When discussing the advantages of an LLC, or limited liability company, many people will bring up the LLC's relative ease of formation and the limited liability protection afforded to LLC members.
However, there's another advantage to an LLC that can be quite significant—depending on the circumstances—and that's the flexibility of LLC profit distribution.
Taxation as a Partnership: Partnership LLC
From a tax perspective, an LLC is known as a pass-through entity. That means that rather than being taxed on the income it makes, this income passes through to its members, who are then taxed on this income individually.
Unless it elects to be taxed as a corporation, a multi-member LLC is treated as a partnership. The LLC's members include their share of the LLC profits on their personal tax returns.
An LLC member's ownership interest is tracked in that member's capital account. The capital account will include a member's capital contributions, as well as allocated profits. Any distributions that are made to the member are subtracted from the balance of the account. In this way, a member's ownership interest in the LLC can be readily identified.
Default LLC Profit Allocation Follows Ownership Interest
LLCs are governed by the rules of the state in which they were formed. State rules provide for the allocation of LLC profit according to each member's percentage of ownership interest.
For example, if Peter and Mary are members of a two-member LLC, and Peter has a 40 percent ownership interest, and Mary has a 60 percent ownership interest, then, under state rules, Peter would be allocated 40 percent of the LLC profits, and Mary would be allocated 60 percent. If no distributions are made, each member's capital account would be increased by the amount of profit they've been allocated.
However, these state rules are default rules, and with an LLC, it's possible to provide for a profit allocation arrangement that's not dependent on ownership interest.
Establishing Alternate Profit Allocation Arrangements
There are numerous reasons why members may wish to have a profit allocation arrangement that differs from their ownership interests.
For example, some members' capital contributions may consist of cash, while other members may make their capital contributions in property or services.
In such a case, the members may decide on a profit allocation arrangement that provides the members who made cash contributions with a higher percentage of profits than their actual ownership percentage until their contributions have been paid back, after which profits would be allocated based upon ownership interests.
Documenting Profit Allocation in the Operating Agreement
Regardless of the type of profit allocation arrangement the members agree on, it's crucial to document the arrangement itself in the LLC's operating agreement.
A verbal agreement will not do the trick; the operating agreement must contain provisions governing how profits are to be divided among members.
If a profit allocation arrangement is not outlined in the operating agreement, then the state's default profit allocation rules will apply.
Allocation and Distribution of Profit Are Not the Same
If you and your co-members have agreed to a profit allocation agreement that feels fair, and your LLC's operating agreement has been drafted to include details of this arrangement, how are the profits split in an LLC?
An LLC's profits must be allocated among its members every year. As long as the operating agreement contains provisions governing how profits are to be allocated, the profit allocation rules as set out in the operating agreement will be followed, rather than the default state rules.
It's important to note, though, that the allocation of profit doesn't have anything to do with the actual distribution of profit. While members are allocated their share of an LLC's profit, they might not actually receive a profit distribution. Regardless, they must include the percentage of the profit they've been allocated in their taxable income for the year.
Because an LLC is a pass-through entity, it's this allocation of profit that ensures that the LLC's profits are taxed in the hands of LLC members.