Summary. The operating agreement is the constitution of an LLC, and the default statutory rules that apply without one rarely match what the members intended. This guide works through the document section by section — what each provision does, the drafting choices, and what happens if it is omitted. It covers formation and capital structure, allocation and distribution provisions and the tax rules constraining them, management and the major decisions list that determines real control, and the transfer and buy-sell mechanics that govern death, divorce, default, and exit. Later sections address fiduciary duties and their modification, deadlock, dissolution, tax provisions, and recurring drafting errors.

Two people start a business. One contributes $400,000; the other contributes the customer relationships and will run it day to day. They agree, over dinner, that they are "fifty-fifty partners."

They form an LLC online for $200 and never sign an operating agreement.

Four years later the company is worth $6 million and they cannot agree on whether to sell. Under the default rules of their state's LLC act:

  • Profits and losses are allocated in proportion to contributions in some states and per capita in others — the members do not know which, and it determines whether the split is 50-50 or 100-0.
  • Distributions require the consent of both, so neither can take money out.
  • Selling the company requires unanimous consent, so either can block it.
  • Neither can be removed, neither can compel a buyout, and there is no valuation mechanism.
  • The only exit is a judicial dissolution petition, which is public, slow, and destroys most of the value it distributes.

Nothing here reflects what either of them wanted. It reflects a statute written to supply defaults for people who did not decide.

The operating agreement is where the deal gets written down. This guide is about what belongs in it.

Threshold decisions

Before drafting, resolve five questions, because they determine the shape of the document.

1. State of formation. The LLC statutes differ meaningfully — on fiduciary duty modification, on charging order exclusivity, on judicial dissolution standards, on whether a series LLC is available, and on default management structure. Delaware offers the most developed case law and the broadest freedom of contract; the operating state is usually the right default for a company with no outside investors.

2. Tax classification. By default, a multi-member LLC is a partnership and a single-member LLC is disregarded. An LLC may elect corporate treatment on Form 8832, and may then elect S corporation status on Form 2553 if eligible. The choice drives the allocation and distribution provisions entirely — an S corporation LLC cannot have special allocations or more than one class of economic interest, so the elaborate waterfall provisions in a partnership-taxed agreement must be stripped out.

3. Management structure. Member-managed (all members have agency authority) or manager-managed (only managers do). Manager-managed is the norm for anything beyond a two-person company, and it is essential where any member is passive.

4. Capital structure. One class of units, or multiple classes with different economic and voting rights? Preferred returns? Profits interests for service providers?

5. Exit expectations. Is this a company that will be sold, held indefinitely, or transferred to family? The buy-sell provisions follow from the answer, and they are the provisions most often omitted and most often needed.

Formation, purpose, and members

Recitals and formation. Name, date and state of formation, the certificate of formation or articles of organization, and a statement that the agreement governs among the members.

Purpose. Broad — "any lawful business" — unless the members intend to limit management's authority to a defined enterprise, in which case a narrow purpose clause is a real restraint and should be drafted deliberately.

Term. Perpetual, or a stated term. Perpetual is the norm; a stated term is used in funds and single-project ventures.

Principal office and registered agent, and a mechanism to change them.

Members and units. An exhibit listing each member, their capital contribution, and their units or percentage interest — updated with each issuance or transfer. This exhibit is the cap table, and keeping it current is the single most valuable administrative habit in the document.

Admission of new members. Specify the approval required, the documents a new member must sign (a joinder binding them to the agreement), and whether preemptive rights exist. Without a joinder mechanism, a transferee can end up holding an interest without being bound by the agreement's restrictions.

Liability. A statement that members are not personally liable for the company's obligations solely by reason of membership, consistent with the statute.

Capital

Initial contributions. Cash, property, services, or a promissory note. For property, state the agreed value and note that contributing appreciated property to a partnership is generally tax-free under § 721 but that § 704(c) requires allocations to account for the built-in gain — a rule that surprises members who contributed real estate.

Contributions of services. A member receiving an interest for services receives either a capital interest (taxable at grant on the value received) or a profits interest (generally not taxable at grant under Rev. Proc. 93-27 if properly structured with a threshold value). Choose deliberately and document the threshold.

