A lot of people believe that in order to create an LLC, all you need to do is file your articles of organization with the California Secretary of State. However, this does not complete the requirements and obligations for creating a California LLC. It simply notifies the state that you have created, or that you are attempting to create, an LLC with a particular name that needs to be protected by the state. What you still need to do in order to complete the creation of your LLC is to create a California LLC operating agreement.
What is a California LLC Operating Agreement?
An LLC operating agreement is essentially a written agreement between its owners (members) specifying how the LLC will be operated. Unlike your Articles of Organization, your operating agreement does not need to be mailed or sent to the Secretary of State or anywhere else. It’s strictly an internal document. This means that you only need to keep a copy of it with your other business and LLC documents.
Your operating agreement is extremely important because it defines how your LLC will be managed and addresses the following issues:
The Members of Your LLC
One of the most important functions of an LLC operating agreement is to simply identify its owners (members). So, your operating agreement should include the names and addresses of all of the members of the LLC.
Members Obligations, Entitlements, Powers, and Rights
Sometimes a group of people get together to form an LLC, but not everyone is intended to be an owner. Perhaps some are intended to be owners, and others employees. An operating agreement allows you to clearly specify each party’s role, entitlements, powers, and rights and to avoid any problems down the road.
Change of Membership
One thing we have to remember is that when you create an organization with multiple members, one of them is undoubtedly going to leave at some point, whether by choice, necessity, death or illness. So, your operating agreement should also cover how membership will be terminated. Furthermore, there should be an established procedure for admitting new members if and when needed.
Member-Managed vs. Manager-Managed
Whether your LLC is member-managed or manager-managed. If you are unsure which of these your LLC is (or should be) consult an experienced attorney for advice.
Member-Managed vs. Manager-Managed
Whether your LLC is member-managed or manager-managed. If you are unsure which of these your LLC is (or should be) consult an experienced attorney for advice.
Each Member’s Percentages of Ownership
Your operating agreement should include each member’s percentage of ownership. For a single member LLC, you will obviously be listed as the only owner and your operating agreement should reflect the fact that you own 100% of the company.
How Your LLC Will Be Taxed
Your operating agreement should also state how you want your LLC to be taxed. Do you want it to be taxed as an S-corporation, a disregarded entity or a partnership?
Each Member’s Contribution to the LLC
Your operating agreement should also include information on each member’s contribution to the LLC. Whether you have contributed a lump sum of cash to the LLC or only service, knowledge and man-hours, this should be reflected in your operating agreement.
How Distributions Will Be Made
Your operating agreement should specify how the distribution of your LLC’s profits and losses will be handled. Will you be taking distributions on a regular weekly, monthly or quarterly schedule? Or, will distributions be irregular? Whichever you choose, the terms should be set forth in your operating agreement.
Approval For Actions Taken by the LLC
Your operating agreement should state whether certain actions taken by your LLC need to be approved in writing by its members. It can specify exactly what type of transactions, purchases or other actions that need written approval before being taken.
How Meeting of the Members Will Be Called
Your operating agreement should also provide information regarding how meetings of your LLC’s members will be called. If you want to commit to having annual meetings, you can put this in your operating agreement. But, if you are the only member of the LLC, you can hold meetings whenever you want. As an alternative, you can state in your operating agreement that anything that can be done in a meeting, may be done in writing in lieu of a meeting. Whatever you decide, it should be stated in your operating agreement.
How (and when) the LLC is to be Dissolved
Your operating agreement should address when and how you can dissolve your company and what steps need to be taken when winding up its business. All of the steps required to dissolve your company, whether they are self-imposed or imposed by the state, should be specified in your agreement.
How Ownership in the LLC will be Transferred
Your operating agreement should address what happens when you decide to transfer ownership of your LLC, either partially or completely. For example, if you later take on a business partner and you want this new person to be a 50% owner, your agreement should state under what circumstances you can transfer ownership and what steps you need to take to do so, as well as, any other requirements that must be met.
How to amend a California LLC Operating Agreement
Finally, your operating agreement should state how it can be amended. If later on down the road, you want to change how your company operates in some ways, your operating agreement should say how this is to be achieved.
This is by no means an exhaustive list of what a well crafted operating agreement should address, and if you don’t already have one for your LLC, you should consult with a lawyer who understands LLC’s and can give you some advice on what issues you should cover.
Why Do I Need a California LLC Operating Agreement for My California LLC?
