Operating Agreements in your Business Plan

We are often asked about how easy it is to “set-up” a Limited Liability Company in Indiana.  The response, in all reality, is easy.  Really easy.  By filling out a few forms for the Secretary of State, you can have an LLC within a few days of application.

But the true reason entrepreneurs seek an attorney for their start-up is not to simply create the LLC.  If that’s all the client wanted, they would buy “Incorporating for Dummies” and go along with their business venture as they see fit.  The purpose for seeking an attorney is to draft a complete Operating Agreement that acts as your business’s governing document.

The Operating Agreement can be as simple as a one page document to as complex as the Internal Revenue Code.  The following are a few provisions, however, that every Operating Agreement should have, regardless of complexity, size or business purpose.

Dissolution and Winding Up

It is important to hash out prior to the creation of your entity how you will dissolve that entity if the entity fails or runs it’s course.  The reason behind this is pretty obvious; when the time comes that the business is failing, the last thing on your mind will be an orderly, responsible dissolution of the company.  Planning ahead for this will save time, money and relationships between business partners.

Transfer of Membership

You may need to discuss the transfer of ownership in any entity.  Often times, Members of an LLC will wish to have first rights of refusal over any transfer of membership.  These provisions will help protect the distribution of future interests to certain individuals, and allow for the already vested Members to have an opportunity to buy out the share of membership attempting to be transferred.

Qualified Income Offset Provision

The Qualified Income Offset (or “QIO”) provision saves Members of an LLC a lot of tax grief and expense.  The purpose of the provision is to protect the Member from unanticipated distributions of expenses and deductions that drive the Member’s capital account below zero.  This provision forces the accounting to automatically apply revenue and income to the Member’s account first until his account reaches, or goes above, zero.

But why is this necessary? 

If your LLC’s Operating Agreement does not include a QIO, then come tax day you’ll be in for a rude awakening.  Without the QIO, your allocations may not have substantial economic effect, and without substantial economic effect, the IRS will not respect your allocations.  This can throw your entire accounting plan out the window, and require you to pay an inordinate amount in taxes that you otherwise were not expecting to have to pay.  This, of course, will be avoided if you choose to be taxed as a corporation under Subchapter C of the Internal Revenue Code.

Minimum Gain Chargeback (“MGC”)

If you’re going to pledge collateral for a loan that you will not be personally guaranteeing (often times advisable), then you will need an MGC provision.  This provision is required to be included in your agreement if you want to allocate in any other manner other than the default allocation method based on your interest in your entity.

These four provisions can save you a lot of headaches when it comes to your business entity.  Without them, you risk large problems in the future that could potentially cripple all of your hard work.



Leave a comment

Filed under Business Planning

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out /  Change )

Twitter picture

You are commenting using your Twitter account. Log Out /  Change )

Facebook photo

You are commenting using your Facebook account. Log Out /  Change )

Connecting to %s