What is an Operating Agreement for S Corp?
The S Corp operating agreement is the founding document of a corporation that has elected S Corp status. Although not a requirement, many states and most banks and other financial institutions require an operating agreement for an S Corporation. Further, operating or by-law agreements are usually required by private lenders and many landlords.
The S Corp operating agreement reflects the S Corp requirements set forth in the IRS tax code. It also informs shareholders regarding their obligations with respect to the operation of the S Corp. The S Corp operating agreement provides that the operation of the S Corp be conducted in accordance with the IRS tax code . In addition to the tax implications of an S Corp, the S Corp operating agreement also addresses how the S Corp will be governed. Further, the S Corp operating agreement requires that all parties to the S Corp be treated similarly. For example, the S Corp operating agreement will require that all the shareholders receive the same dividend payments. All the shareholders will be requited to contribute to losses of the S Corp on the same proportionate basis. Also the S Corp operating agreement will be required to state how and when distributions will be made.
Components of S Corp Operating Agreement
The makeup of an S Corp Operating Agreement is somewhat different from that of an Operating Agreement drafted for a limited liability company. As opposed to the basic structure provided above, the management structure and profit distribution provisions in an S Corp may not be quite as straightforward.
S Corporations have to have a Board of Directors. Even while only one or two people are engaged in running the business (common in a small business), it’s customary to appoint at least three members to the Board. The Board is responsible for general management of the corporation. A typical provision in an S Corp Operating Agreement may look like the following:
"The Corporation shall be managed by a board of directors consisting of at least three (3) persons. Members of the Board need not be Shareholders. Each director shall serve a term of one year and may be removed with or without cause by the Shareholders holding a majority of the votes entitled to be cast at a meeting of Shareholders. The directors shall select from among their number a chair, secretary, treasurer, and such other officers as they may deem desirable, which officers shall serve at the pleasure of the Board."
Shareholders of an S Corp can also run the corporation themselves. If the provisions of the Operating Agreement don’t require a Board of Directors and the Shareholders are actively engaged in the management of the S Corp, you can use the same language as outlined above for the Board of Directors.
As far as voting goes, the S Corp Operating Agreement will probably contain a simple provision stating that Shareholders or directors have the right to appoint persons to act on their behalf and that the persons chosen will have the same authority as the Shareholder or director. Managers will then be free to attend the Board meeting in person or via an electronic device. The law permits managers to vote by proxy in writing. If the S Corp must elect officers, the voting rights will be similar to those of the limited liability company discussed above.
Distributions in an S Corp are usually made according to the proportionate shares owned by each Shareholder. The law doesn’t change this. Although it’s common to have an S Corporation make tax-free distributions, distribution provisions might include a specific reference to such. Here’s an example of a distribution provision to get you started:
"Distributions of cash or other assets may be made to Shareholders and transferees in proportion to their respective Ownership Interests. Distributions may be made at such times and in such amounts as determined by the board of directors.
Cash distributions to Shareholders shall be made by wire transfer or in checks drawn on the bank account of the Company. Each check shall be deposited to each Shareholder’s account designated by the Shareholder or, if no account is designated, shall be given to each Shareholder in person or sent to such Shareholder’s address, as set forth in the Company’s books and records. If no address is given, any check shall be sent to or left at the principal place of business of the Company.
How Does Having an S Corp Operating Agreement Benefit the Shareholders?
Having a properly drafted S Corp Operating Agreement is advantageous for many reasons. The best reason is that it provides legal protections and clarity for all of the members and for the company as a whole. The Operating Agreement will address all aspects of your company structure, from ownership to management, to the business market entry in a way that is most favorable to you. In the best case scenario, however, an Operating Agreement will also provide legal protections against fraud and breaches of fiduciary duties through its bylaws, which function as an internal bill of rights and can be enforced in a court of law. That way, if erroneous transfers of equity or other disputes arise down the line, you have created an objective standard against which to evaluate when and to what extent a member has breached their fiduciary duty to the company or the other members.
How to Write an S Corp Operating Agreement
S Corp Operating Agreements are legal documents entered into by the members and managers of an S Corporation. When a business is owned and operated by an individual or just a single organizational entity, such as an LLC, there may not be any need for an operating agreement. However, if an individual or company is one of the owners of an S Corporation, meaning that they own a share, multiple shares, or have a member’s interest in an S Corporation, a S Corporation Operating Agreement should be used in order to establish individual rights and expectations.