Additional contributions. Three approaches, and the choice matters enormously:

  • No obligation — members may but need not contribute more. Safe for members, dangerous for the company's funding.
  • Mandatory capital calls with a defined trigger, notice period, and consequences for failure.
  • Optional calls with dilution — a non-contributing member's interest is diluted by a formula, or the contribution is treated as a loan with a preferred return.

Remedies for failure to contribute should be explicit: dilution on a stated formula (often punitive, at 1.5x or 2x), conversion to a loan, forfeiture of voting rights, or a right in the other members to purchase. An agreement with a capital call obligation and no remedy has an unenforceable obligation.

Capital accounts should be maintained in accordance with Treas. Reg. § 1.704-1(b)(2)(iv), increased by contributions and allocated income and decreased by distributions and allocated loss. State that they are so maintained; the tax provisions depend on it.

Loans from members, and whether they carry interest, are subordinated, and require approval.

No interest on capital, and no right to withdraw capital except as the agreement provides — both worth stating, because the statutory defaults are not uniform.

Allocations and distributions

This is the section most often copied from a form without being understood, and it is where the economics actually live.

Distributions first, because that is what members care about:

  • Tax distributions. For a pass-through entity, members owe tax on allocated income whether or not cash is distributed. A mandatory tax distribution provision — a stated percentage of taxable income allocated, at an assumed rate, distributed quarterly to fund estimated payments — prevents the recurring disaster in which members owe tax on phantom income. Make it mandatory and senior to discretionary distributions, subject to legal availability and any loan covenant. Confirm the company's credit agreement carves it out.
  • Discretionary distributions, at the manager's or members' determination, subject to a solvency test.
  • The waterfall, which specifies the order: first to unreturned preferred return, then to unreturned capital, then to members pro rata — or whatever structure the deal requires. Where there is a preferred return, specify whether it is cumulative and whether it compounds.
  • Liquidating distributions, which should follow either the waterfall or positive capital account balances, depending on the allocation approach chosen.
  • Distributions in kind, and whether they are permitted.
  • Withholding — the company's authority to withhold and treat withheld amounts as distributed, which is essential where there are nonresident or foreign members.

Allocations of profit and loss, for a partnership-taxed LLC, must be respected by the Service. Two approaches:

Layer-cake allocations with substantial economic effect, Treas. Reg. § 1.704-1(b)(2), requiring: capital accounts maintained per the regulations; liquidating distributions in accordance with positive capital account balances; and either an unconditional deficit restoration obligation or a qualified income offset with the accompanying minimum gain chargeback and nonrecourse deduction provisions. This is the traditional structure, and it works — but it requires the liquidation waterfall to follow capital accounts, which is not always what the parties want.

Target (or forced) allocations, the modern approach: the agreement states the distribution waterfall as the economic deal, and allocates income and loss each year so that each member's capital account equals what they would receive on a hypothetical liquidation at book value. This aligns the tax allocations to the business deal rather than the reverse, and it is now the prevailing drafting practice — though it is not squarely blessed by the regulations, and it requires careful drafting.

Regulatory allocations that must appear either way: minimum gain chargeback, partner nonrecourse debt minimum gain chargeback, qualified income offset, gross income allocation, and a curative allocation provision offsetting the distortions the regulatory allocations create.

Section 704(c) allocations for contributed property with built-in gain or loss, with the method (traditional, traditional with curative allocations, or remedial) specified.

Section 754 election authority, permitting a basis adjustment on a transfer of an interest or a distribution — valuable to a buyer of an interest, administratively burdensome for the company. Give the manager discretion, or require it on request with the requesting member bearing the cost.

A caution. If the LLC will elect S corporation status, all of this disappears: an S corporation may have only one class of stock, allocations must be strictly pro rata, and distributions must be proportionate. Special allocations, preferred returns, and waterfalls terminate the election. Do not adapt a partnership agreement for an S corporation LLC without stripping these provisions.

Management and control

Member-managed. Each member is an agent of the company with authority to bind it in the ordinary course. Simple, and unsuitable for anything with more than two active participants or any passive investor.