First of all, pursuant to California Corporation’s Code §17050, every LLC is required to have an operating agreement in place, whether it be a single-member LLC or a multiple-member LLC. Apart from that, having a well drafted, custom operating agreement for your LLC offers the following benefits:
A California LLC Operating Agreement Provides Flexibility
State law provides for a number of rules and regulations by which you must operate your LLC. But, with an operating agreement, you can adjust some of these rules and regulations and set a customized standard by which your LLC will be operated. This is one of the main benefits of an LLC––the flexibility to operate your company the way you want, as opposed to having to do so by the default rules set forth by the state.
A California LLC Operating Agreement May Provide Tax Advantages
When an LLC is set up properly, it can offer some great tax benefits, but this will require you to have an operating agreement in place. If you don’t have a good operating agreement in place, an LLC effectively offers you no tax benefits. Furthermore, if you happen to be audited by the IRS and you don’t have a document such as an operating agreement in place specifying how you elect to be taxed (as an S-corporation, partnership, or C-Corporation) you will be taxed as a partnership (or disregarded entity) by default, which may increase your tax liablity.
A California LLC Operating Agreement Can Provide Asset Protection
The biggest benefit of setting up a California LLC is undoubtedly the asset protection it provides. To explain, when your LLC is set up correctly, if it incurs a debt or a liability, or if someone sues your LLC, they will not be able to come after you individually as an owner and attach your personal assets to satisfy the debt. This is often referred to as protection from inside-liability. It works the other way as well, if you personally incur a debt or become involved in a lawsuit where you are being sued, they will not be able to get to the assets owned by your LLC. This is often referred to as protection from outside-liability. Your LLC effectively creates a wall of separation or liability protection between your business and your personal finances.
The primary purpose of your operating agreement is to maintain this layer of protection by showing the court that you treat your LLC as if it is separate from you and that you respect it as a separate business entity. Furthermore, having an agreement in place indicates that you are managing your business properly and as such you should enjoy the benefit of asset protection offered by doing business as an LLC.
What if I don’t have an Operating Agreement for My California LLC?
If you file your articles of organization with the California Secretary of State but fail to create an operating agreement, your LLC will not be in compliance with the state law and should you ever be sued or subject to an IRS audit, your personal assets and the assets of your LLC will be exposed to liability because you have not specified who your company’s owners are, how your LLC operates, your preference of tax treatment, and so forth.
So, in order to protect yourself from a lawsuit or IRS audit, you need to take the extra step and prepare a good operating agreement for your LLC.
Does a California Single Member-LLC Need An Operating Agreement As Well?
California requires all LLCs a have an operating agreement, even single member LLCs. This may seem odd, since with a single-member LLC there will not be any votes or disagreements amongst the members, and you can for the most part do whatever you want with the company. But, an operating agreement is nonetheless very important because a single-member LLC is still a business and you still need evidence that your business is being managed properly.
Furthermore, even a single-member LLC will usually need to show an operating agreement in the following situation:
- To a lender when seeking a loan for your business
- When you purchase real estate in your business’s name
- To your accountant or tax consultant when they are providing you with assistance
- To your lawyer when seeking legal advice
- To potential investors and business partners
- To the court when your LLC is involved in a lawsuit.
How to Create a California LLC Operating Agreement
In order to create a California LLC Operating Agreement, you will need to have some basic information ready:
- Your LLC’s formation date;
- The name and address of your registered agent;
- Your LLC’s general business purpose;
- The names and addresses of our all of your LLC’s members; and
- Each member’s percentages of ownership.
Bear in mind, you can make amendments to your final operating agreement whenever you want. In fact, an operating agreement is meant to be fluid and to be amended as your business grows.
Making Changes to Your California LLC Operating Agreement
If you need to make simple changes, such as a change of address or a change in the name of your registered agent, you can usually do this yourself by simply revising your operating agreement and having all the members sign it.
However, to make more complex changes such as a transfer of interest from one member to another, or when you decide to take on investors in order to raise funds, it is best to have these changes made by an experienced attorney. Changes such as these can have profoundly negative legal and tax consequences if not done correctly.
For help with preparing or amending your California LLC operating agreement, contact Odgers Law Group to schedule an initial consultation. Our experienced LLC attorneys can ensure that 1) your you cover every issue legally needed to be addressed, 2) that the agreement is in compliance with state law, and 3) you are protecting yourself and your business as best as you can.
Odgers Law Group has business attorneys that serve all of San Diego County including Poway, Del Mar, Sorrento Valley, Carmel Valley, La Jolla, Encinitas, Cardiff, Solana Beach, Carlsbad, Mission Valley, 4s Ranch, Ramona, Escondido, Rancho Bernardo, and all of San Diego North County, Los Angeles, Beverly Hills, Culver City, and Century City.