What is an S Corporation?
An S Corporation is an incorporated business that has chosen to be taxed as an S Corporation. The business structure is ideal for those looking to operate as a small business owner without utility and telecommunication liabilities. While many large companies file taxes through C Corporations, S Corporations are made for small businesses. S Corporations pass corporate income, losses, deductions, credits, and other tax items through to their shareholders for federal tax purposes. Therefore, S Corporations avoid double taxation on income taxes. One notable difference between an S Corporation and a C Corporation is the limit on shareholders. S Corporations can only have up to 100 shareholders while C Corporations do not limit ownership. C Corporations are the more common corporate structure, meaning larger corporations file as C Corps. Unlike an LLC , S Corporations must issue stock in exchange for corporate income. LLCs allow for greater flexibility in management of the business and distribution of profits while offering liability protection. Because distributions are not as strictly regulated within an LLC, S Corporations often include language in their operating agreements to provide for the right to make varying distributions of profits. The S Corporation is one of the best business structures for small business owners. S Corporations are similar to C Corporations in terms of appearance (i.e. limited liability, corporate formalities like record keeping, etc.). However, as mentioned, when JD, CPA, and MBA Stephen Wills refers to this business entity, it is in reference to S Corporation as it applies to tax filings. Specifically, most small businesses incorporate as an S Corporation for tax purposes.
What is an Operating Agreement?
An operating agreement serves as the backbone of your business. It is a document that describes how the company should operate and establishes the internal protocols for your business. It outlines the daily tasks, the distribution of profits, management, and important decision making procedures.
Also called company agreements, the purpose of an operating agreement is to identify the members of the organization, as well as the structure of the corporation. S Corporations must have operating agreements to remain compliant with the IRS. It not only provides guidance and clarity when dealing with complex tasks and decisions, but can also be used to settle disputes. It helps to avoid conflicts, which is especially important in small business or family-run companies. Having a written guide also enables members to stay on the same page. It establishes clear expectations and eliminates any guesswork when it comes to how things should be handled.
S Corp Operating Agreement Key Items
While an operating agreement is not required for corporations, even an S corporation can benefit from having an operating agreement that delineates the rights and responsibilities of the shareholders and directors. With an S corporation, the key components of an operating agreement are similar to those of a traditional operating agreement.
At the core of an S corporation operating agreement is the company’s ownership structure. No more than 100 shareholders can own shares in an S corporation and all shareholders must be either individuals, estates or certain trusts. Each shareholder can have only one class of stock and the corporation may only conduct business within the United States mainland, Puerto Rico or any U.S. territory.
There needs to be clarity in the operating agreement regarding how the S corporation is organized and who is part of the ownership. For example, shareholders should be identified by name, social security number, home address, the number of shares and their capital contribution. The operating agreement should also specify the percentage interest of the corporation each shareholder has. Ownership percentages are typically based on the number of shares owned.
The operating agreement should address management responsibilities. For instance, how will the S corporation be run and who is allowed to make decisions? With most S corporations, shareholders elect directors who are responsible for overseeing the operations of the company. The operating agreement should explain how directors are elected and how often elections are held. The operating agreement should also outline the voting process. For example, what percentage of votes need to be cast in order for a measure to be adopted?
Another important aspect of an S corporation operating agreement is how profits are handled. For example, the operating agreement should specify whether profits are distributed to shareholders or retained within the company. Additionally, if shareholders receive distributions, the process for how they are distributed should be described. It is also important to address whether shareholders are permitted to receive loans from the S corporation.
Another key element of an operating agreement is how the S corporation resolves conflicts. For instance, it should identify a procedure for resolving disputes among shareholders. When there is a dispute between shareholders, it can create difficulties in running the operation. Having a built-in dispute resolution mechanism can reduce conflicts between shareholders and provide a pathway for swift and fair resolution. Dispute resolution mechanisms can include mediation, arbitration and referring the matter to corporate counsel.
Given the complexities of establishing and maintaining an S corporation, all S corporation owners should have a comprehensive operating agreement. An experienced business attorney can draft an operating agreement tailored to the needs of the business and its shareholders.
