A LLC (Limited Liability Company) is usually chosen of a form of association for business activities because of three main advantages: it is relatively easy to create a LLC, it involves limited liability protection to the LLC members and it offers a flexible LLC profit distribution. While the last is less known, it is an important advantage for any business choosing this form.
Taxation as a Partnership: Partnership LLC
From a tax perspective, if you do not choose to have your LLC treated like a corporation, it will be considered a partnership and it will be taxed as a pass-through entity. This means that the LLC is not taxed on the income it makes, but the profit share of each of the LLC members is included on their personal tax returns and therefore taxed as an individual income.
For each of the LLC members, ownership interest and allocated profits are tracked in their capital account and any distribution to the members are subtracted from the account making the ownership interest easy to identify.
Default LLC Profit Allocation Follows Ownership Interest
The allocation of the LLC profit is governed by the rules of the state in which the LLC was formed and it usually means a profit share according to the percentage of ownership interest of each LLC member.
For example, if John, Gladys and Derek are all members of a three-member LLC with the following percentage of membership interest: John – 35%, Gladys – 35% and Derek – 30%. Under the state rules and according to their membership interest percentage, John and Gladys will each receive 35% of the LLC profits and Derek will receive 30% of the LLC profits. Pending no distributions are made, each member will receive in his capital account the amount of money representing the allocated profit.
Taking into consideration that state rules are the default rules, if the members of the LLC consider necessary, another profit allocation arrangement can be set that has no connection with the ownership interest.
Establishing Alternate Profit Allocation Arrangements
Establishing an alternate profit allocation arrangement may be determined by a variety of reasons. One of the most frequently encountered situation is when some members have made their capital contributions in cash and other in property or services. In such a situation, members usually decide a temporary profit allocation arrangement that will ensure a higher profit percentage for the members that have made their capital contribution in cash, until their have received their contribution back.
Documenting Profit Allocation in the Operating Agreement
Because the state rules are governing profit allocation for LLC by default, it is essential to have any other profit allocation agreement in writing in the LLC’s operating agreement. Even if a verbal agreement is considered sufficient between the LLC members, it is not enough for the state. The operating agreement needs to include the details of profit allocation between LLC members. If you don’t put it in writing, then officially the state’s default rules apply.
Allocation and Distribution of Profit Are Not the Same
Once you and all the other co-members of the LLC have agreed to a fair profit allocation arrangement and the LLC operating agreement includes all the details of the arrangement, the LLC profits will be allocated every year among the members. If the allocation rules set by you and the co-members of the LLC have been included in the operating agreement, the state rules are no longer the ones being followed in profit allocation.
In the specific case of the LLC it is important to understand the difference between allocation and distribution, and the fact that a member needs to include the allocated profit share in their taxable income even if they haven’t actually received a distribution of profit. Due to the fact that an LLC is a pass-through entity, including the profit share in the taxable income of the members is essential since it ensures LLC profits are taxed.