The operating agreement of an S Corporation is a document for managing a business structure. In general, an operating agreement is a document that defines how a limited liability company is to be managed. In effect, the s corp uses the corporate bylaws and incorporation documents to organize the operations of the company.Want to learn more about the operating agreement for an S Corporation? Continue reading our article.
What Is an S Corporation and an Operating Agreement?
A corporation stands for one of today’s most popular business models. It is an independent legal entity formed under state law to conduct commercial activities.
According to the section of the Revenue Code regulating their activities, corporations are divided into a C corporation and an S corporation. Both provide limited liability protection, but an S corporation has some unique features. Above all, it involves “pass-through” taxation. While C-corp profits are taxed twice, an S corporation delegates tax reporting responsibilities to the owners.
In addition to this, there are other distinctions. For example, an S-corp has some limitations regarding the type and number of shareholders, which a C-corp does not have.
To summarize, to qualify as an S corporation, a company has to fulfill the following criteria set by the IRS:
- 1 class of issued shares;
- Registering a venture in America;
- All shareholders, who are individuals, should be citizens or residents;
- No more than 100 owners, etc.
A business founded by two or more owners is often at risk of management conflicts, so a clear structure is especially valuable for an S corporation. This can be achieved, among other things, by drawing up an internal document fixing the management hierarchy and the basic principles of the organization. It may be called an Operating Agreement or the corporate bylaws.
The primary functions of the Operating Agreement are as follows:
- Accelerating the work of the enterprise by standardizing basic procedures;
- Preventing managerial misunderstandings;
- The chance to avoid default rules;
- Additional separation of personal and corporate assets.
How Does an S Corporation Operating Agreement Work?
The fundamentals of an S-corp are similar to any other corporation. The main merit of this type is that the owners and directors are protected from personal liability for the firm’s debts and obligations. It ensures that if an S corporation is sued, the creditors’ claims will be strictly limited to the company’s assets. The owners’ personal property, such as a car, house, or savings, will remain intact regardless of the corporation’s financial status. The only thing a shareholder risks is their investment in the capital of the firm. Naturally, this protection is not absolute. A court may bring the S-corp owners to personal liability if it concludes that the integrity of the “corporate veil” has been violated. In the event of a mixture of personal and corporate funds, for example.
Unlike a C corporation, an S-corp allows all the benefits of “pass-through” taxation. Such entities are not subject to federal income tax, transferring this duty to the shareholders. The latter report their share of income, as well as expenses received from the enterprise, on their personal tax returns.
In return for more favorable working conditions, S-corps are required to follow certain restrictions. Specifically, this applies to shareholders. Only individuals, who are citizens or residents of the USA, trusts, or non-profit organizations can become owners of an S corporation. The total number of shareholders should not exceed 100. The S-corp itself can also be based only in the USA.
An Operating Agreement, or corporate bylaws, is an important prerequisite for the growth and stable functioning of a venture. By separating rights and obligations, it avoids management conflicts and misunderstandings. Moreover, the bylaws protect an S-corp from state default rules. Due to their general nature and emphasis on a wide range of companies, default rules are often not in the best interest of particular firms.
Advantages and Disadvantages of S Corporations
Choosing the S-corp tax treatment provides access to a great number of benefits. First and foremost, it concerns taxes, of course. For any organization, taxes are one of the major expenditure items, so the exemption from paying corporate income tax at the federal level constitutes a significant perk. Thanks to this, you can save money by investing in developing your own enterprise and expanding its capabilities.
Another strength of an S corporation lies in giving the owners engaged in the daily running of the firm a paycheck. Normally, business owners are not considered employees, but such a structure makes this possible. Nonetheless, there are a few niceties. Keep in mind that the owner’s salary cannot be too high or too low, otherwise, your venture runs the risk of attracting the IRS’s attention. It’s best to set your salary based on the average for the appropriate position in your chosen field.
As for the downsides of registering an S-corp, the first thing to note is the significant time and money involved. You should prepare the Articles of Incorporation, corporate bylaws, and other paperwork, as well as pay the mandatory fee, the amount of which depends on the state. Besides, you have to choose and appoint a registered agent maintaining them throughout the whole period of the enterprise’s existence. Of course, you can save money by outsourcing this duty to an acquaintance or doing it yourself, but this option has serious drawbacks.
Along with start-up costs, there are several ongoing maintenance costs for the firm. You may have to pay an annual report processing fee, franchise tax, and other fees. The good news is that you can generally get a tax deduction for these.
Another reason why S-corps are not widespread is the qualification criteria for shareholders. Companies with more than 100 owners cannot qualify for S-corporation status. Additionally, other corporations and LLCs are prohibited from acquiring S-corp shares.
Finally, S corporation activities are under strict IRS scrutiny. This applies both to the salaries of the shareholders and to the dividend distribution procedure. For an S-corp only a direct allocation of funds, proportional to the ownership share of each shareholder, is permissible. At the same time, it is crucial to comply with all legal requirements since in case of violation, the IRS will deprive the company of its S corporation status.
How To Create an S-corp Operating Agreement?
To draw up an Operating Agreement for an S corporation, you are to consider the most meaningful aspects of its operations and possible risks. Moreover, you should be prepared by researching current state corporate law or by consulting with a lawyer in advance.
The main blocks typically included in the agreement are the following:
- Basic company information
Provide the official name of your firm and, if any, the DBA names registered under it. You should also include the legal address of an S corporation.
- Shares and stocks
Only individuals, who are residents or citizens of the USA, as well as trusts and nonprofit organizations, can be shareholders of an S corporation. Furthermore, there is a limit on the number of owners — no more than one hundred. Fix these provisions of the legislation in your Operating Agreement and state that an S-corp issues only one type of stock.
- Board of directors
Describe who will be on the board of directors and disclose their roles. Define the appointment, term of office, and retirement procedures. Note that some states have a statutory minimum number of board members.
As with the board of directors, the owners of the S corporation have to establish the number of officers needed to keep the company running. Determine the procedure for their appointment and removal from office. List the rights, duties, and responsibilities.
According to the law, all corporations are required to hold meetings of shareholders and directors once a year. The owners cannot override this rule but have the right to make such meetings more frequent. In addition, it is necessary to determine the location of these meetings, as well as the minimum number of participants required for the meeting to be considered valid.
- Paperwork and accounting
The activity of S corporations is associated with the inevitable need to meet formalities, as such companies are under constant control. The state, the IRS, and shareholders can request access to S-corp documents for review at any time. As such, the firm should establish a list of papers to maintain. For example, meeting minutes.
Furthermore, you will most likely be required to file various annual and financial reports. Quality and timely preparation of documentation will not only save your S corporation from unnecessary questions from the state or the IRS but will also benefit the organization itself. Thus, having reliable written evidence will make it easier for you to protect your interests in the event of a legal dispute.
A company’s goals and needs are largely determined by its stage of development. As it grows, you may need to make some changes to the Operating Agreement to make it more up-to-date. For the amendments to be legally effective, you need to follow the procedure by having the new version of the document certified with the required number of signatures.
The ready-made Operating Agreement will not take effect until it has been signed by the owners or the board of directors. Remember that clauses contrary to the law have no legal effect.