Why a Proper Operating Agreement Matters for S Corporations and Partnerships

Many business owners treat an operating agreement as a formation document — something downloaded from the internet, signed, and then forgotten.

That misses the real purpose of the agreement.

A well-designed operating agreement is not just a legal formality. It is the financial and operational rulebook for the business. It determines who controls the company, how owners are paid, how cash is distributed, what happens when more money is needed, and how an owner can eventually leave the business.

These questions matter for every closely held business, but they are especially important for multi-owner S corporations and partnerships. In those entities, the agreement can affect tax reporting, owner basis, compensation, distributions, succession planning, and the financial consequences of a dispute.

A Boilerplate Agreement Is Usually Not Enough

Boilerplate agreements are designed to be broadly usable. That is also their biggest weakness.

A standard online agreement does not know:

• Whether one owner contributed more cash than another;
• Whether one owner works full-time while another is primarily an investor;
• Whether the company has elected S corporation status;
• Whether the owners expect equal distributions;
• Whether an owner has loaned money to the business;
• Whether the business depends heavily on one individual;
• Whether the owners have personally guaranteed company debt;
• Whether one owner could afford to buy out another owner; or
• Whether the owners plan to sell the business or pass it to the next generation.

When an agreement does not address an issue, state law often supplies the answer. That default answer may be very different from what the owners assumed or verbally agreed to.

In other words, failing to make a decision does not mean there is no rule. It usually means the owners have accepted a rule written by someone else.

The Agreement Must Match the Tax Classification

One of the most common problems is an agreement written for an LLC without considering how the LLC is taxed.

An LLC can be taxed as a partnership, S corporation, C corporation, or disregarded entity. The same legal entity can therefore operate under very different federal tax rules.

S Corporation Agreements

An S corporation must have only one class of stock and must satisfy federal restrictions on eligible shareholders and the number of shareholders.

An agreement that gives one owner preferential economic rights, disproportionate distributions, or different liquidation rights can create an S corporation eligibility problem. The owners may have intended to reward one shareholder for additional work or investment, but the method used in the agreement may conflict with the S corporation structure.

S corporation owners also need to separate three different ways money can move between the shareholder and the company:

1. Wages for services performed;
2. Shareholder distributions; and
3. Repayment of bona fide shareholder loans.

These categories are not interchangeable. A working shareholder should receive reasonable compensation for services before payments are treated as non-wage distributions.

A good agreement should not try to set a permanent reasonable salary. Compensation changes as the business and the owner’s responsibilities change. But the agreement should establish that working shareholders will receive reasonable compensation under a process reviewed periodically by management and the company’s tax adviser.

Partnership Agreements

Partnership-taxed businesses have more flexibility than S corporations, but that flexibility creates more complexity.

A partnership agreement may need to address:

• How profits and losses are allocated;
• Whether an owner receives a guaranteed payment;
• How distributions are made;
• How capital accounts are maintained;
• How debt is allocated among the partners;
• How contributed property is treated;
• What happens when an owner contributes services instead of cash; and
• How the economics change when a new partner is admitted.

A boilerplate agreement that simply says profits are divided according to ownership percentages may not work when one partner receives a preferred return, contributes appreciated property, guarantees business debt, or performs substantially more work than the other partners.

Your CPA Should Review the Agreement

An attorney should draft the legal agreement. Your CPA should help make sure the financial and tax provisions work as intended.

This is not a question of choosing between a lawyer and a CPA. The strongest agreements are created through collaboration.

An attorney focuses on enforceability, state law, fiduciary duties, liability protection, dispute resolution, and legal remedies. A CPA can evaluate whether the agreement’s financial provisions match the company’s bookkeeping, tax filings, cash-flow needs, and owner expectations.

A CPA should review questions such as:

• Will the distribution provisions work under the entity’s tax classification?
• Are tax distributions required so owners can pay tax on pass-through income?
• Does the agreement distinguish owner loans from capital contributions?
• Are compensation provisions consistent with S corporation or partnership tax rules?
• Can the accounting system track the capital accounts required by the agreement?
• Will a buyout create unexpected ordinary income or capital gain?
• Who has authority to make tax elections, including state pass-through entity tax elections?
• Does the agreement create an economic arrangement that differs from what the tax returns currently report?

The time to answer these questions is before the agreement is signed — not after the owners are in a dispute or a tax return has already been filed inconsistently with the agreement.

Owner Loans Must Be Documented

Closely held companies frequently move money informally.

An owner transfers cash to the company when the bank balance is low. The company later sends money back to the owner. No promissory note is prepared, no interest is charged, and nobody clearly decides whether the original transfer was a loan or a capital contribution.

That creates both tax and legal problems.

The agreement should require owner loans to be separately documented and approved. The documentation should address:

• Principal amount;
• Interest rate;
• Payment schedule;
• Maturity date;
• Whether the loan is secured;
• Whether repayment is subordinate to bank debt;
• Whether early repayment is permitted;
• What happens if the company cannot make payments; and
• Whether other owners have the right or obligation to participate proportionately.

