Recognizing the Operating Agreement
An operating agreement is a key document for any limited liability company (LLC). It catalogs essential information for the company, specifying the obligations and responsibilities of the business’ owners. The operating agreement is required by law in some states, and others make it optional, but regardless of the situation in your state, it will be a key source of information about what your LLC is supposed to do, and how it should do it.
Specifically, the operating agreement defines the financial and managerial duties of the members. Information included in an operating agreement can cover many aspects of the LLCA’s operations, including:
The operating agreement also typically contains protocols for the resignation of members, and procedures for profit-sharing among members.
When there are no written guidelines for the operations of an LLC, members must legally operate in accordance with the laws of their state. These laws will include regulations regarding equity distribution, liability, and taxation, along with other important areas of governance. For this reason, it’s often recommended that when forming an LLC, a formal operating agreement is still put in writing, even if it is not required or written simply to work around unpleasant aspects of the state laws that may be more desirable to you to be specified in your company’s regulations .
In the event that a dispute does arise regarding the rights of LLC members and how management will be carried out, the operating agreement becomes the key point of reference. In most cases, if there is any discrepancy between the operating agreement and the regulations of the state, the operating agreement will take precedence. Again, this is why it’s beneficial to have a detailed and explicit operating agreement that spells out the important aspects of your company’s governance. This is especially true if your state offers a very loose set of regulations pertaining to the operation of LLCs. Your operating agreement can provide explicit detail about the aspects of your business’ operations where state regulations may be vague or conflicting for the most expedient resolution of any issues.
Your operating agreement can also allow you to avoid some specific laws in your state that might be unpalatable to you or your members, such as the default assumption in many states that any profits from your company will be subject to double taxation (as the income goes to the LLC, and then to its owners).
Having a clear and concise operating agreement can help to avoid conflicts and reduce the potential for misunderstandings or differences of opinion between members.
Distinguishing Partnership Agreements
Partnership agreements are essential documents in the creation of a business partnership. They specify the terms of the partnership, primarily focusing on the allocation of profits and losses. However, partnership agreements can be much more complex than the division of capital; they also outline the management roles and responsibilities of each partner. They can address how new members may be added to the partnership and how capital may be acquired.
While a partnership agreement often covers how unresolvable conflicts should be handled, such as through arbitration or mediation, some partnership agreements are more explicit in determining how conflicts should be resolved or how partners should exit when they want out.
Legal Distinctions
Operating agreements and partnership agreements are distinct documents that apply to different types of business entities. The primary legal differences lie in the type of company they govern and their purpose. Unlike partnership agreements that only apply to general and limited partnerships, operating agreements are a requirement for the formation of limited liability companies (LLCs). We have provided four examples below with brief explanations of the legal distinctions.
First, a corporate entity is one formed as a separate legal entity where ownership shares are purchased. Corporate entities are not governed by operating agreements. Instead, corporations are managed via articles of incorporation and by-laws.
Second, a general partnership is a business entity where two or more individuals share profits and losses as well as management responsibilities. Operating agreements are not applicable to a general partnership and instead a partnership agreement governs a general partnership.
Third, partners in limited partnerships are not required to adhere to an operating agreement. Instead, limited partnership agreements define management authority and profit sharing for limited partnerships.
Fourth, an LLC does not exist until an operating agreement is executed and filed with the appropriate state agency. In states like Connecticut, processing the operating agreement with the Secretary of State is a requirement for the legal recognition of an LLC.
Identifying the Similarities
Despite their distinctions, there are a few overlaps between the operating agreement and the partnership agreement. Both generally have a primary function of outlining clear guidelines for the management, financial, decision-making, and dispute-resolution aspects of the LLC or partnership. The agreements also tend to have flexible and adaptable writing styles to both address the operational objectives and provide ample room for flexibility in other areas, and they typically require unanimous agreement of the parties to amend the document. Given these similarities, it is essential to understand how the operating agreement differs from an LLC partnership agreement, and determining the right choice is only part of the analysis.
Determining When to Use an Agreement
When it comes to determining whether to use an operating agreement or a partnership agreement, the decision is largely driven by the business structure you employ. If you find that the business entity you are forming is a limited liability company (LLC), you will need an operating agreement. LLCs are governed by state statutes and regulations and require an operating agreement that allocates rights and obligations, details the structure of the company, and outlines how profits will be divided among the members. Because an operating agreement is required for LLCs, it provides a level of assurance that these issues will be addressed.
On the other hand, a partnership agreement is used for a general partnership or a limited partnership. This agreement can cover some of the same topics that an operating agreement does, but they are not necessarily required by law. However, if you are detecting the potential for future disputes, a partnership agreement can be useful. In addition, the document can be beneficial if you want to clearly define the conditions for distributing profits and losses and regulating other aspects of your partnership. For example , the passage of responsibility and authority may be important. The agreement can clarify the extent to which one partner can act on behalf of another, thereby alleviating any questions with respect to the legal authority.
