Understanding the S Corporation Operating Agreement

What is an Operating Agreement for an S Corporation?

I’m very interested in this concept of an S Corporation Operating Agreement and what its use is. In terms of the process of putting a business together, we’re starting out like everyone else would and moving toward incorporating an S Corporation, and it is my understanding that at that point in time we will then need to draft and introduce this document. My question is what exactly this document would "do?"
An S Corp Operating Agreement is an internal document similar to an operating agreement in a LLC business structure. It basically operates like a partnership agreement for a corporation. The S Corporation operates under a certain internal structure , and this its rules or regulations, or both. Separately, an S Corporation should be established with its own by-laws. By-laws are similar to rules or regulations, but they consider external rules, laws and regulations (such as those created by statute). An operating agreement would define the internal processes of the S Corporation, including how decisions will be made, how new members can join, and what happens if there’s a dispute with members.

What to Include in an S Corporation Operating Agreement

A standard S Corp Operating Agreement will include several key elements, such as an The ownership structure section explicitly lists the names of all of the shareholders, the number of shares owned by each individual and the total number of shares that have been allocated to the company. It will also set forth the schedule of ownership. For many investors, the ownership schedule is critical because it outlines who will be paid first in the event that the company must liquidate. The management duties outline all of the obligations of executives at the company. In particular, if the S Corp Operating Agreement designates a director or certain officers, this section will note whether a director can delegate specific authority to officers, managers, employees or agents. Some S Corp Operating Agreements even address who might be authorized to sign checks in the absence of the president or treasurer. The voting rights section of the S Corp Operating Agreement specifies how many votes are needed to approve certain matters. For instance, whether shareholders are authorized to issue bonds, mortgages and notes for the company will be noted in this section, as will any annual meetings that the company holds.

Benefits of an S Corporation Operating Agreement

A formal operating agreement for an S Corporation provides the protection of law that helps guide business operations. As with other corporate entities, S Corporations benefit from the protection afforded to the owners through limited liability. However, having a written operating agreement that outlines the rules, roles and responsibilities involved in running the company provides several other key advantages for the company entity.
The first advantage of the written agreement is it protects the company from future disputes about how the business is to be operated. Although the legal structure generally provides protection, the terms of operation and ownership is often a matter of interpretation left to family, shareholders or even the court if no agreement was made.
A second advantage concerns the clarity it brings to roles within the company. Even when there are only a few people operating a company, different responsibilities and duties may not be clearly delineated. The operating agreement helps everyone understand where they fit into operations of the company and how their role is legally addressed.
The third advantage involves the resolution of potential future conflict. When there is proper documentation videotaped or written that explains how things should be done, the risk of conflict is decreased. If there are conflicts in the future, the agreement provides a framework for handling the problem in a structured way that legally protects all involved.

How to Create an Operating Agreement for an S Corporation

A typical process for drafting an S corp operating agreement could be as follows:

• The shareholders (S Corp members) schedule a meeting, and put together a team consisting of their attorney who is experienced in dealing with S Corporations, along with the appropriate professionals, accountants, and financial planners.
• The shareholders determine, based upon their expectations from the company, whether they will need to vote any other persons into the corporation as shareholders S Corporation members.
• The S Corp shareholders contemplate whether or not to hire a business valuation expert to address the valuation issues relating to the buyout provisions of the S Corp operating agreement (buy-sell provisions).
• The shareholders select which options from Chapter 14 of Title 13 of the Delaware Code (the Delaware LLC Statute) they would like to include within the S Corp operating agreement.
• The chosen options are inserted into the S Corp operating agreement, and the S Corp shareholders will schedule another meeting to discuss the agreement, and the shareholders will sign the S Corp operating agreement.