When drafting an S Corporation Operating Agreement, it is best to have at least the following involved: a corporate attorney, an original owner or company representative, and a newly proposed passive member. It is essential to the process, that the original owners and company representatives let the new passive members know the prior agreements, rules, and regulations, if any, that existed prior to their entering into the agreement. Passive members are individuals or companies that have a preferred financial interest in an S Corporation. It is important to have the original individuals all on the same page, as they already hold an interest in the S Corporation.
In order to draft an S Corporation Operating Agreement, an attorney will need to consult with the original owners, a newly proposed passive member, the IRS, and other government agencies that aid in the process of creating an S Corporation. The attorney will also need to contact the Secretary of State’s Office and make sure that all of the forms necessary to complete the deal are filled out and submitted on-time. Having experienced legal assistance from a corporate attorney who specializes in business and/or corporate law is recommended, because the documents necessary to make a valid, binding S Corporation Operating Agreement are rather complex.
Where Can You Get PDF Templates for S Corp Operating Agreements?
When searching for S Corp operating agreements, there are a number of reputable sources that offer downloadable PDF templates. One option is the Small Business Administration (SBA) website, which provides a wide range of resources for small businesses, including a library of free downloadable documents. Many local chambers of commerce also offer free templates that can be downloaded after creating an account with the chamber.
Another good source for S Corporation operating agreements is legal websites such as Rocket Lawyer and LawDepot. These sites provide customizable legal documents, all of which have been reviewed by legal professionals prior to their publication. Many law firm websites also offer drafts of legal documents free of charge prior to your hiring the law firms in question .
The sites we list here offer templates that are pre-drafted and require only the addition of some basic information concerning the business to be formed. This allows you to consult with an attorney to receive their input without being charged exorbitant fees.
In addition to checking with local or regional organizations, you may also ask companies that insure small businesses for their recommendations. Even though many times these companies operate only on a national basis, their agents often are well aware of local and regional resources for legal information.
The final option for obtaining a quality S Corporation operating agreement is to seek one out from an attorney who specializes in business law or small business representation. They will have a model document for immediate use. Of course this will come at a cost but spending some money at the outset can save you thousands if an issue arises with the IRS down the road.
Legal Ramifications and State Requirements to Keep in Mind
Operating Agreements can be a bit like insurance policies. You have them to protect you under circumstances that you hope would never happen. However, they help create clarity in your business direction and strategy in case something does happen. One of the unfortunate limitations of Operating Agreements is that each state treats them a bit differently. Some states impose certain requirements for the contents of the Operating Agreement, while others are less specific. The corporate laws of the states in which your businesses are registered will govern the formation and management of your S Corporation and its related entities. The laws of each state may vary in terms of its requirements for S Corporations. States such as Delaware or Nevada have much more lax requirements than other states like Massachusetts that are much more strict.
It is important to research and analyze the laws of each state carefully to comprehend the full implications of forming an S Corporation in that state. Such factors should include taxation laws as compared to other states, availability of tax credits and incentives, tax rate for regular corporations and S Corporations, tax audit requirements, and corporate laws and statutes. In particular, it is important to consider whether the state has any specific requirements regarding minimum or maximum powers to be provided to the directors or officers, quorum requirements for board meetings and voting requirements for shareholders and directors. While this creates a whole new level of complexity to an already complex issue, it is definitely worth the effort and consideration sometime down the road when legal issues arise with your S Corporation.
Common Errors to Avoid When Creating an S Corp Operating Agreement
Mistakes to Avoid with S Corp Operating Agreements
A vital aspect of an S Corporation’s compliance and operational efficiency is the operating agreement. An operating agreement governs an S Corporation and informs the shareholders and managers how the company should conduct its business.
A few common operating agreement mistakes include:
Not Having an Operating Agreement
It is advisable for an S Corporation to have an operating agreement even if you are the only owner of your business. Even if you are a sole owner, you should have a formal document that describes your rights, obligations and responsibilities.
Not Updating an Operating Agreement
When forming an S Corporation , starting with an existing agreement rather than crafting a new one can save time and money. Many business owners rely on previous agreements that are altered using "cut and paste" as a method to create new provisions that do not 100% apply. The agreement should be updated to reflect legal changes and changes to business practices.
Creating a Conflicting Operating Agreement
Sometimes business owners will create operating agreements that include conflicting provisions. A conflict can lead to confusion and disputes between owners. A skilled business attorney can craft an agreement that is clear, concise and meets the company’s needs.
Failing to Execute the Operating Agreement
Even if you have a temporary agreement in place it is important to sign the document. Failure to execute the operating agreement or other corporate documents is often one of the things the IRS will focus on during an audit.