Manager-managed. Managers — one, several, or a board — have exclusive management authority; members do not bind the company. Specify:

  • Number of managers, how appointed, and by whom.
  • Term, removal (with or without cause, and by what vote), and resignation.
  • Board mechanics where there is a board: quorum, notice, meetings, action by written consent, and voting.
  • Officers, if any, with delegated authority and a statement that officer titles do not by themselves confer agency authority beyond what is delegated.
  • Compensation and reimbursement.

The major decisions list is the heart of the control provisions. It enumerates the actions requiring member approval — or supermajority or unanimous approval — notwithstanding the manager's general authority. A working list:

  • Amending the operating agreement or the certificate.
  • Admitting a new member or issuing additional units.
  • Selling all or substantially all assets, merging, converting, or dissolving.
  • Incurring indebtedness above a threshold, or granting liens.
  • Capital expenditures above a threshold.
  • Entering into or amending a contract above a threshold or with a term beyond a stated period.
  • Related-party transactions.
  • Changing the nature of the business.
  • Making or changing tax elections, including entity classification and the § 754 election.
  • Hiring or terminating key employees, and setting officer compensation.
  • Commencing or settling litigation above a threshold.
  • Making distributions other than tax distributions.
  • Filing bankruptcy.
  • Acquiring another business.
  • Adopting or materially changing the annual budget.

Voting. Specify whether votes are per unit or per capita, what constitutes a quorum, whether action by written consent is permitted and at what threshold, and what the approval thresholds are for ordinary matters, major decisions, and amendments. Set them with a purpose: a 60 percent threshold in a company where one member holds 55 percent gives the minority a veto; the same threshold where a member holds 70 percent gives nothing.

Information rights. Members' rights to financial statements, tax information, and to inspect books and records — including the timing of K-1 delivery, which is a recurring source of friction. The statutory default rights exist but are often narrower and more procedurally cumbersome than what members expect.

Transfers, buy-sell, and exit

The default rule in most states is that a member may assign the economic interest but that the assignee becomes a member only with the consent of the other members — receiving distributions without voting or information rights. That default protects against unwanted partners but does nothing about the underlying problem: an unwanted economic participant, and no mechanism for anyone to get out.

Transfer restrictions:

  • A general prohibition on transfer without consent, with defined permitted transfers — to affiliates, to a trust for estate planning, or to family members — each conditioned on the transferee signing a joinder and on the transferor remaining liable.
  • A right of first refusal: a member with a bona fide third-party offer must first offer the interest to the company and then to the other members, on the same terms, within a defined period.
  • A right of first offer, which reverses the sequence and is friendlier to the seller.
  • Tag-along rights, allowing minority members to participate pro rata in a sale by a majority holder.
  • Drag-along rights, allowing a defined majority to compel minority members to sell on the same terms — with protections: the same price and form of consideration per unit, no disproportionate indemnity, no non-compete imposed on a passive holder, and several rather than joint liability.
  • Restrictions on transfers that would terminate an S election, cause a publicly traded partnership problem, or trigger a default under a loan.

Buy-sell provisions answer what happens when a member leaves involuntarily. Define the triggers:

  • Death — usually a mandatory purchase, funded by life insurance.
  • Disability — defined by a period of inability to perform, with a determination mechanism.
  • Retirement or voluntary withdrawal, with a notice period.
  • Termination of employment, distinguishing with and without cause.
  • Divorce, where a spouse might otherwise receive an interest — a mandatory purchase from the non-member spouse, and ideally a spousal consent to the agreement signed at the outset.
  • Bankruptcy or an involuntary transfer, including a charging order or a creditor's levy.
  • Breach of the agreement or a restrictive covenant.

For each trigger, specify whether the purchase is mandatory or optional, who has the right (company first, then members pro rata), the price, and the payment terms.

Valuation is where these provisions fail. Options:

  • An agreed value updated annually by written consent — simple, and reliably neglected after year two.
  • A formula — a multiple of EBITDA or revenue, with defined adjustments. Predictable, and can drift from reality.
  • Appraisal, with a defined process: each side selects an appraiser, the two select a third, and the result is the average of the two closest or the median. Specify the standard of value (fair market value or fair value), whether discounts for lack of control and lack of marketability apply, and who pays.
  • A hybrid — a formula with an appraisal right if either side disputes it.

