Articles of Incorporation vs. Operating Agreement: What’s the Difference?

An Overview of Business Formation Documents

A business formation / operating agreement is a set of governing documents that establishes an LLC or other corporation (e.g. c-corporation, S corporation, Non-profit corporation, etc.) as a legal business entity. A set of articles of incorporation typically establish the company and assign or appoint owners. In other words, the articles of incorporation document the initial owners of the newly formed company or LLC. For example, the articles of incorporation can assign voting rights to shareholders . A operating agreement is an internal document signed by the owners that spells out ownership and operating agreements and other details about ownership.
They are literally the two fundamental types of controlling documents of an LLC, corporation, or otherwise legally established company. A business formation / operating agreement enables a business owner(s) to clearly and simply document how ownership is organized and governed.
It is important to also have an operating agreement so that the tax identity of the company or association is clear for tax purposes.

Articles of Incorporation Explained

Articles of incorporation, sometimes referred to as a certificate of incorporation, is a legal document that acts as the foundation for incorporation of a corporation. It comprises information relevant to your company, including: your principal address, duration, purpose, the number of shares, and details on your board of directors. In essence, it includes all the details required to form your corporation and relates to other aspects like securities, mergers, taxes, and sale transactions.
When you submit the articles of incorporation to an appropriate state agency, this will establish your business as a corporation. At this point, the business is formed in law, although its formation may take longer procedurally. For example, a limited liability company, or LLC, may technically become an LLC upon incorporating. However, an LLC formed in Illinois will only be recognized by other states as a valid business after the articles of organization are filed with its Office of Secretary of State.

Operating Agreements Explained

An operating agreement is essentially an internal document that lays out the rules for how the business is going to work. It’s not a public document, so owners can be more flexible in constraining themselves than they would be in order to comply with state law. For example, if a company has 4 owners, and it wants to restrict the transfer of ownership, it can do that in the operating agreement by requiring that any transfer be approved by the other 3 owners. Unless otherwise restricted by state law, this provision could typically be included in an LLC operating agreement without any issues, but would cause issues if included in a corporation’s bylaws or articles of incorporation.
The major components of an operating agreement, aka Regulations or Bylaws, will generally include the following:
Again, no state statute requires a limited liability company to adopt an operating agreement, but in the absence of such an agreement, state statutes will govern your operating agreement. This is why limited liability companies are sometimes called "creature of contract." The statute will determine how the limited liability company must operate in the absence of an operating agreement. Therefore, it is critical for the owners (commonly referred to as "members") to draft and adopt an operating agreement if they wish to dictate how the members and managers will be able to manage the company, the membership structure, the distribution of profits, and membership voting and management rights. The operating agreement is therefore vital because it governs all these issues, and because a limited liability company may have a very different management structure, and varying natures and priorities, than a corporation.

Distinctions Between Articles of Incorporation and Operating Agreements

One of the biggest differences between articles of incorporation and operating agreements is what type of business they are used for. Articles of incorporation are used specifically for corporations, while operating agreements are used specifically for limited liability companies. Another notable difference between these two documents is that articles of incorporation are legally required for all corporations, while operating agreements are not legally required for all LLCs. Corporations are regulated by the state of incorporation and must follow the laws of that particular state, while limited liability companies must follow the laws in the state where the business was formed, so the content of an operating agreement can vary depending on individual state laws. However, if a general partnership were to choose not to create an operating agreement, it would essentially be denied the liability protection that’s given to other types of businesses. Although the operating agreement is considered the most comprehensive of all entity agreements, it is not required in every state. Besides the fact that articles of incorporation are required to establish a corporation and an operating agreement is not necessarily required to establish an LLC, other key differences also exist between these two types of documents. For example, articles of incorporation are only used in corporations, while articles of organization are used for limited liability companies (LLCs) and are generally the equivalent of an articles of incorporation document. The language in an articles of incorporation will only discuss the corporation, while an operating agreement covers one or another type of business. Operating agreements are generally longer than articles of incorporation, which are relatively concise in nature. In terms of the information that needs to be included, articles of incorporation are more restrictive than operating agreements. In addition, articles of incorporation do not address ownership interests in a corporation, while operating agreements outline such ownership as well as profits and losses.

