S-Corp Operating Agreement: What & Why
What is an S-Corp Operating Agreement?
When a business operates as an S Corporation, shareholders should take care to have an operating agreement in place. Despite the term "Corporation" being in its name, an S-Corporation is still a limited liability company, but one that has chosen to tax itself as if it were a C corporation. This is a structuring and tax decision, not a designation of business type. All S Corporations are limited liability companies, but not all limited liability companies are S corporations. And, just like any other limited liability company , an S Corporation will benefit from having a well-written operating agreement in place. An operating agreement for an S-Corporation is also referred to as the S-Corporation bylaws or S-Corporation shareholder agreement. But regardless of what you call it, it is important that the S Corporation have an adequate operating agreement in place; ideally one that provides a comprehensive and detailed framework to direct the S Corporation’s governance and business operations. As explained in greater detail elsewhere in this article, the operating agreement should set forth the legal ownership of the S-Corporation, the powers and management rights held by shareholders, the voting rights held by shareholders, and should otherwise, identify how the S Corporation will be governed.
What to Include in Your S-Corp Operating Agreement Template
In a typical operating agreement template for an S-Corp, there are several key elements that are typically included. It should detail how members will be admitted to the company, how capital contributions will be distributed, how profits and losses will be allocated, how members will contribute their time to the business, how decisions will be made and how they will be reported, what happens if a member decides to leave, or one member should die, get divorced, or become incapacitated. An operating agreement acts as the "road map" of the company.
Members can draft their own operating agreement, or they can use an S-Corp Operating Agreement template from an online site. There are several basic arena’s to focus on when drafting an operating agreement based on how the members wish to run the company and how much control or limited control they want to have.
Manager Managed or Member Managed: This means, how will the company operate as it relates to control. Will there be "managing" members with greater say over the operations of the company, i.e., the Manager Managed option is typically used when there are several members in the Company and one or two members will have control. A Member Managed S-Corp means that all parties have equal say so in the gestione of the company and typically all members have a vote in how decisions are made. There is no right answer because each agreement is unique but the owner(s) of a company need to understand that there are significant differences to having a Member Managed or Manager Managed business.
Amending the S-Corp Operating Agreement: Many people see this section as perfunctory, however, it is an important section of the agreement. Because a LLC is an entity, the members of an LLC must decide as a group to change any provision in the operating agreement. The process to amend the terms of the agreement should be specifically spelled out in the agreement. Members need to understand that even if there are popular provisions in their agreement that they think will never change, there must be a process to amend those provisions.
Dissolution of the S-Corp: A dissolution provision will state how the company can be dissolved. It is important for the members to spell out the process to dissolve the company. Statutorily, a majority of the members must agree to dissolve the company, however, it is best to have a method dedicated in the agreement to allow the members to dissolve the company.
Advantages of a Personalized S-Corp Operating Agreement
For S-Corporations, the operating agreement is the bedrock of the company, however, very few companies even have them. With the right language tailored to the specific needs of the company, an S-Corporation operating agreement will lay the foundation for the company and provide clarity about several issues that could become contentious. These issues include how new shareholders can buy into the company and under what circumstances, such as a divorce, will a shareholder be required to sell their shares. Imagine two minority shareholders that don’t get along. Without clear language in the operating agreement, how will the company handle that quandary. A customized S-Corporation operating agreement would specifically address this and prevent a majority shareholder from being left in a position where they cannot ignore or remove the problematic shareholders.
Many contracts like the owners’ agreements / operating agreements for S-Corps are not created with enough attention to detail to address the points outlined above. As a result, the resolution of problems that arise come down to expensive litigation. A customized S-Corp operating agreement can prevent that problem or at least decrease the chance of the problem occurring.
It is important to not forget about estate planning. If one of the shareholders dies, how will the company handle that situation? Remember, it’s not just about getting the shareholder’s spouse bought out without having to go to court. It is also about making sure no one else other than the spouse now owns voting rights on the shares. That could create some real difficulties for the company. A customized S-Corp operating agreement can be used to prevent that from occurring by addressing all the issues that could arise upon the death of a shareholder.
Five Steps to an Effective S-Corp Operating Agreement
The process of creating an operating agreement is similar to the procedures for drafting a contract. However, there are a few differences. The first step is creating a draft operating agreement, which can be done using templates available online, or as a blank slate for your corporation’s requirements. After creating a draft, you should consult with your shareholder(s) and potentially legal counsel to gather more input and practice due diligence. Once you are satisfied with the terms and conditions present, you may proceed with acquiring the approval of your other stakeholders, or board of directors.
In the following section we will explain the steps in detail to help you draft the appropriate operating agreement for your S-Corp.
Create the Draft:
Once you are ready touch base on the different aspects that you want included in your operating agreement, you will need to sit down and create a draft. You can do this independently, or using one of the many templates found online. You may also delegate this task to one or more people among your board of directors. Even if you decide to create the draft personally, submitting requests for suggestions from other members of your board can be helpful for your S-Corp agreement. Once you have created a final draft, the next step is consultation.