Payment terms matter as much as price. A mandatory purchase at fair market value payable in cash on closing can bankrupt the company. A note over five years, at a stated rate, secured or unsecured, subordinated to institutional debt, with acceleration on a sale, is the workable structure. Life and disability insurance funding turns the death and disability triggers from an existential problem into an administrative one.

Put and call rights — a member's right to require the company to purchase, or the company's right to compel a sale — with triggers, notice, and the same valuation and payment mechanics.

Fiduciary duties and their modification

This is where LLC law differs most sharply from corporate law, and where the state of formation matters most.

Delaware. Section 18-1101(c) of the Delaware LLC Act permits the operating agreement to expand, restrict, or eliminate fiduciary duties — but the implied contractual covenant of good faith and fair dealing may not be eliminated. The Delaware courts require that any elimination be clear and unambiguous; a general disclaimer will not do it. Section 18-1101(e) permits the agreement to limit or eliminate liability for breach of duties, including fiduciary duties, except for a bad faith violation of the implied contractual covenant.

The Uniform acts. The Revised Uniform Limited Liability Company Act takes a different approach: the operating agreement may not eliminate the duty of loyalty or the duty of care, but may identify specific types or categories of activities that do not violate the duty of loyalty if not manifestly unreasonable, and may alter the duty of care except to authorize intentional misconduct or a knowing violation of law. The implied covenant may not be eliminated, but the agreement may prescribe standards for measuring performance.

Other states fall between, and several are silent, leaving the question to case law.

Drafting decisions:

  • Do you want duties? In a company with passive investors, the investors want them. In a joint venture between two sophisticated operating companies, both may prefer contractual standards only.
  • If modifying, be specific: identify the categories of permitted conduct — competing businesses, pursuing opportunities the company declines, transacting with affiliates on stated terms — rather than a general waiver.
  • Corporate opportunity waivers are common and valuable, particularly for investors with a portfolio. Draft them to identify what is and is not the company's opportunity.
  • Conflict transaction procedures: disclosure, approval by disinterested members or managers, and a safe harbor for transactions so approved, with a fairness standard as the fallback.
  • Exculpation and indemnification — the standard package indemnifies managers and officers for actions taken in good faith and in a manner reasonably believed to be in or not opposed to the company's interests, excludes fraud, bad faith, intentional misconduct, and knowing violations of law, and provides for advancement of expenses subject to an undertaking to repay. Confirm the company can obtain D&O insurance to back it.
  • The implied covenant cannot be waived anywhere. It fills gaps consistent with the parties' reasonable expectations, and it is the residual protection when a discretionary power is exercised in a way the agreement did not anticipate.

Deadlock, dissociation, and dissolution

Deadlock is the failure mode of the 50-50 company, and an agreement without a mechanism condemns the members to judicial dissolution.

Mechanisms, from mildest:

  1. Escalation to principals, then to a defined mediator, within stated periods.
  2. A tiebreaker — a neutral director, an outside adviser, or a designated member with the deciding vote on specified matters.
  3. Shotgun (buy-sell) provision — either member may name a price per unit; the other must either buy at that price or sell at that price. Elegant and brutal, and it favors the member with liquidity, which is why it is sometimes modified to require the offeror to demonstrate financing.
  4. Auction — both submit sealed bids; the high bidder buys.
  5. Russian roulette and Texas shootout variants of the same idea.
  6. Mandatory sale of the company through an investment banker if deadlock persists beyond a period.
  7. Dissolution as the backstop.

Whichever is chosen, define the triggering deadlock precisely — a specified matter, unresolved after a defined process, over a stated period — so that the mechanism cannot be invoked opportunistically over a routine disagreement.

Dissociation. Specify the events causing a member to cease being a member and the consequences: whether the former member retains an economic interest, loses voting and information rights, and whether a buyout is triggered. The statutory defaults vary and rarely match expectations.

