Articles of Organization vs. Operating Agreement: Key Distinctions

What Are Articles of Organization?

Articles of Organization is a legal paperwork that states the formation of an Limited Liability Company (LLC) or a Limited Partnership. This document is a required filing in every state before beginning the business. These Articles are usually filed with the Secretary of State’s office in your organization’s state. This filing creates the LLC or LP as a separate legal entity and therefore has the legal ability to own property , enter into contracts, sue, and be sued.
The information that is usually requested in the Articles include the name of the LLC or LP, its type of management (manager-managed or member-managed), members/managers information, the address of the company’s registered agent, and the purpose of the business.

What the Heck is an Operating Agreement

An operating agreement is a formal, internal document that is not typically filed with the Secretary of State. It outlines general details about the LLC’s structure and management. If desired, members can draft an operating agreement that covers every conceivable aspect of operating a business. However, the level of detail covered lessens after having an operating agreement in place for a few years. Even so, having a clearly written operating agreement allows members to avoid misunderstandings or arguments over business operations.
An operating agreement establishes who will manage the company. Many states allow members to adopt a "member-managed" organizational structure. Unless the members choose to appoint one or more managers for the company, membership role will be based on ownership percentages. The operating agreement can establish details regarding how members will participate in the business. For example, it can define the duties of certain members. This is especially useful for companies that have silent partners who may not participate at all in some aspects of running the business. The operating agreement establishes how the business will make decisions. For example, some companies allow members to make decisions by consensus. In such cases, members get an equal vote. Other companies allow for decision by contract percentage. The operating agreement provides details about the voting process. Some may also require unanimous consent for certain types of decisions, such as ones that dissolve the company or transfer large amounts of capital. States mandate that companies organize certain information on their website, and the LLC’s operating agreement will contain those elements.
The operating agreement outlines how to dissolve the company and how to distribute the assets. In the absence of such provisions, states’ LLC acts specify how the winding up process occurs. LLCs normally require members to meet certain criteria in order to qualify for distributions. For example, a member may need to be employed. The operating agreement specifies how the distribution process works. Depending on the business, the operating agreement may specify specific activities, such as terminating employees.
The operating agreement takes precedence over the state’s LLC act. However, there are circumstances where the operating agreement does not apply. For example, if a member is under 18, in a state that does not allow minor members, then that member cannot vote or participate in most meetings. Similarly, if a member is declared incompetent, such as if they become incapacitated or mentally unfit, then the member cannot vote or participate in most meetings. In these cases, the remaining members can elect another member to serve in their place. The operating agreement may specify how to handle such situations.

Articles of Organization vs Operating Agreement

The primary difference between an article of organization and an operating agreement is that the former is a legal document – a contract between the owners and the state – while the latter is a privately-created internal document that is only signed by the owners. It is similar to a contract that you may sign with a third party, but instead of having a singular "offeree" and "offeror" – with one party signing with a "yes" and the other responding "no" – which would create a binding contract if accepted, it involves the "offerees" stating, "yes" to a "joint private enterprise."
From a content perspective, articles of organization are statutes that your state has created and an operating agreement is a contract that you and your business partners create. In other words, the Articles of Organization provide the rules with which the LLC must comply, whereas an operating agreement provides the rules with which the members of the LLC must comply. The State does not review operating agreements for compliance prior to approving the articles of organization. In other words, filing an operating agreement is not a requirement for creating an LLC. However, they do typically provide a structure to your operating agreement, especially if you have drafted one specifically for your LLC.
Because the Article of Organization is going to be filed with the state, the information it requires is usually public information, such as the LLC’s contact information and the name of its Resident Agent. In contrast, an operating agreement is generally confidential and can be kept out of public view; as a result, the information it contains is usually that which is not required to be reported on the Article of Organization. This includes how ownership is shared among members, management structure, distributions to members, decision making and other aspects of your business structure that you may or may not want third parties to know about. This makes the operating agreement a more flexible document as it allows any number of agreements your members and managers wish to enter into, whether good or bad for your LLC.
If you plan to apply for funding for your LLC, you are likely going to need an operating agreement for that process. Banks and other private organizations wanting to lend to or invest in your business want to see the specific ownership structure, management hierarchy, and other key aspects of your LLC’s information. As the LLC doesn’t provide that in the article of organization, it is much more likely to ask to see your operating agreement than go through the information on the Article of Organization.
Provisions in an LLC operating agreement may cover:
The above list is not exhaustive but simply a basic outline of some of the items commonly found in operating agreements.