Consultation:
The next step in the process is presenting the drafted S-Corp operating agreement to your stakeholders, and potentially your legal council. This will help identify any red flags in the document, and allow for open discussion in making changes to the draft. A few changes may be made to the document during this stage. This step is crucial to prevent any future disputes in your company.
Approval:
Once you have finalized the agreement, it is time to receive approval from your shareholders if you have one, or your board of directors. Once all parties agree to the terms and conditions, the final step is signing the document.
Common Mistakes to Avoid When Drafting S-Corp Operating Agreements
When creating an S-Corporation operating agreement, it’s easy to make mistakes that can create pitfalls down the road. Here are several common errors and how to avoid them. Benefit sharing among owners: It’s important to realize that shareholders of an S-Corp are always subject to the allocation and distribution rules (as discussed above). So, a clause about different classes of stocks is moot in an S-Corp operating agreement. The IRS views all shares in an S-Corp as identical in value. S-Corps can only issue one class of stock. The IRS does allow shareholders to have preferred stock, but S-Corps may not issue preferred and common stock. Ownership rights after divorce: In the unfortunate event that a shareholder gets divorced, that person’s spouse may be entitled to some or all of that equity. S-Corps can avoid giving a former spouse any ownership interest in the company when the operating agreement specifies that such transfers require majority shareholder approval. This will not preclude court-ordered distributions of cash or assets, but it will keep a former spouse from gaining an unfair ownership stake in the business . Controlling authority and management structure: While it’s important to specify who has the controlling authority to sign documentation and manage the day-to-day operations of the business, it’s also critical to pay attention to the management structure. It’s advisable to specify how many directors are required for major decisions, but do not assume that your shareholders will all behave like other directors. Major shareholders can still exercise disproportionate control over the company because their shares mean their words and actions carry more weight. Founder and key employee contracts: It’s not uncommon for S-Corps to have separate contracts for the founders or key employees. While these can be beneficial, business owners should be careful not to make unfair promises. All owners should be treated fairly. If one owner is getting a higher salary, they should expect to get a proportionate amount of equity. Otherwise, you risk diluting the equity of the other owners for years to come. In the case of a founder or key employee who is receiving equity over a period of time, you can protect the company from their immediate exit by including a clause requiring that the employee must buy back the remaining equity while paying a penalty in the case of immediate termination.
S-Corp Operating Agreement Template: The Pros and Cons
The internet is rife with templates both free and paid for a multitude of legal documents, including operating agreements for S-Corporations. As with most things, there are pros and cons to using these templates. We’ll consider both here.
On the plus side, templates are a great way to get a general feel of how an S-Corp operating agreement should be structured. They can also save your company money by eliminating the need to hire attorneys to draft your document from scratch. Remember, though, that every S-Corp is unique, and the terms of your business may be more complicated than what is laid out in the template.
That brings us to the cons. While these templates can save you time and money on your legal documents, you may be sacrificing clarity and protection for your business in doing so. For example, there are many uses for S-Corps, and not all of them will be accurately covered in the template language. In some cases, you may need to add to or amend the language to fit your needs. Making the wrong amendment could cause problems. Consider this example: Let’s say you had set up your S-Corp such that its losses could be allocated equally among 100 shareholders. You received a template that spelled out how the losses were to be allocated, but failed to state how you wanted those losses allocated if you added a veteran shareholder to the company who received 10 percent of shares. By default, the losses will still be allocated equally, which could create an outcry that you didn’t mean to allocate to the new shareholder, or could create the need for an amendment to the operating agreement that makes it clear how those new shares should be treated. Either way it can change the distribution of profits and will require that the new shareholder amend his or her tax return after the end of the calendar year in order to take a credit against taxes not originally paid. While it’s understandable that you’d want to save time and money on legal fees that can be pretty expensive, don’t forget that in the end, it might cost you much more.
S-Corp Operating Agreement FAQ
Do I need a written operating agreement? Yes. A written S-Corp operating agreement is critical for maintaining your elections with the IRS and protecting you in the event of dispute or audit.
I have a written operating agreement. Do I need to update it? If you change ownership, change locations or your business is reorganized you should likely revisit your operating agreement. You should also have a legal professional review your operating agreement at least every three years. Legal professionals at Vandenack Weaver will review your own S-Corp agreement and determine whether you need to start from scratch or make necessary amendments.
My S-corp operating agreement is out of state. Do I need to prepare a new one? No. If you have an S-Corp agreement in another state, you may not need to have a legal professional review it unless there are changes to your business operations. If you are an S-Corp in a state other than Nebraska , Illinois or South Dakota, feel free to call Vandenack Weaver for a review.
My operating agreement needs work but I don’t have a big budget. Will you review it for free? We will review your operating agreement to ensure you understand any potential legal risks, but we cannot write your agreement from scratch or make major amendments to your agreement without a formal engagement at an hourly or flat rate. However, we are happy to refer to you one of our partner law firms for a more extensive review.
I plan to add a new owner to my S-Corp soon. Do I need to wait until new owners are added to get an operating agreement? If new owners are going to join your S-Corp, you should work with a legal professional ahead of time to determine any changes that need to be made to your operating agreement.