When and How to Use Each Document

There are several scenarios in which you would use articles of incorporation over an operating agreement. These documents apply to different business structures, and there are some differences between yours and the member-managed LLC or manager-managed LLC.
For a general corporation, you would file articles of incorporation. This document is the one that states shareholders own the company and can elect board members who then elect officers. In this situation, the board of directors is generally the member-managed side, with the shareholders as owners.
The other scenario in which you would use articles of incorporation is when the business is a C corporation. C corporations are also called stock corporations due to the fact that they have shareholders. Like a general corporation, they must file articles of incorporation. The shareholders elect the board of directors and the board elects officers who run the company.
An S corporation is another type of business structure that uses articles of incorporation. This scenario mimics the process for the C corporation; the only difference is in taxation . These corporations file as a corporation with the IRS, but they don’t actually pay corporate taxes. Instead, the corporation passes through the income, and the shareholders pay taxes as individuals. A limited liability company may also file as an S corporation. All corporations are required to have articles of incorporation.
An operating agreement is a written agreement between members of the LLC. The agreement works as a contract between the members and includes how the business will be accounted for and who will run it. The operating agreement is the document that spells out the details of running the LLC. Specific details within this document include how profits or losses are allocated, how decisions are made, how distributions are made, and how members can join or leave the company.
If a corporation incorporates as a limited liability company, it would typically use an operating agreement. Articles of incorporation are not necessary, since the limited liability company will not need the approval of a higher authority, as they would with a general corporation, C corporation or S corporation.

Legal Requirements and Implications

Legal Responsibilities and Compliance
The articles of incorporation and the operating agreement also impose several responsibilities on the members, which are meant to ensure the transparency of the company’s operations and serve as a protection for the personal interests of members.
For example, all corporate acts decided by a member or manager of a corporation must be done in good faith and always in the best interest of the corporation. Doing otherwise is a breach of fiduciary duty and can lead to criminal repercussions for the individuals involved. Breaches of fiduciary duty not only carry criminal penalties, but they also mean that the parties involved can have their personal assets used to pay off the debts of the company.
Both LLCs and corporations must hold annual meetings (or pre-scheduled regular meetings) during which designated members or managers can meet to discuss any subjects that require a vote. Failure to do so and failure to keep records of each of these meetings will make it difficult to prove who made what decisions in the event the organization gets sued or faces a criminal investigation.
We therefore recommend you enlist the services of a qualified business lawyer who can help you in drafting your articles of incorporation, drafting your operating agreement and ensuring that you are compliant with all requirements and recordkeeping expectations set forth in your documents.

Common Errors and How to Avoid Them

Despite the importance of these documents to your business structure, many owners of new companies either fail to ensure they have the right paperwork or just don’t understand the difference between articles of incorporation and operating agreements. Of course, this most commonly results from their lack of familiarity with the legal process and terminology. The following are some common mistakes to which you should be attuned:

Insufficient details — When drafting your operating agreement, all the details provided will become official. Therefore, it should include every single detail, not just the basic information of formation. This includes each member’s name, ownership portion (percentage), voting rights and how profits will be divided.
Allowing for unreasonable business perimeters — In some cases, the business does not yet exist at the time these documents are created. Drafting such legalese when you’re not totally certain what you’re drafting for, then, could be a recipe for disaster.
Forgetting to amend — Life is full of changes and therefore there will come a time when your articles of incorporation and/or operating agreement needs an update. Failing to do so can result in issues with the IRS and state governments. Whenever you add new members, experience major property-loss events or decide on employee stock options, consult a skilled business law attorney about changing your articles of incorporation or operating agreement.
Not seeking legal counsel — Too many owners take on the process solo and end up with the wrong paperwork for their company structure or they miss loopholes that could have been avoided by hiring an attorney. Do not attempt to draft or amend your articles of incorporation or operating agreement without legal representation — it’s vital to protecting the future interests of your business.
Failing to adhere to local and state requirements — Every state or municipality has different requirements for articles of incorporation, such as filing fees, business license requirements, or approved forms. Do not file paperwork with the Secretary of State’s office before you have clearly fulfilled your local government’s requirements.
Not defining "good cause" provisions — Obviously, details are very important to articles of incorporation and operating agreements, and these are no exception. Be sure any sections talking about "good cause" are clearly defined so that there is no dispute when it comes time to refer to them.
Failing to date — Nothing says "set in stone" quite like a date change. If your operating agreement is not signed and dated by your members, you do not have proof between them as to the agreement.

Conclusion and Best Practices

In conclusion, this article highlights the distinction between the Articles of Incorporation which are filed with the state and the Operating Agreement which is an agreement among the owners which sets forth all of the obligations of their relationship. The key difference is that the Articles of Incorporation are a public document while the Operating Agreement is a private document. The Articles of Incorporation can be found through the state’s website while the Operating Agreement must be requested from the owner.
The Operating Agreement is often the most important document for multi-owner LLCs and Corporations. It is the agreement that sets forth each shareholder’s or member’s ownership percentage in the company as well as the rights and duties of each owner . So while the Articles of Incorporation must be filed with the state, oftentimes the Operating Agreement is not filed anywhere.
Best Practices for Business Owners:

Have an Operating Agreement, it is to your benefit.
Make sure that the Operating Agreement sets forth the ownership percentages of all of the owners.
Make sure that the Operating Agreement sets forth the process for selling their shares or membership interest.
Make sure that the Operating Agreement sets forth the process if the company is to be dissolved.
Make sure that the Operating Agreement sets forth how to resolve disagreements among the owners.