This is particularly important for S corporations. A shareholder generally receives debt basis only for money personally lent to the S corporation. Merely guaranteeing a company loan is generally not enough.

Partnership liabilities work differently. Changes in a partner’s share of partnership debt can increase or decrease the partner’s tax basis and may be treated as deemed contributions or distributions. Without proper documentation, the company, the owners, the CPA, and the IRS may reach different conclusions about the same transaction.

Distribution Provisions Need More Than One Sentence

Many agreements simply state that the company may make distributions as determined by the owners. That language leaves too many important questions unanswered.

Owners of pass-through businesses can owe tax on company income even when the company retains the cash. A tax-distribution provision reduces the risk that an owner receives a tax bill without receiving the funds needed to pay it.

The agreement should specify:

• Whether tax distributions are mandatory or discretionary;
• The assumed federal and state tax rates;
• Whether state pass-through entity taxes are considered;
• When tax distributions will be made;
• Whether earlier distributions reduce later tax distributions;
• Whether the company must retain a minimum level of working capital; and
• Who decides when additional distributions are appropriate.

For an S corporation, economic distributions generally need to respect the shareholders’ ownership percentages and the one-class-of-stock requirement. The agreement should not casually create preferred economic rights for one shareholder.

Buyout Terms Should Be Agreed Upon Before Anyone Wants Out

A buyout provision is one of the most valuable parts of an operating agreement.

Owners often assume they will work something out if someone retires, becomes disabled, dies, or wants to leave. In reality, that is the moment when the parties are least likely to agree.

A proper buy-sell section should identify the events that trigger a potential or mandatory buyout, including:

• Death or long-term disability;
• Retirement;
• Voluntary withdrawal;
• Termination of employment;
• Loss of a required professional license;
• Bankruptcy or creditor action;
• Divorce or attempted transfer to a former spouse;
• Fraud, theft, or serious misconduct;
• Material breach of the agreement;
• An owner’s desire to sell to a third party; and
• A deadlock between owners.

The agreement must then explain how the business interest will be valued. Possible approaches include an independent appraisal, a stated formula, an agreed value updated annually, or a combination of methods.

Payment terms are just as important. A buyout price is meaningless if the remaining owners or the company cannot afford to pay it. The agreement should establish the down payment, installment period, interest rate, collateral, personal guarantees, and consequences of default.

Key-Person Insurance and Buy-Sell Funding

When a business depends heavily on one owner or employee, the agreement should address insurance.

Key-person insurance and buy-sell insurance are related, but they serve different purposes.

Key-person insurance is generally owned by the business and provides cash to the company after the death of an essential person. The funds may help replace lost revenue, recruit a successor, satisfy debt, or stabilize operations.

Buy-sell funding is intended to provide money to purchase a deceased owner’s interest. Depending on the structure, the policy may be owned by the company, the other owners, or a separate trust or arrangement.

An agreement that merely states that insurance is required is incomplete. It should address:

• The required amount of coverage;
• Who owns each policy;
• Who pays the premiums;
• Who is the beneficiary;
• How frequently coverage is reviewed;
• How insurance proceeds must be used;
• Whether proceeds reduce the remaining buyout obligation;
• What happens if coverage becomes unavailable or prohibitively expensive; and
• What happens if the responsible party allows the policy to lapse.

The insurance coverage should be coordinated with the valuation provision. A business worth $5 million should not rely on a $500,000 policy to fund a mandatory cash buyout.

Other Provisions Business Owners Commonly Miss

A good agreement should also address the less obvious issues that often create problems later.

The Agreement Should Be Reviewed as the Business Changes

Even a well-written agreement does not remain appropriate forever.

The owners should revisit it when:

• A new owner is admitted;
• The company elects S corporation status;
• Ownership percentages change;
• A major loan is obtained;
• The business acquires another company;
• An owner gets married or divorced;
• The value of the company increases substantially;
• The owners change their compensation or distribution practices;
• The business becomes dependent on a new key person;
• An owner begins planning for retirement;
• Estate-planning documents are updated;
• The company expands into additional states; or
• Tax laws or state laws materially change.

The review should include both the attorney and the CPA. The agreement, tax returns, accounting records, insurance policies, and actual business practices should tell the same story.

A Good Agreement Protects Both the Business and the Relationship

A proper operating agreement is not a sign that the owners distrust each other. It is a sign that they respect the business and the relationship enough to discuss difficult issues while everyone is still cooperative.

The agreement should answer the questions the owners hope never arise:

• What happens if we disagree?
• What happens if one of us stops working?
• What happens if the business needs more money?
• What happens if someone dies?
• What happens if an owner wants out?
• What happens if the company cannot afford the buyout?

The cost of creating a customized agreement is small compared with the cost of litigation, a failed S corporation election, an unexpected tax result, or a forced buyout with no funding plan.

At Lipsey & Associates, we recommend that business owners have their operating or shareholder agreements reviewed by both qualified legal counsel and their CPA. The attorney ensures that the agreement works legally. The CPA helps ensure that it also works financially, operationally, and for tax purposes.