLCs with only one owner, are one of the most popular kinds of businesses. Many people choose this type of entity to take their passion project or side hustle to the next level. For the purposes of this post, we’ll assume that you’ve decided a single-member LLC is perfectly right for your business.
Because there’s only one member, a single-member LLC can be less complicated to run than a typical multi-member LLC. And it requires considerably less paperwork than a corporation.
As an LLC, there are two key documents required for formation.
The first is your Articles of Organization, which needs to be filed with the state where your business is formed in order for your business to be legit. This document states your legal name, the company’s purpose, registered agent, estimated duration, and planned management structure.
The exact details for the Articles of Organization vary from state to state, but in general, it is merely just stating exactly what your company is, how it will be managed, and who will be running it.
The second document is your Operating Agreement. Below we'll go through step-by-step each provision contained in a single-member operating agreement.
What's an operating agreement?
An operating agreement is a contract between LLC members similar to a partnership agreement or a shareholders agreement. It shows the structure of the organization. It sets out the members’ duties, rights, and responsibilities in the operations and finances of the LLC. Most importantly, it covers what happens when a member wants to leave the business and how and when a member can transfer or sell their LLC interest.
The debate around single-member LLCs and operating agreements
So the question you must be asking yourself is, “Why would I need an operating agreement with myself?” Well, there is an excellent really good reason… for protection!
So if you are starting a business you want to make sure you have all of your legal paperwork in place. In researching your state’s requirements you might even discover that you’re not legally required to have an operating agreement for your LLC. (But, in many states, you are required by law!).
Does this mean you’re off the hook and can skip this step?
Nope! Regardless of whether you’re legally required to have the agreement, it’s truly a necessary document for your business. While we talk about a lot of other reasons below, here’s the most obvious one—who owns your business?? If you set up Widgets, LLC, and 5 years down the road you’re trying to sell it—imagine going to a prospective buyer without any proof you actually own that business!
Your Articles of Organization—that doc you file with the state—doesn’t say you own it. It might say you’re the registered agent, but that doesn’t mean you own it. That’s what the operating agreement does, among many other things. Let’s talk about some other reasons.
First, we’ll go over why your single-member LLC needs an operating agreement. Then we’ll cover the topics that are usually included in an operating agreement.
Why have an operating agreement?
Here are 3 reasons why having an operating agreement can be useful.
1. It can secure your liability protection.
That’s right. An operating agreement helps protect your personal assets from your business assets. This is crucial to understand, as it’s the primary main reason that your single-member LLC needs an operating agreement.
Even if an operating agreement isn’t required in your state, running your company without an operating agreement could jeopardize your LLC status.
Think about it. The main benefit of an LLC is the liability protection it offers. It’s probably the reason why you created your LLC in the first place.
What does "liability protection" even mean?
In case you’re confused, let’s quickly go over what we mean by liability protection. LLCs protect your personal assets, such as your home and bank accounts, against people who sue your business for some reason (like damaging property or breaching a contract).
To keep this liability protection, you need to keep your business affairs and personal affairs separate. This includes not “commingling funds,” which means not treating your business finances as personal finances. It also includes respecting various business formalities, like keeping and maintaining meeting minutes.
If you don’t keep your business and personal stuff separate, then you risk someone “piercing the corporate veil” in court, which means they could legally get around your liability protections for not treating your business like a business.
An operating agreement is a key business document that shows your business operates like a legit company. Without the operating agreement, your state might not acknowledge you as an LLC, which means someone could sue you without there being any shield to protect your personal assets.
You’ve already put in the time and effort to form your LLC to get liability protection. So just go ahead and get an operating agreement to make that liability protection secure.
2. Without an operating agreement, your state's default rules will apply to your LLC.
If you don’t have an operating agreement, your state’s default rules apply. Default rules are set by states so that, if a contract does not specify certain terms, there are rules set in place to fill these gaps. But since they’re made for the lowest common denominator of situations, they can sometimes give businesses unwanted results.
An example is helpful here. Your state might have a default rule that gives someone, like a spouse or child, the right to inherit the assets of your LLC in the event of your death or incapacitation. But this right to inherit assets might not be coupled with the right to manage it.
So, if you want a specific person (like someone who knows the business and has worked there a long time) to take over your LLC in the event something bad happens to you, then you need to state that in your operating agreement. If you don’t, you could have a situation where you become incapacitated and your 2-year-old daughter is expected to take over the company and run it.
3. Banks and investors may require it.
They might want to see your operating agreement as proof that you own your LLC. Your state registration document alone might not prove that you own your LLC. So, it’s best to come prepared and have your operating agreement ready.
What’s in a single-member LLC operating agreement?
Now that you understand the importance of having a single-member LLC, you’re probably wondering what it entails and how to get started. Here is a list of what your operating agreement should cover.
- The name, location, and purpose of your LLC. Name and location seem evident enough, but you also want to be sure to explain the purpose of your LLC. You don’t have to be extra specific. In fact keeping your statement generalized leaves the door open for you to take on new ventures without having to refile.
- Your LLC’s registered agent. The registered agent is the person who is responsible for receiving and taking care of important documents on behalf of your company.
- The term of your LLC. Unless you have a specific time frame for the business, you can just state the duration as perpetual.
- Information about LLC membership. This section requires more thought. Here‘s where you can list yourself as sole member and manager. You also state the rights and duties of each member (even when it is just you), including any capital contributions, any voting rights each member might have, and management structure. This may all seem silly since you are the only member, but it is an important part of getting your single member LLC in place.
- How profits and losses are distributed. Here you will want to clearly state how all profits and losses will be accounted for and distributed.
- Accounting and record-keeping information. You will need to state who is responsible for the accounting and record-keeping (you, an independent accountant, or an accounting firm) and what accounting method you’ll you will use (cash or accrual).
- Indemnification and limitation of liability. These statements help to limit the amount you can be financially responsible for in the case of a lawsuit against your company.
- Dissolution. This is the plan for what to do when things… well, don’t go as planned. How to dissolve your LLC and designate who will maintain control of the LLC in the event of your death or demise.
What to do if you add another member to your LLC
Most of us small business owners dream of the day when our business expands past what we can manage by ourselves. If you find yourself in that fantastic position and you are ready to add another member to your LLC, you will need to redo the above paperwork in accordance with the agreement between yourself and the new partner.
Does the type of operating agreement matter?
The short answer is "yes." The agreement varies if you're a single-member vs. a multi-member LLC. It also depends on if you're manager or member-managed, and how you're taxed.
Do you need a lawyer for this?
If you get to this point and ask, "What next?" The biggest question is, "Do you need a lawyer to help you with all of this? To help you setup the LLC? And to draft the operating agreement?" Sometimes, yes (especially if you have multiple owners). But more often than not for single-owner businesses, you don't need a lawyer to start your business. Read our post to find out what best applies to your scenario.
Alternatively, if you know to DIY it (as most single-owner LLC owners do), and you know how you'll be managed and taxed, you can get one of our operating agreements below by clicking on the relevant link:
- Single-Member Operating Agreement Template, Manager-Managed LLC
- Single-Member Operating Agreement Template, Member-Managed LLC
- Single-Member Operating Agreement Template, S Corporation LLC
- Multi-Member Operating Agreement template, Member-Managed LLC
Or, if you wanted to get the agreement, plus 100+ other contract templates, along with a step-by-step, interactive platform to help you start your LLC, check out our LLC Starter Pack.