Mistakes to Avoid with S Corporation Operating Agreements

One of the more common mistakes we see with S Corp operating agreements is in allowing for different classes of stock. It’s important to note that an S Corporation must consist solely of one class of stock, meaning that all shares of the corporation must have identical rights. There is an exception, however, for a corporation that has voting and non-voting shares of the same class of stock. For instance, voting shares must be offered to all shareholders, but non-voting shares of the corporation may be offered to some shareholders. The key here is that in order for an S Corp to operate as such, it is crucial that it does not have two or more classes of stock.
Another error some corporations make is in providing for different rights at different times in the future under the agreement. We have seen this commonly overlooked issue arise in corporations that were successful in getting a great buyout deal. Many times shareholder agreements will contain provisions that kick in as a result of a certain event happening, such as a buyout, but fail to provide for the consideration required to exercise the buyout right. As a result , the corporation is stuck with the default purchase price provided in the agreement which may be grossly undervalued as a percentage of fair market value, or vice versa.
It is also important to make sure that the corporation updating the agreement proceeds with the proper procedures that are required under the document. Frequently, S Corporations think that a simple formality, such as revising the members or directors section of the agreement, can be accomplished with a simple written consent. The agreement may require a majority vote of the shareholders and/or directors of the corporation. Even a simple noncompliance with these formalities could have negative legal repercussions, such as the loss of S Corp tax status or shareholder rights under the S Corp.
It’s important to remember that an operating agreement, or by-laws, is a contract between the shareholders. Therefore, the breach of these agreements can result in claims for damages against other shareholders or directors of the company. It is important to consult with a corporate business attorney when drafting an operating agreement and to properly sign off on all required formalities that are needed to operate legally and that protect your rights within the company.

Legal Guidelines and the Law

It is important for shareholders to understand the legal requirements that govern S Corp Operating Agreements. While the formation and running of S Corporations are generally governed by state corporate laws, the S Corporation status is entirely dependent on adherence to specific requirements set forth in the Internal Revenue Code (IRC). This includes both compliance as an S Corporation as well as adherence to such requirements in operating and governing the shareholders with an S Corporation.
From a state perspective, the requirements are generally minimal. There are certain statutory provisions that must be included in the S Corp Operating Agreement that would also need to be part of an LLC Operating Agreement. For instance, the S Corporation Operating Agreement must specify who is authorized to execute documents on behalf of the Company. A sample provision may read as follows:
"[Name] is hereby authorized to sign documents and conduct other business for and on behalf of the Company."
State statutes will require other provisions but those are not unique to S Corps.
On the federal side, no S Corp Operating Agreement or operating details need to be filed with the IRS. Further, the IRS does not require any particular form for an S Corporation Operating Agreement. However, the IRS has taken the position that it may be necessary to amend existing S Corp Operating Agreements if there is noncompliance with the restrictions applicable to S Corporations.
Finally, in the event of any conflict between the IRC requirements for S Corporations and the state law requirements for corporations, the IRC provisions will prevail. In other words, S Corporations have to comply with both the state law and the IRC requirements but only in cases of conflict will the IRC provisions trump state law.

Updating an S Corporation Operating Agreement

Despite the fact that the S Corp Operating Agreement is not required to be in written form, it is highly advisable to have one documented in writing due to the numerous practical, tax, and corporate governance issues that can arise in its absence. Even if there is an Operating Agreement in writing, there may be a need for an amendment to the Agreement to fully satisfy the purposes for which it was drafted, changes in circumstances amongst the shareholders and significant events that could occur. When drafting or updating your Operating Agreement, you should think about whether the existing Agreement would provide sufficient guidance to aid management in directing the affairs of the company or whether an amendment needs to be made. The following are some examples of circumstances that may require an amendment to your Operating Agreement:
a. There has been a new shareholder.
b. An existing shareholder has acquired more equity.
c. The interests of an existing shareholder has been diluted.
d. The business of the company has changed.
e. The Partnership no longer fits the needs of the company and needs to be converted to a corporation.
f . The shareholders have a dispute that can be entirely resolved through amendments to the Operating Agreement.
g. The Operating Agreement was not written by a professional and may not be sufficiently specific to address the complexities associated with tax and corporate issues that arise.
h. The Operating Agreement does not meet the requirements of applicable laws.
i. The S Corporation no longer qualifies as a small business corporation under the Internal Revenue Code.
In order to amend your S Corporation Operating Agreement, the Process varies and is usually set out in the current Operating Agreement. If not, general default provisions under state statutes will apply or if applicable, you may determine your own process through it past practices. The reasons and process for amending the Operating Agreement should be carefully established in advance in order to ensure that each shareholder has an equal voice in the future modifications to the Agreement. In some situations, tranquil and reasonable discussions between the shareholders can lead to a mutual agreement to modify the Operating Agreement but in the event the parties fail to reach an agreement, there are certain statutory provisions that may apply to resolve the dispute.