State to State Differences in Legal Requirements

The legal requirements for LLC formation and administration differ significantly across states. While the Articles of Organization are generally mandatory, Operating Agreements are not universally required. A handful of states even allow for single-member LLCs that don’t need Operating Agreements at all. An overview of these variations is as follows:
California: Articles of Organization must be filed with the Secretary of State prior to LLC formation. An Operating Agreement is not required, but such an agreement is advisable.
New York: New York mandates the filing of Articles of Organization with the Secretary of State prior to formation. All multi-member LLCs are required to have a written Operating or "operative" Agreement, although the state allows for oral and implied agreements as well.
Florida: Articles of Organization must be filed with the Florida Secretary of State prior to LLC formation. A written Operating Agreement is not required, but strongly recommended.
Virginia: Articles of Organization must be filed with the Virginia Secretary of State prior to formation of the LLC. Operating Agreements are generally not required.
Delaware: Articles of Organization must be filed with the Delaware Secretary of State prior to formation. Although Delaware does not require a written Operating Agreement , it is wise to use one to avoid unwanted exposure of LLC assets to creditors.
Nevada: Articles of Organization must be filed with the Nevada Secretary of State. An Operating Agreement is required.
Alaska: Articles of Organization must be filed with the Alaska Secretary of State prior to formation of the LLC. A written Operating Agreement is not required.
Texas: Articles of Organization must be filed with the Texas Secretary of State, but written Operating Agreements are optional.
Arizona: Articles of Organization must be filed with the Arizona Secretary of State. Written Operating Agreements are not required.
North Dakota: Articles of Organization must be filed with the North Dakota Secretary of State. Written Operating Agreements are not required.
Oklahoma: Articles of Organization must be filed with the Oklahoma Secretary of State prior to formation of the LLC. A written Operating Agreement is not required.
Kansas: Articles of Organization must be filed with the Kansas Secretary of State prior to formation of the LLC. Written Operating Agreements are not required.
Wyoming: Articles of Organization must be filed with the Wyoming Secretary of State. A written Operating Agreement is not required.

Why You Should Care about Both Articles of Formation and Operating Agreements for your LLC

For limited liability companies and the protection offered inside a lawsuit, you need both documents.
Having an LLC does not guarantee protection from liability in a lawsuit. Not if you fail to do the LLC right. You are filing for "limited liability" in name only. If you rely on just the Articles and fail to comply with the laws on keeping your LLC up to date, you may have more than you bargained for. See the next section on Articles. The operating agreement protects you from your partners or members. Knowing how the other owner(s) will interact or having some notice of what they may plan to do is critical. As an example, in an LLC, one owner may not sell out without the permission of the other owners. Once members see the other owner covered and on the hook for actions taken by others, they will be more thoughtful in their actions. The operating agreement also solves problems that are not covered in the articles of organization. The articles are very basic in its contents. It simply states who is in the LLC and some general rules like who can make changes. The operating agreement covers what happens when an owner dies, quits, what votes are needed for decisions, settles disputes, or handles an owner’s arrest all because the articles are vague. The operating agreement is where the detail goes. The operating agreement is a contract. So it can be more flexible and detailed. The articles do not have as many rules in it, so it may be limiting. You want your operating agreement to cover ALL of the possible concerns that you may have. Doing this will avoid the nightmare of what is not covered. Having a comprehensive agreement will save you a headache when your partner does not agree with what happens if there is a problem.

