Operating Agreement for Disregarded Entity: What You Need to Know

Forming a limited liability company (LLC) is a popular way to protect personal assets while operating a business. When forming an LLC, you`ll need to choose a tax classification for the entity. Most LLCs are taxed as either a partnership or a corporation. However, sometimes an LLC can be classified as a “disregarded entity” for tax purposes.

What is a Disregarded Entity?

A disregarded entity is a type of LLC that is considered “invisible” for tax purposes. Essentially, the LLC is treated as a sole proprietorship, and the business`s income and expenses are reported on the owner`s personal tax return. This means that the LLC itself doesn`t file a separate tax return or pay taxes directly to the IRS.

Operating Agreement for Disregarded Entity

Even though a disregarded entity is not required to file a separate tax return or pay taxes, it is still recommended that an LLC operating agreement be created. An operating agreement is a legal document that outlines the rules and regulations for how the LLC will operate. While disregarded entities are not required by law to have an operating agreement, they are still highly recommended.

Here are some reasons why you should have an operating agreement for a disregarded entity:

1. Clarifies Ownership and Management

An operating agreement outlines who owns the LLC and how the business will be managed. This document is incredibly important for disregarded entities because, without it, the LLC`s sole owner may have trouble proving that they own the business, especially if they have multiple LLCs.

2. Provides Liability Protection

An operating agreement can help limit the owner`s personal liability for the business`s debts and obligations. This is especially important for disregarded entities because the LLC`s business activities are reported on the owner`s personal tax return. If the LLC is sued or goes bankrupt, the owner`s personal assets could be at risk.

3. Sets Terms for Dissolving the LLC

An operating agreement can also outline how the LLC will be dissolved if necessary. This is important for disregarded entities because, without it, the LLC`s owner may have trouble proving that they have the authority to close the business.

Creating an Operating Agreement

Creating an operating agreement for a disregarded entity is relatively simple. The document should include the following sections:

1. Introduction

The introduction should include the name and address of the LLC, the date it was formed, and the business`s purpose.

2. Ownership

This section should outline who owns the LLC and what percentage of the business each owner has.

3. Management

The management section should outline how the LLC will be managed. This includes who will be responsible for day-to-day operations and decision-making.

4. Capital Contributions and Distributions

This section should outline how much money each owner has contributed to the LLC and how profits will be distributed.

5. Dissolution

The dissolution section should outline how the LLC will be dissolved if necessary. This includes what happens to the business`s assets and liabilities.

Conclusion

While disregarded entities may not be required to have an operating agreement, it is still important to create one. An operating agreement can protect the owner`s personal assets, clarify ownership and management, and provide a roadmap for the LLC`s dissolution. If you`re unsure about how to create an operating agreement, it`s recommended that you consult with an attorney or a tax professional.