Pre-Registration Legal Requirements
Creating an Effective Operating Agreement for Your S Corp
Legal Requirements and Compliance:
Complying with the laws of your state when it comes to drafting an operating agreement for your S Corporation is ideal for keeping your business out of legal trouble. While it’s true that there are many ways to get around self-governing the management of an S Corporation, going through the proper channels when it comes to drafting an operating agreement is a proactive approach to managing your small business. There are some states that have specific requirements when it comes to an S Corporation operating agreement. Some states require that all individuals of a voting share be present in order for voting to take place at a shareholder meeting. Other states require that any voted on resolution be placed in writing in order for it to be considered legally binding. Still other states require that all shareholders vote at the same time for resolutions to be passed. If you already have an established S Corporation that currently functions under the operations of a verified operating agreement, sometimes the law is not as strict about requiring an entirely new operating agreement and simply updating the old one when it comes to legal compliance will suffice. Maintaining written records of meetings of shareholders and board of directors is encouraged in most states, although strictly not required. Keeping minutes that describe what took place during a meeting will also help the shareholders and board of directors remember who voted on what resolutions for future reference. Although it is not recommended for a company to go without an operating agreement, if your S Corporation has filed an operating agreement with the state and it is lost, getting a replacement copy drawn up and filed with the state again is all that will be required. In most states, replacement copies of the operating agreement can be filed online. However, those states that require signed operating agreements will often demand that a notarized copy of the operating agreement be filed with the state.
Drafting & Customization
Your operating agreement will be only as effective as the specifics you include in it. That is why the draft you and your attorney put together is so important. An S Corporation is a pass-through entity, which means the income and losses pass through to the shareholders. But how you decide to use the operating agreement will affect what language is drafted and how it is customized for your situation. One of the first things you will have to consider is whether or not you want your S Corporation to be managed by shareholders or elected directors. If the decision is made to follow the corporate structure of having elected directors and officers, essentially you will be drafting an agreement that closely resembles a bylaws, although it will still be different in key ways. Any amendment or changes to the operating agreement will also require the approval of more than 50% of the shareholders. On the other hand , having the S Corp managed by shareholders means that the shareholders have more direct control over the corporation. An operating agreement is necessary in this case to establish the rights, duties, and obligations of the shareholders. Assuming that you will not go the directors route, the elements of the operating agreement can be customized in a number of ways. Once a general idea of what to include has been decided, the specifics of who, what, where, when, and how need to be laid out. Important aspects of defining your S Corp will include (1) who will manage the obligations under the terms of the operating agreement, and (2) how will finances be managed. You will also need to explain how decisions will be made, such as who gets to decide when to issue new stock, for example. Each situation may require different language, so work closely with an attorney to ensure your agreement is personalized correctly. Avoid simply using template agreements, which can be found online, and then expecting the document to simply work out. A well-written operating agreement will save you headaches.
Common Pitfalls
While there are numerous paths to successfully establishing an enforceable and enforceable operating agreement, business owners often find themselves making the same mistakes. Common pitfalls include:
Failing to update your operating agreement. A key to maintaining a valid operating agreement is to periodically review and revise the agreement along with any changes in law, circumstance, or members. Failing to do so could render some provisions unenforceable.
Not having an operating agreement. While an operating agreement may not be required, it is always a good idea. Operating agreements that are created by lawyers are typically more robust because they have witnessed the common problems. As such, they will try to prevent issues before they arise.
Having a generic operating agreement. Businesses are not cookie-cutter; your operating agreement shouldn’t be either. Generic operating agreements often fail to address unique concerns or issues, which can have disastrous effects on a business. Business owners should give their full attention to the operating agreement to ensure they cover everything specific to their business.
Legal Help
While you can get sample operating agreements from your Accountant or your friends, there is no substitute for adequate legal representation. You’ll want to properly address those situations and conditions that are unique to your specific business and its owners. Experienced entrepreneurial business lawyers will be able to address these issues based on their experience with hundreds of different types of businesses and their unique needs. An experienced entrepreneurial business lawyer will have dealt with different industries and structures, so they will be able to guide you into developing the appropriate S corporation operating agreement for your particular business and avoid many pitfalls that someone without this experience would encounter.
Conclusion and Next Steps
You now have a complete roadmap to create the perfect operating agreement for your S Corporation. So, how do you get the ball rolling?
First, schedule time on your calendar (about six hours), get into the proper mindset ("I’m going to create an S Corp operating agreement in the next few weeks") and start answering the questions above. Be completely honest in all your responses.
Next, type up your answers in a Word document that is clearly identified as a "Draft S Corporation Operating Agreement" (including the date).
Then , email it to your attorney and ask for feedback. We recommend hiring an attorney with C-Corporation experience—it makes all the difference in the world when your attorney truly understands Corporations and the advantages of structuring your business properly as an S Corp.
Finally, once you’ve made the appropriate edits, have your attorney finalize the document and present it to your shareholders for their signature.
After that, you’re good to go! You can breathe easier knowing that you have a solid legal document that provides clarity to all your shareholders should a disagreement arise in the future. And your S Corp will be firmly protected from liability concerns in terms of your business operations and be fully compliant with IRS regulations as to its compensation structure.