Dissolution. Specify the events: a stated date, the members' vote at a defined threshold, the sale of all assets, or a judicial decree. Then the winding up provisions: who acts as liquidator, the order of distribution (creditors including member creditors, then members per the waterfall or per capital accounts), and the filing of articles of dissolution.

Judicial dissolution is available by statute — in Delaware, § 18-802, "whenever it is not reasonably practicable to carry on the business in conformity with the operating agreement." Courts apply it narrowly. It is a remedy of last resort, and a well-drafted deadlock provision is what keeps members out of it.

Tax provisions

Partnership representative. Under the centralized partnership audit regime, the agreement must designate a partnership representative with sole authority to act for the partnership in an audit and to bind all partners. Address:

  • Designation and replacement.
  • The representative's obligations to inform members and to consult before making elections.
  • Authority to make the push-out election under § 6226, and whether member consent is required.
  • Whether the partnership will elect out under § 6221(b) if eligible (100 or fewer partners, all eligible partners), and a covenant by members not to transfer to an ineligible holder.
  • Indemnification of the representative, and an obligation of former members to bear their share of an imputed underpayment attributable to a reviewed year.

Many operating agreements still designate a tax matters partner under the repealed TEFRA regime. Those provisions are obsolete and should be replaced.

Other tax provisions: allocation of tax items consistent with book allocations; § 754 election authority; withholding obligations and treatment of withheld amounts; a tax year and accounting method provision; authority to make elections; the obligation to deliver K-1s by a stated date; state composite return and nonresident withholding mechanics; and a pass-through entity tax election provision, which most states now offer and which can produce a meaningful federal benefit for members.

Miscellaneous provisions that matter

  • Amendment — the threshold, and a protective provision that no amendment may disproportionately and adversely affect a member without that member's consent.
  • Confidentiality binding members, with carve-outs.
  • Restrictive covenants — non-compete and non-solicit obligations of members, which are far more enforceable in the LLC ownership context than in employment, but still subject to state law limits.
  • Dispute resolution — negotiation, mediation, then arbitration or litigation, with venue and governing law, and consideration of whether an arbitrator should have authority to order the equitable remedies the buy-sell provisions contemplate.
  • Notices — addresses, methods, and when deemed given, including email.
  • Spousal consent, executed at signing, acknowledging the agreement and the transfer restrictions.
  • Entire agreement, severability, counterparts, and electronic signatures.
  • Waiver of the right to seek partition and of the right to demand a return of capital.

Recurring drafting errors

  1. No operating agreement at all, leaving statutory defaults nobody has read.
  2. A form from another state, importing a fiduciary duty regime or a dissolution standard the members did not choose.
  3. A partnership-style waterfall in an entity electing S status, terminating the election.
  4. No tax distribution provision, so members owe tax on income they cannot access.
  5. No buy-sell mechanism, so death or departure produces a stalemate.
  6. A buy-sell with a price but no payment terms, which can bankrupt the company.
  7. A buy-sell with no funding — no insurance, no reserve, no note structure.
  8. No deadlock provision in a 50-50 company.
  9. A major decisions list that does not match the voting thresholds — requiring unanimity for a decision the parties expected the manager to make.
  10. No joinder requirement, so transferees are not bound.
  11. No capital call remedy, making the obligation unenforceable.
  12. An obsolete tax matters partner provision.
  13. No spousal consent, leaving a divorce court to allocate an interest.
  14. Signature blocks that do not match the entity's records, and an exhibit of members never updated after the first issuance.

A worked example

Two founders and an investor form Ridgeway Analytics, LLC. Founder A contributes $50,000 and works full time; Founder B contributes technology and works full time; the investor contributes $750,000 for a 25 percent interest with a preferred return.

