S Corporation Operating Agreement: What Is It?
The S Corporation Operating Agreement is a foundational document for a small company that has elected Subchapter S corporate status. Like other corporate agreements, the S Corp Operating Agreement describes the relationship of the shareholders and officers with each other and with the company itself. With S Corporations in particular, this document can be crucial for the company’s long-term financial viability. Maintaining S Corporation status reduces the taxes that the company pays and that the shareholders pay on dividends.
The S Corp Operating agreement serves the same purpose as the bylaws do for larger corporations who have not made the S Corporation election . The Articles of Incorporation, or the Certificate of Incorporation, is the document that establishes the corporation and set out basic facts about the company, such as the date it was created, its principal place of business, and the number and value of shares. The bylaws and articles supplement each other and provide the framework in which the company operates. Although bylaws are not typically filed with the Secretary of State in Virginia, the Articles of Organization are.
Because S Corporations have tax advantages that will not be enjoyed by other companies, the Virginia S Corporation Operating Agreement may be subject to greater scrutiny from the IRS. The IRS may use, and sometimes even cite, the provisions of the Operating Agreement to support their position that the company does not qualify for S-Corporation status.
Key Terms in an S Corporation’s Operating Agreement
An S Corporation Operating Agreement is not mandated by the law in many of the 50 states. However, the S Corporation operating agreement is important in helping the S Corporation owners and shareholders govern their S Corporations. The S Corporation Operating Agreement will explicitly lay out (and should be updated from time to time) rules for running the S Corporation and what happens if the S Corporation owners or shareholders cannot agree on certain issues.
Perhaps the most basic and essential items of an S Corporation Operating Agreement should include how the S Corporation will be managed. This includes a description of the S Corporation management structure, and the rights and responsibilities of the S Corporation shareholders, officers and S Corporation managers. This is handled somewhat uniquely within S Corporations, as management of the S Corporation is generally not in accordance with the number of shares owned.
Another item that is crucial to include in an S Corporation Operating Agreement is a discussion on how S Corporation decision making will take place. Will there be voting, or will the issue be solely in the hands of the S Corporation officers or certain S Corporation shareholders? Should decision making be delegated to managers, or will it be a function of the shareholders? These are all examples that need to be discussed in the S Corporation Operating Agreement.
Finally, another key area that needs to be discussed in the S Corporation Operating Agreement is how the S Corporation will distribute profits to its shareholders. The S Corporation Operating Agreement should outline how profits are distributed, whether on a pro-rata basis according to the number of shares owned, or whether the S Corporation distributes profits based on some other formula.
Advantages of Having an S Corporation Operating Agreement
The specific ways in which an S corporation operating agreement will benefit your business will depend on the nature of the business as well as the structure of the S corporation. Generally, though, the following are some benefits of having an effective operating agreement in place:
Protection from Personal Liability: When an S corporation elects special tax treatment, owners protect their personal assets against the debts and liabilities of the corporation. This is accomplished by forming a corporation under the law, which is a separate entity from the owners/shareholders, following all corporation formalities and treating the corporation as its own entity. Having an effective operating and shareholder agreement further protects the corporation by ensuring that all of these actions occur consistently.
Respect for the Terms of the Agreement: Having a solid operating agreement in place helps to ensure that all owners of the corporation know what is expected of them. It will outline how profit and loss will be allocated, which can provide clarity and avoid disputes among owners. It can also establish any rules and regulations for management and establish the rules that all owners must agree to follow.
Easier Management: A clear operating agreement can help to avoid conflicts and confusion. S corporations benefit in situations where the shareholders have a clear understanding about the management and the responsibilities each owner is responsible for. Shareholders know who has the authority to make certain decisions and how ownership interests change within the corporation.
Clarity in Ownership and Transfers: An operating agreement can establish restrictions on the transfer of shares in the corporation, which will help to reduce the number of disruptive changes that occur within the organization. Also, the S corporation election consists of only one class of stock, which must equal in rights. If there is any double taxation or unfair action by the S corporation shareholders, the IRS will terminate the S corporation election. S corporation operating agreements are designed to avoid these types of problems.
