Defining an S Corporation
An S Corporation is a corporation formed under state law (totaling 50 States) that has elected to be taxed as a pass-through entity. The corporation agrees to internal rules and regulations which are contained in its By-Laws and it has a reason for its existence, which is to provide a return to its investors. In order to become an S Corporation, a corporation must make an election through the Internal Revenue Service. It will retain its charter as a corporation. However, it will be treated as a pass-through entity for purposes of federal income tax.
The election requires that each of the shareholders sign agreeing to be taxed as a pass-through entity. The corporation must have 100 or fewer shareholders , and only US based entities or individuals may be shareholders. In addition, a C Corporation may not be a shareholder of an S Corporation, nor may certain trusts, estates or partnerships (although there are narrow exceptions under specific conditions). This limits its attractiveness to most investors. However, the most significant distinction between a C Corporation and S Corporation is that an S Corporation’s income, deductions and credits are passed through to the shareholders in order of priority. This is a substantial difference in the method that the federal government taxes corporations.
The Significance of an Operating Agreement
An operating agreement is a legally binding document that governs the internal affairs of an S-Corporation. Despite the fact that there is no provision in the Internal Revenue Code requiring an Operating Agreement, it is important to have one. Such agreement establishes the rules of governing the corporation and helps avoid potential disputes. Even if not mandated, many states require corporations and other entities to adopt a governing document. For instance, California requires corporations to adopt Bylaws. Other states require a Partnership or LLCs to adopt a Partnership Agreement or Operating Agreement. Please check with a local attorney to find out what the requirements in your state.
The agreement sets out the rights and responsibilities of the shareholders and directors. It will make clear how management is supposed to make decisions and determine the process by which they will resolve disputes. The agreement should also detail the transfer of ownership and continuity of the business in the event of an owner’s death or termination.
The shareholders have to agree upon the corporation’s voting procedures, including the number of votes required to pass a resolution. The shareholders can likewise set out their own rules regarding voting rights, including an outline of how/who can cast proxy votes, such as allowing shareholders to vote by telephone, vote by proxy or by consent in writing, etc. There are many other issues that are worth addressing in an Operating Agreement and these issues will be examined below.
Common Features of an Operating Agreement
The Operating Agreement is the document that sets out how your business will be owned and run. The members of an S Corporation can agree on any number of agreements that govern company operations, but there are some key components that will likely be particularly relevant to running a small business:
Management
The most important aspect of a company’s operation is how the company will be managed. Will it be member-managed, and all members will be actively involved in the operation and management of the business? Or will it be manager-managed, with one or more managers who run the company and the government of the company is vested solely in them? The Operating Agreement should clearly lay out this structure.
Decision-Making
Once the members and managers are organized, there needs to be a clear process for how decisions will be made, both in regular, day-to-day operations and in extraordinary matters like the sale of the company. The members of the company can decide if they want to take a quantitative vote – each member has an equal vote – or a qualitative vote – where the voting members overlook the potential damage of one member with a "bad idea" and focus instead on the merits of the proposal.
Profits and Losses
How will the company’s profits and losses be divided? Will one member receive a higher proportion of profits if they have made a larger investment in capital? This Allocation of Profits can usually be determined by individuals’ capital or sweat equity contributions to the company.
Distributions
Once profits are allocated, how does the company distribute those profits? It is essential to provide for distributions, both scheduled and liquidating, so as to ensure members receive both their agreed-upon salaries or dividends and their proper share of the profits.
A well-written Operating Agreement will consider all potential issues and clearly set out a path for resolution. Your business will run better over the long run if you have considered every dimension of company operation up front and planned for it.
Writing the Agreement: Points to Consider
When you draft an operating agreement for your S corporation, there are several best practices to keep in mind. First and foremost, clarity of terms is paramount. Every term should be clearly defined and every provision should be easy to understand. In addition, the agreement should be in compliance with both state and federal law. Although it is not a requirement for S corporation operating agreements to be filed with the Texas Secretary of State, it is highly recommended that you get legal advice and formalize your agreement according to Texas law . After all, the S corporation is a legal entity and that includes having a legal agreement that governs its terms and conditions. In addition, there should be flexibility for the future so that the corporation can adapt to changing business needs and economic conditions. Finally, the agreement should be customized, rather than be a boilerplate document that simply lists general terms and conditions of doing business as an S corporation. It is highly recommended that you get legal advice before putting together your corporation’s operating agreement.
Frequent Errors to Avoid
When it comes to creating an operating agreement, there are a number of common mistakes that can jeopardize the success of an S corporation and its owners. One of the most frequent pitfalls is the use of vague or ambiguous language in the agreement. Such language can lead to confusion and misinterpretation, making it difficult to resolve disputes or make important decisions. It is crucial to use clear and precise terms to ensure that all parties have a complete understanding of their rights and responsibilities.
Another common mistake is the failure to include comprehensive clauses in the operating agreement. For example, an agreement that lacks detailed provisions on the distribution of profits, the management structure, or the procedure for making significant business decisions may create legal disputes down the line. Additionally, leaving out clauses related to the transfer of ownership interests or how the corporation will be dissolved can cause conflict and confusion.
Finally, a common error in the creation of an operating agreement is the failure to update it regularly. As the business grows and evolves, the operating agreement should be revisited and revised to reflect any changes in the ownership structure, management, or business model. Failing to update the agreement regularly can lead to legal issues, as well as limit the company’s ability to adapt to new circumstances.
Rules for Amending and Updating an Operating Agreement
It is imperative that you regularly review your operating agreement to ensure that it reflects the most current structure and operations of your business. It is not uncommon for the business landscape to change frequently and standing still is rarely the best approach. The same holds true for your S corporation.
Every time there is a major change to your business settings, it should trigger a review of your operating agreement, with the goal of amending it if necessary to better capture the current state of the business.
The process of updating or amending your operating agreement can be started by any of the shareholders, but should involve collaboration and open communication, along with the review of legal counsel, to ensure that all aspects of the changes are fully understood and accounted for in the revised document.
Many operating agreements will contain a section providing for how amendments or updates are to be made, including the vote necessary to pass such a change in the agreement. In general, the greater the change, the greater majority of votes required to pass it . A simple update to the address of the corporation may only require a 51% majority vote, while an amendment of voting or profit-share rights may require 80%, or even a unanimous, vote. Because the vote required to pass an amendment will often be fixed in the existing operating agreement, any such provision must be reviewed to determine the proper vote necessary to amend the agreement.
In the event that the listed vote does not pass, the only other option would be to propose the new voting dynamics across all shareholders and then draft up an updated operating agreement that is in line with the preferred voting dynamics. However, this could lead to tensions and possibly even litigation between shareholders.
Regardless of who puts forth the changes or how they are presented, the process by which such changes are created and passed should be clearly defined in a way that all shareholders can understand and agree upon. Once the changes are agreed to, an updated operating agreement must be drafted and signed by the necessary party members.