One area in which a partnership agreement is different from an operating agreement is the way in which it relates to profit sharing. A partnership will typically be required to distribute profits according to a more egalitarian formula than would be the case with an LLC. In many instances, profits will be split 50/50 among the partners, for instance, whereas an LLC agreement could have some members more actively involved in the business, while others’ involvement would be related to providing financing. Thus, the members’ obligations are different, and the division of profits would be reflective of these differences.
As always, consult with a knowledgeable business attorney who can help you draft a clear operating or partnership agreement that fulfills the requirements of your business entity and protects your individual and corporate interests.
Drafting Considerations and Recommendations
In the gap between partnership law and operating agreements are a host of issues that can end up creating major problems for member-owned LLCs. It makes good sense for their owners to read as much as they can about the subject—in this case even when there is no clarity about where the line between the two documents is drawn.
Quite a few things matter when you are drafting either an operating agreement or a partnership agreement. Is it really your agreement, or that of your accountant? Who decides what messages should go to customers, and when? What happens when one member of the partnership wants to sell his shares and stay in business only with the buyers or one of the buyers? Tweaking verbiage is not an effective way of dealing with issues like these!
Partnership Agreement Tips
Don’t Focus on the Small Stuff
It’s the nitty gritty that will turn into your nightmare, so avoid wasting time; be pragmatic and focus on the big points, like how the business will be run while you are partners, and how it will ‘settle up’ if someone leaves.
Have a Well-Drafted Partnership Agreement
Tax accounting for partnerships is best handled with a well-drafted partnership agreement. The terms of the partnership deal mainly with questions of management and operations, but they also cover how distributions will be made and how decisions will be reached. The partnership agreement is the basic corporate document, like the articles of incorporation, by-laws, and any other required state documents, but it is the most important because it regulates every aspect of the relationship between the partners.
Create an Operating Agreement
Unlike the partnership agreement, which deals with the business of your unit (keep in mind that a partnership is an "entity"), an operating agreement deals with the individuals who own the corporation. It is similar to a partnership agreement, but covers a wide range of provisions. An operating agreement creates a mutual plan for the company in the event of dissolution, outlines how the corporation will be able to react to the unexpected, and resolves disputes that might arise between corporation members.
As mentioned above, the principal difference between the two agreements is in what they cover. Essentially, the partnership agreement governs the business, while the operating agreement governs the rights and responsibilities of the members. The operating agreement may be tailored to meet the needs of the members or owners of the partnership. Both have their benefits, and both play important roles in managing relationships among the owners of the business.
Legal Implications for Not Having an Agreement
Not having a formal operating agreement or partnership agreement in place carries with it certain legal consequences for LLCs and partnerships that can expose them to unforeseen operational risks. Of particular note, these entities will primarily be governed by default state statutes dictating how the entity is to be managed and how authority is delegated within the entity. This means that the managing, voting, and other control rights allotted to individuals within the entity will all be outlined by statute rather than in the individual’s operating or partnership agreement. A lack of a formal agreement can also lead to disputes over what, if any, voting rights must be exercised to act in the best interests of the entity or what constitutes the binding action of the entity. More often than not, this requires litigation to determine the intent of the parties when they formed the entity, as well as the scope of their managerial rights and obligations.
Under usual circumstances, limited liability companies are governed by their operating agreement and partnership are governed by their respective agreements as well. However, absent a formal agreement, an operating agreement will default to that of the state’s default statute and a partnership will fall under the default state law governing partnerships. As seen in the table below, the governing statutes are more restrictive than the language of an operating or partnership agreement would have been had one been put in place. Decision-making processes may be restricted to unanimous consent or limited entirely to a designated manager or general partner . These default laws can be counterproductive for the management of an entity, though; despite the fact that LLCs are primarily created for the purpose of protecting the members with limited liability, some state statutes withhold the "corporate veil," allowing members to be held personally liable for certain activities of the company. This same potential liability also applies to partnerships, albeit not under the liability exception that an LLC using the corporate veil has.
If disagreements arise where no written terms govern the situation, these default laws will be interpreted in accordance with statutory provisions, which are generally set out in states’ internal affairs laws. For example, a dispute may arise between two or more LLCs where the companies have not defined the allocation of partnership profits or losses among members. Conversely, where a company has defined the allocation, that term is enforced with no regard to whether a particular member contributed greatly to the success of the business or otherwise played a key role in establishing the company. The company’s profits will be divided according to the language of the agreement, even if that means, among several LLC members, two particular members with less involvement may receive a greater share of the profits than those who were more involved in the day-to-day management of the business. Without an operating or partnership agreement defining the contributions of each individual, the courts will have to interpret the members’ understanding and expectations at the time of the entity’s formation. This could lead to an ambiguous and potentially unjust result.