Avoidance of Unwarranted Special Treatment by Creditors: Another benefit of a good operating agreement is that it can spell out what happens in the event of a buyout of a shareholder. A solid buy-sell agreement can provide certainty to all shareholders that someone else will buyout their interest in the corporation if they die, are legally incompetent or declares personal bankruptcy. Without such an agreement, creditors can avoid long buyout delay periods and force a sale to settle claims.
Creating an Effective S Corporation Operating Agreement
When considering the creation or modification of an S Corporation Operating Agreement, developing an understanding about what is generally included in this document is beneficial. This section is designed to help business owners and other parties comprehend the details of an S Corporation Operating Agreement.
Understanding The Basics
To begin with, a S Corporation Operating Agreement is a set of governing rules or by-laws used to outline decision-making processes, distributions, transfers of ownership, the management structure and other important business functions. For entities that are not limited liability companies (LLCs), it is not necessary to have a formal Operating Agreement; however, it is recommended to have some form of a written document with the required information for S Corporation compliance.
Developing A Comprehensive Agreement
The steps for creating a well-rounded S Corporation Operating Agreement are as follows:
– Look For Templates
It is possible to find S Corporation Operating Agreement templates online. Make sure to look at several resources to find a basic template that meets your company’s needs . Additionally, some law firms offer free, sample Operating Agreements for different types of business entities.
– Choose A Template
There are nearly unlimited options for how to draft an S Corporation Operating Agreement. It is up to the business owner to determine the degree of complexity of the document. As a result of appearances, content and other factors, one template may be worth utilizing more than another.
– Make Modifications To The Template
Once the template is selected, the business owner will have to modify the template to meet the unique needs of the company. There is a chance that the S Corporation Operating Agreement could be broken into two individual documents – one for the rules of corporation and one for ownership. Other documents also provide room for additional provisions to be added.
– Create The Final Draft
Once revisions are complete, make an individual review of all the proposed changes made to ensure that nothing was left out. Finally, have an attorney review the final draft to ensure that the S Corporation Operating Agreement is compliant with all federal, state and industry regulations.
Common Pitfalls with S Corporation Operating Agreements
Common mistakes to avoid with an S Corporation Operating Agreement
The left hand does not know what the right hand is doing. Sometimes this phrase can ring true when a member in a managing capacity gets an idea or decides upon action regarding an S Corporation without consulting other members. One member cannot unilaterally bind the other members unless all members’ consent is first secured. There are no surprises with a well-drafted operating agreement.
A common mistake that is made with S Corporations is having the operating agreement not being reviewed or updated through the years. As can be deduced from this article, circumstances do change and it is impossible for an operating agreement to address every scenario. Having regular reviews, and making routine updates, will insure that the operating agreement meets the company’s needs.
It is easy to forget about an operating agreement once the business is up and running. However, it is important to not get too bogged down or lazy with these agreements. Requiring members to sign off on an operating agreement ensures that all members are aware of the terms and any changes that have been made.
S Corporation Operating Agreement FAQs
1. Do I need a written S Corporation operating agreement?
Generally, yes. Because of the complex nature of managing a business with multiple owners, having a legally binding agreement is essential for smooth operational and future planning. And in the event of a future dispute, it will be a lot more difficult to mitigate if you don’t have an agreement in place.
2. What happens if I don’t have a written operating agreement and later have a serious dispute with my co-owners?
Your state’s default laws will govern all decisions regarding the company. This could be very problematic and is one of the main reasons it’s so important to set up a formal agreement .
3. What’s the difference between an LLC operating agreement and an S Corp operating agreement?
The two are relatively similar, but there are two key differences worth noting:
4. What’s the most important factor to keep in mind when crafting an S Corporation operating agreement?
The governance structure of your company. Your agreement needs to be inclusive of your unique employee structure and what these employees will need to maintain compliance.
5. I have an agreement in place. Do I still need a buy-sell agreement?
Yes. A buy-sell agreement outlines what will happen if a company owner leaves the business.