What is an S-Corporation Operating Agreement
An S-Corporation (S-Corp) operating agreement is a legal document that outlines the rules that govern how any business that has elected to be treated as an S corporation will operate. While not explicitly required by law, it is an extremely valuable tool for any small business corporation. An operating agreement serves a few primary purposes: Although not legally required, an operating agreement is an important document for every small business corporation . Creating and adopting an operating agreement before problems arise will help ensure clear guidance in the event of a future dispute. Of course, since an operating agreement is just that, an agreement, a company does have some flexibility when it comes to what terms and restrictions it wishes to include. In practice, the specific terms found in every S-Corporation operating agreement are different from one company to another.
The Advantages of Having S-Corp Operating Agreements
Whether you are the sole owner of an S-Corp or have multiple shareholders, it is prudent to have a well-crafted operating agreement in place. Among these are:
Providing Legal Protection
In many states, the law does not require you to have a written agreement in place for protecting your business, unless there are more than three shareholders. However, even without that requirement, your rights and responsibilities should never be left to chance because having a strong written document in place can protect you by clearly establishing and outlining expectations of the S-Corp’s operation. A well-drafted purchase and sale agreement in the operating agreement is essential to clarifying terms of the transaction and providing the best legal protection and guidance for voluntary and involuntary termination of business relationships.
Defining Roles and Expectations
When there is no S-Corp operating agreement, it can be very difficult to determine how to handle various issues between the owners of S-Corps. Without an operating agreement in place and with no policies or procedures put in place to govern your company, your S-Corporation will be at the mercy of how the default rules of operation can establish itself under state law. If your S-Corp is unable to find solutions on its own, you may have to take certain matters to the court to have them resolved. This can be very costly and lengthy for many business owners. With an operating agreement in place, you can specify the rules and procedures you want your S-Corp to follow when conducting business, such as how profits will be shared among shareholders, how directors are appointed and other key areas such as decision making and dispute resolution.
Clarifying How Conflicts Will Be Resolved
Ultimately, one major benefit of having an S-Corp operating agreement is that it can save you a lot of time and money in understanding how issues that are vital to your business will be resolved. When it comes to handling conflict, it is important to have clear answers to questions like how owners can withdraw from the business, how shares can be bought, and future limitations on the buyer’s ability to acquire additional shares.
Essentials of an S-Corporation Operating Agreement
At the core, an operating agreement for a corporation should hold information about business structure, management responsibilities, and general obligations of shareholders. Below is a brief overview of what is included in each section.
Business Structure
This portion provides basic information about the business, including business name, location, registered address, purpose, and number of shareholders. In addition, it provides an overview of how the business will be organized and the terms of the business ownership.
Management Responsibilities
The management section of an operating agreement outlines authority for ongoing business decisions. More specifically, it determines if management authority is held by a board of directors or if it is reserved for shareholders. Management responsibilities also include extensive details on shareholder voting rights and procedures.
General Obligations of Shareholders
The last section of an operating agreement covers the general obligations of shareholders. This includes information about dividends, distributions, accounting practices, limitations on liability, and any other legal obligations of ownership.
Comparison of S-Corp and LLC Operating Agreements
An LLC Operating Agreement and an S-Corp Operating Agreement serve a similar purpose by providing a set of rules and regulations that the members or shareholders of a business must abide by. LLC’s and S-Corps both enjoy pass-through tax treatment by avoiding double taxation of state and federal taxation. Due to some of the corporate formalities that S-Corps are required to adhere to, including annual meetings, S-Corp Operating Agreements may be more elaborate than what is required for an LLC. An LLC Operating Agreement, however, has flexibility as to what issues it can and should include.
An LLC is a flexible business entity that does not require an Operating Agreement under Pennsylvania law; a company can still benefit from one. An Operating Agreement can be used to establish management structure and voting rights of an LLC, distribute profits among members, address contributions of capital, record agreement on transfer of ownership, and the death and exit of a member. It is also useful in listing what the LLC cannot do and establishing standards of performance to prevent any form of dissension among its members. This is particularly useful if members do not take an active role in the daily management and decision making of a business. No specific form of an Operating Agreement is required, so the Agreement can be tailored to fit the needs of the members and the LLC. The members also have flexibility to amend or terminate the Agreement. As noted above, no two LLC’s are alike and similarly no two Operating Agreements are alike.
The By-Laws of an S-Corp are similar to those of an LLC Operating Agreement; however, they contain a few additional components beyond what is typically contained in an LLC Operating Agreement. For example, By-Laws typically address:
While an LLC Operating Agreement can and often does include these topics, By-Laws go one step further. Because an S-Corp has shareholders instead of members, the By-Laws will include specific provisions regarding the rights of shareholders, which are not necessary in an LLC Operating Agreement. By-Laws also include restrictions on the transfer of stock, provisions for buybacks and stock redemption plans, as well as procedures for issuing stock that are not typically addressed in an LLC Operating Agreement. In short, an S-Corp By-Law will be more complex than an LLC Operating Agreement; however, both documents provide invaluable guidance regarding operation of the business and the roles and responsibilities of its owners.