Risks Associated with Confusing the Two

While there are overlapping functions, Articles of Organization (AOOs) and Operating Agreements (OAs) serve distinct purposes in the lifecycle of an LLC. The AOO serves primarily as a formality to establish the business entity itself. On the other hand, the OA is effectively the rulebook of an LLC. These rules may or may not be the default rules for the state in which the LLC was formed, but the members of the LLC that signed the OA agree to follow the newly established rules, even if they differ substantially from what the state prescribes. If there is no OA, the default rules for the state apply.
The most common pitfall for small businesses is not having any operating manual to govern their actions. So how exactly can this negatively affect the operations of your LLC? Let’s consider the following examples.
When litigation arises in business, LLC members/participants can be left in the lurch when taking legal action or defending lawsuits without the protection of an operating agreement. For example, if the operating agreement does not spell out how a member would be removed or what would happen to their share of ownership in the event of death, or judgments against them, the member may find that they lose their share of ownership to the LLC upon becoming subject to such an event.
Let us say that two members run the business, and one decides to purchase a truck for the company. That member could not merely take the depreciated value of the truck out of profits as a distribution, because from an accounting perspective, that would decrease both the value of the business and shareholders’ equity in it. Presumably, the other member would want an equal contribution, and the two should be required to agree that this is a capital contribution (see below Why is it Important to Adhere to Some of the Remedies for Disputes & Dissolution) to increase the capital account. If there is no OA, the default provisions apply, which means that the contributions would be distributions and would have been made without consensus.
These are just two occurrences that demonstrate how confusion between AOOs and OAs can lead to serious pitfalls for LLC members. Let’s also look at families who own a business with no owner members. One of the most common examples of this is when one family is being prejudiced by the LLC’s finances—think "bought the boat" or "paid for the party … twice!" Or, let’s say that one family member gives money to pay for college and is cut off with the explanation that "they have lost interest in the business."
Providing the funds to obtain a minority interest in an LLC is a capital contribution for the purchasing family and should be preserved in the proportion in which it was provided . Members should not be able to arbitrarily pay for something that other members are "interested" in but do not actually pay back.
There are alternative solutions designed for LLCs besides forming a new corporate entity to resolve disputes. The most effective remedy for minor disputes is mediation. Here are three common ones: Mediator(s) do not make decisions. They listen to the disputing parties and educate them about the costs and outcome if the issues are resolved through court proceedings. Mediators also prepare agreements for signature (which is binding) to be signed on the date of the mediation. Between two LLC members where no OA exists, the state’s default provisions govern. So, for example, if there is a 50/50 partnership and one member loses a judgment, 100 percent of the LLC membership (no matter how the judgment was obtained) is allocated to the creditor. The probate rules default provisions apply to all kind of partnerships and corporations. They state that the creditor can take possession of 100 percent of the business if the judgment is obtained personally from one of the partners or corporate officers. This means that if a bank judgment is issued for an LLC member that is sued personally, the bank can attach all assets, including the LLC membership, leaving nothing for the other members or to be distributed through the probate process. In this case, the OA would protect the non-participating family member by spelling out the distribution of proceeds (to avoid litigation expenses). Even if the OA defaults provisions are applied, both families will likely litigate for years to gain access to equal proceeds. If the deceased member had an estate plan, the probate process would include transferring these assets. Unfortunately, many people pass away intestate. In that case, each family would have to litigate separately and probably spend more than the business is worth (see below for solutions). There are many others, but the main point is that to operate a business successfully, you cannot substitute and confuse the documentation.
So what happens if you go ahead and operate a business without an operating agreement? The families will each try to stick to the default provisions, which require litigation to protect their interests. In addition to these issues, each family may have to incur the cost of winding up and dissolving the LLC. If all of this is successful, the taxes owed will be passed along to the respective family members on their individual returns. Against the backdrop of the above information, the pitfalls become obvious when two or more families are involved in an LLC and no operating agreement is in place (and is inconsistent with the default provisions), or no operating agreement at all exists. You cannot substitute and confuse the documentation, and there are various remedies for resolving LLC disputes.