What the agreement does:

  • Capital. Three classes: Class A units (investor, with an 8 percent cumulative non-compounding preferred return and return of capital before common), Class B units (founders), and a pool of profits interests for employees, with thresholds set at each grant date.
  • Allocations. Target allocations following the distribution waterfall, with the required regulatory allocations and a curative provision. Partnership tax classification; no S election, because the multi-class structure would terminate it.
  • Distributions. Mandatory quarterly tax distributions at an assumed rate, senior to everything else and carved out of the eventual credit facility. Then the waterfall: preferred return, return of capital, then pro rata.
  • Management. Manager-managed by a three-person board: one designated by each founder, one by the investor. Officers appointed by the board.
  • Major decisions. Sixteen enumerated items requiring board unanimity, and four — amendment, new equity, sale of the company, and dissolution — requiring both board unanimity and holders of 75 percent of units, which gives the investor a blocking right on those four and nothing else.
  • Transfers. Prohibited without board approval; permitted transfers to estate planning vehicles with a joinder; ROFR to the company then to the members; tag-along for all members on a sale by a holder of more than 20 percent; drag-along on approval by the board and 75 percent of units, with price, form, and several-liability protections.
  • Buy-sell. Mandatory purchase on death, funded by cross-purchase life insurance on both founders. Optional purchase on disability after 180 days, on termination for cause (at the lower of cost or formula value), and on divorce (from the non-member spouse, at formula value). Formula: a stated multiple of trailing EBITDA, with an appraisal right if either side disputes it by more than 15 percent. Payment: 25 percent at closing, balance over four years at a stated rate, subordinated to institutional debt.
  • Fiduciary duties. Retained, with a corporate opportunity waiver for the investor's other portfolio investments, an affiliate transaction procedure requiring disinterested board approval, and full indemnification and advancement backed by a D&O policy.
  • Deadlock. Escalation, then mediation, then — if a major decision remains unresolved for 90 days — a mandatory engagement of an investment bank to run a sale process.
  • Tax. Founder A designated partnership representative with an obligation to consult; push-out election requires board approval; § 754 election at the board's discretion; K-1s by a stated date; pass-through entity tax election authorized.
  • Spousal consents executed by both founders' spouses at signing.

Every one of those provisions answers a question that the statutory default answers differently — and in most cases, badly.

Frequently asked questions

Do we need an operating agreement if there is only one member? Yes. It evidences separateness for veil-piercing purposes, it is required by lenders and landlords, it establishes the manager's authority to sign, and it is the first document a buyer asks for.

Can we just use a template? A template is a starting point. The provisions that matter — allocations, distributions, major decisions, buy-sell, deadlock, and duties — are the ones templates handle generically, and they are the reason to have the document at all.

What happens if we do not address something? The state statute supplies a default. Read it before assuming you can live with it, particularly on distributions, transfer, dissociation, and dissolution.

Can we waive fiduciary duties? In Delaware, yes, if done clearly and unambiguously — except the implied covenant of good faith and fair dealing. Under the uniform acts, only partially. Check the governing statute.

How do we value an interest for a buyout? Choose a mechanism in advance: agreed value updated annually, a formula, appraisal, or a hybrid. Also specify whether minority and marketability discounts apply, which can change the number by 30 percent or more.

What is a profits interest? An interest in future appreciation only, with a threshold equal to the entity's value at grant. Generally not taxable at grant if structured under the safe harbors — and it makes the holder a partner, receiving a K-1 rather than a W-2.

Do we need a partnership representative? Yes, if taxed as a partnership and not eligible to elect out. The designation and its constraints belong in the agreement.

Should spouses sign? Yes, in every state, and especially in community property states. A spousal consent acknowledging the transfer restrictions prevents a divorce court from creating a member nobody chose.

Conclusion

An operating agreement is not paperwork. It is the answer to a set of questions that will otherwise be answered by a statute the members never read, at a moment when they have stopped agreeing.

Six provisions do most of the work: tax distributions, so nobody owes tax on money they cannot reach; the major decisions list, which defines who actually controls the company; transfer restrictions with a joinder, so the members never acquire a partner they did not choose; a funded buy-sell with a valuation mechanism and payment terms the company can survive; a deadlock provision, in any company where a deadlock is possible; and a clear treatment of fiduciary duties appropriate to the relationship.

Draft those six carefully and the rest of the document is administration. Omit any of them and the members are relying on a court to reconstruct a deal they never wrote down.

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This guide is provided for general informational purposes and does not constitute legal or tax advice. LLC statutes differ materially by state, particularly on fiduciary duty modification and dissolution, and tax treatment depends on elections and facts. Consult qualified corporate and tax counsel before adopting or amending an operating agreement.