How to Draft a S-Corporation Operating Agreement
A business owner can draft an S-Corp operating agreement with a trusted advisor, such as a business attorney who is experienced in the area of corporate law. A business owner can also choose to use a template that’s available from many legal software or forms websites. However, website templates typically lack the guidance necessary to help you spot issues that could have a major impact on an S-Corporation’s operation. It’s best to rely on templates that contain commentary from experienced business lawyers.
The step-by-step guide below provides a good starting point for understanding the essential provisions needed in an S-Corp operating agreement: 1. State the names of the individuals creating the agreement and define their roles and bases for authority. Include information about how the business will be managed, by whether the S-Corporation will be managed by its members or a manager. 2. Identify the S-Corporation’s location including the state and county where it will operate primarily. 3. Then include the date of formation of the corporation, the duration of the corporation and any provisions specific to the type of business being conducted, such as franchise business provisions. 4. Specify whether the corporation can purchase or sell any of the members’ memberships. 5. Write down how assets and liabilities will be allocated and what percentage or balance of percentages owners will have in the company . While salaries and personal draws are considered asset allocations, the S-Corp operating agreement needs to spell out how member salaries, distributions, and draws will be calculated. 6. Address how debts and liabilities will be allocated among the owners and non-owners. 7. Document how profits and losses will be shared among members and managers. 8. List the decisions that require a vote, especially those that may differ significantly from the 50/50 ownership model. List the type of votes required for each decision. 9. Include dispute resolution provisions. Often, owners will use private arbitration, but the operating agreement should specify how disputes are resolved. 10. Describe the rules for transferring an ownership interest, including what happens to the interest if an owner dies or becomes disabled or decides to sell their interest in the S-Corp. 11. Include traits mandatory in the event operating agreement. If your business might add partners or change locations, consider an at-will provision. This sort of provision doesn’t bind the business to staying in the same location or with the same members indefinitely, allowing the flexibility to make ongoing changes as necessary. 12. Consider including a buy-sell agreement. This type of provision specifies how a partner can leave the company and how to value his or her departure so that the business can pay the partner for his or her stake.
Although a sufficient operating agreement has many components, the primary focus should be on how the S-Corp will be managed and how disputes among S-Corp shareholders will be resolved.
Mistakes to Avoid with S-Corp Operating Agreements
One of the last things any business owner wants after they’ve formed a new business is to find out that their S-Corp operating agreement is void. The most common pitfalls occur when a business ignores state specific laws or does not address the needs of multiple shareholders. Hiring an attorney to draft your agreement helps avoid costly corrections in the future and keeps your business on good legal standing. Teaching business owners how to avoid some of the more common mistakes associated with S-Corp Agreements can save time and money later.
Here are a few examples of what common mistakes can create problems: Changes that appear too often- In many cases, S-Corp agreements are so general in nature that they have to be revisited and updated frequently. Instead of creating a lot of problems for your shareholders, it’s better to address more than the immediate needs by creating a shareholder agreement with clearer guidelines. Missing out on key events-Making decisions and authorizing specific cases of action as Corporate Officers, or a Board of Directors or Officers, can create a real disaster if those actions are not documented as a bylaw. This creates room for litigation because the bylaws lack details on defining how all major decisions are made. No buy/sell agreement to protect owners self-interest-Unfortunately, many owners forget to include buy/sell provisions. When these key provisions are missing, it leaves an S-Corporation vulnerable to potential problems. It’s smart to include buy/sell provisions to protect your self-interest and your family’s interests. Each of these mistakes can be avoided when you have an attorney draft an S-Corp operating agreement that is written to suit your business. An S-Corp agreement is not the same as a stockholder or limited partnership agreement. Always consult with your attorney to determine what type of agreement you need for your business. Many business owners are fund-crowdsourcing to form a new corporation, which is a great idea, but it’s wise to consult with your attorney to make sure you know what you’re buying.
Updating S-Corporation Operating Agreements
One of the most important governing documents of any corporation is the S-Corp operating agreement. These agreements establish a number of key operating functions, including how profits will be allocated, working member terms, working shareholder limitations, and much more. However, these documents are usually drafted as one-off solutions to specific issues, and over time, those issues may change. Otherwise benign or even beneficial terms in the operating agreement may become outdated, unresponsive, or even detrimental to your corporate wellness. As an example, if your general tax liability has increased , you may not want to preserve a clause that was intended to shelter your taxes through [other provisions]. So making sure that your S-Corp operating agreement is brought up to date from time to time is vital to have an effectively operating corporate structure. In order to ensure that your S-Corp operating agreement is modified correctly, you will need to conduct an office meeting at the start of each financial cycle. You will need to review your current S-Corp operating agreement thoroughly, comparing it against how the company is currently operating. During the meeting, you should discuss any potential changes to the S-Corp operating agreement you might want to implement. Once the meeting is over, you must legally and properly update your S-Corp operating agreement to reflect any modifications. These changes may be pretty minor but are legally vital to ensuring that your goals are being met through your S-Corp operating agreement.
