Many of my business clients are creating single-member LLC's either for their business or to manage real estate and rental properties that they own. In these situations, one of the most common discussions we have is whether or not they should create an Operating Agreement (they should) and why they even need one if they are operating their LLC on their own without a business partner. Their logic, which isn't really unfounded, is that with only one member involved, it might seem unnecessary to go through the process of writing out an agreement with yourself.
However, having a well-drafted operating agreement is crucial for any single-member LLC. This document provides essential legal, financial, and operational protections, ensuring the business runs smoothly and mitigating potential risks.
As with any document you have drafted for your business (or for your estate plan for that matter), it's important to make sure you are getting a document tailored for your situation. While your friend who started a business may not need an operating agreement, there can be a variety of reasons why it makes sense for you and your business. So let's look at 7 common reasons a single-member LLC would need an operating agreement.
7 Reasons a Single-Member LLC Needs an Operating Agreement
This list of reasons for a single-member LLC is going to be a good starting place, but should not replace a call to your business lawyer to discuss what's the best option for you and your business.
1. Clarifying Ownership and Structure
While it may seem redundant for a single-member LLC, an operating agreement serves as a formal declaration of the ownership and structure of the business. It explicitly states that the LLC is owned and managed by a single person. This clarity can be vital in legal situations where proving ownership or the structure of the business is necessary.
2. Maintaining Limited Liability Protection
One of the primary advantages of forming an LLC is the limited liability protection it offers. This protection ensures that the owner’s personal assets are separated from the business’s liabilities. Without an operating agreement, this separation could be challenged. Courts may look at the lack of formal documentation and treat the LLC as an extension of the owner’s personal affairs, thus potentially exposing personal assets to business liabilities. One of the best defenses in Court is to have your documents all properly drafted and in place, showing the Court that you are running a legitimate business. In addition to your operating agreement, this can include corporate minutes and resolutions and other documents.
3. Demonstrating Professionalism and Credibility
An operating agreement can enhance the credibility of your single-member LLC. Banks, investors, and potential business partners often require an operating agreement as part of their due diligence process. Some banks will actually give you a template form to sign in order to open a bank account - not a path I recommend for an operating agreement for your business. It's one thing to sign a corporate resolution authorizing your bank to hold funds for your LLC, it's quite another to blindly sign an operating agreement template given to you by a bank employee. The presence of an operating agreement signals that you have taken the necessary steps to formalize your business operations, which can be crucial when securing loans or engaging in contracts with other entities.
4. Avoiding State Default Rules
In the absence of an operating agreement, your LLC will be governed by the default rules of the state in which it was formed. These rules may not always align with your intentions or preferences for how the business should be managed or operated. An operating agreement allows you to customize your business’s operational procedures, including decision-making processes, profit distribution, and dissolution terms, according to your specific needs. And if your LLC is formed in certain states (New York for example), you are actually required to have an operating agreement in place under the laws of the state.
5. Facilitating Business Continuity and Succession Planning
An operating agreement can outline what happens to the business in the event of the owner’s incapacitation, death, or decision to sell the business. This is particularly important for single-member LLCs, as there is no other member to automatically take over in such circumstances. By including provisions for succession planning, the operating agreement ensures that the business can continue to operate or be transferred smoothly according to your wishes.
6. Managing Potential Disputes
While it might seem unlikely that a single-member LLC would encounter internal disputes, conflicts can arise, particularly in cases where the business grows, hires employees, or takes on contractors. An operating agreement can outline how disputes should be resolved, whether through arbitration, mediation, or another method. This preemptive measure can save time, money, and stress in the future. Many of my litigation clients have found out the hard way that not having an operating agreement can lead to lengthy and expensive lawsuits over the disputes they have within the LLC.
7. Ensuring Tax Flexibility
The IRS treats single-member LLCs as “disregarded entities” for tax purposes, meaning the LLC’s income is reported on the owner’s personal tax return. However, an operating agreement can help clarify how the LLC’s profits and losses are allocated, which can be important for tax planning purposes. Additionally, if you ever decide to bring on additional members or change the tax classification of your LLC, an existing operating agreement can simplify the transition process. This is an area where it is important to connect with your accounting professionals as well to make sure you've got the proper tax foundation for your business.
Wrapping Up
Even though a single-member LLC might seem straightforward, the benefits of having an operating agreement cannot be overstated. This essential document provides legal protection, helps maintain limited liability, and ensures that your business is operated according to your preferences rather than default state rules. Moreover, it enhances the professionalism and credibility of your business, making it easier to engage with financial institutions, partners, and investors. Taking the time to draft a comprehensive operating agreement is a wise investment in the future stability and success of your single-member LLC.
Do I Need a Business Attorney?
If you've started your single-member LLC, but haven't done an operating agreement yet, now is a good time to get it done, so if you'd like to discuss it further, let's schedule a Legal Strategy Session online or by calling my Edina, Minnesota office at (612) 294-6982 or my New York City office at (646) 847-3560. My office will be happy to find a convenient time for us to have a phone call to review the best options and next steps for you and your business.
