Articles of Incorporation vs Operating Agreement: The Differences
There are around 32 million small businesses operating in the US. Many of those businesses are sole proprietorships with no employees. These are often freelance or online-only businesses operating out of a person’s spare room or garage.
A small number of those businesses involve multiple owners, employees, and operate out of a specific physical location like a storefront. When a business functions like that, it becomes more complex and may require an operating agreement or articles of incorporation.
Wonder about the articles of incorporation vs operating agreement differences? Read on for a breakdown of both and how they contrast.
What Is an Operating Agreement?
You can think of the operating agreement as the document that sets out how owners in a business deal with each other. This agreement is typically for internal use and is designed to avoid problems between owners.
You typically see operating agreements in LLCs or limited liability companies. LLCs are one of the simplest business structures available and work as pass-through entities. That means that the income passes through the business and shows up as personal income for the owner.
This structure makes it a popular choice for small businesses. It simplifies the taxes. At the same time, it protects the owner or owners’ personal assets if the business fails or gets sued.
What Is In an Operating Agreement?
The exact contents of any given operating agreement will depend on several factors, including:
- State rules or regulations
- Type of business
- Number of owners
- Level of trust between owners
With those caveats in place, operating agreements usually cover four broad areas of concern: finance, operations, management, ownership. The agreement itself lays out specific details, such as:
- Business description
- Profit distribution
- Funding options
- Management duties
- Ownership transfers
- Financial bookkeeping
- Voting rights and limitation
By setting out these details on paper, the business gets a guiding framework that everyone can point to if friction occurs. For example, let’s say that a member/owner hires a manager and someone else objects. The operating agreement should have guidance on the when and how of manager selection.
Do You Need One?
An operating agreement is a practical step for most small businesses. It forces everyone involved to sit down and really consider how the business will run over time. Creating an operating agreement also gives you a chance to build in checks and balances while things are calm and running smoothly.
Most states don’t require an operating agreement for LLCs. However, a handful of states require that you both have an operating agreement and that you file it with the state.
The states that mandate LLC operating agreements are:
- New York
Other corporate structures such as S Corps or C corps may operate under different rules. Make sure you research your state’s rules on operating agreements or consult with a business attorney.
What Are Articles of Incorporation?
Your operating agreement is all about how owners in your business interact with only a modest nod to the state. Articles of incorporation are almost entirely about you interacting with the state.
Depending on your business structure and state, articles of incorporation might go under several names, such as:
- Articles of incorporation
- Certificate of Incorporation
- Corporate Charter
- Certificate of formation
The term certificate of formation typically applies only to LLCs, while the rest typically apply to corporate structures.
The function of articles of incorporation is for you to get official recognition from the state that your business exists. There is a registration process you go through, although the exact steps and recipients can vary by state.
Going through the process gives the business legal standing as an entity separate from you. More importantly, it legally separates your assets from the business’s assets.
What Is in the Articles of Incorporation?
Your state will set out specific rules about the information that you must include in your articles of incorporation. With that said, there are common elements that you should expect that you’ll need in yours when you file with the state. Those common elements include:
- Business name and business address
- The function of the business
- Bylaws (for corporations)
- Names of the people incorporating the business
- Share ownership information
- Relevant business restrictions
- Creation date
Remember, these are only common elements. Your state may ask for additional information or expanded details around some of these elements.
Do You Need One?
If you operate your business under a corporate structure, you typically must file your articles of incorporation. If you run an LLC, you typically don’t need a certificate of formation.
Getting that certificate of formation on the books may prove helpful down the road. It can help you demonstrate that your personal assets should remain shielded from lawsuits or debt collection aimed at the business.
Articles of Incorporation vs Operating Agreement
Articles of incorporation and operating agreements address very different aspects of your business. Your articles of incorporation or certificate of formation deal almost entirely with how the business interacts with the state.
It essentially tells that state that the business exists and secures the legal protections that go with official state recognition.
Your operating agreement is all about how the owners of the business handle things internally. It basically establishes ground rules for things like dealing with the finances and assigning duties.
Articles of Incorporation, Operating Agreements,and You
The articles of incorporation vs operating agreement question compares two things that are only marginally connected. As long as it doesn’t violate any relevant laws, your operating agreement can say pretty much anything that you want it to. Most states don’t even expect that they’ll see it with LLCs.
Your articles of incorporation or certificate of formation are all about formal recognition from the state. Filing for them tells the state that you exist. Getting them is that state legally acknowledging your business.
Looking for more tips on business management? Check out the posts in our Business section.
Alan Roodey is a professional Author and contributor to many sites. He loves to write on various topics.