LLC Profit Distribution: Everything You Need to Know
LLC profit distribution is a complicated topic. There are IRS regulations, state-level regulations, and regulations at the county level that all govern how you conduct business. 3 min read
2. Managing LLC DIstributions
3. Liability for Improper Distribution
4. Distributions Upon Dissolution
5. Draw vs. Distribution
Updated July 16, 2020:
LLC profit distribution is a complicated topic. There are IRS regulations, state-level regulations, and regulations at the county level that all govern how you conduct business.
Differences Between Salary and Distribution
Business owners may talk about their "salary," but generally, that is not how owners are paid. You pay a salary to an employee, but as a business owner, the way you are paid depends on how you form your business. You need to know how to you pay yourself after you file a limited liability company. You pay taxes on an LLC based on the election you select with the IRS, either as a sole proprietorship, S corporation, or corporation.
The difference between salary and distribution is that salaries are taken out before distributions are made. The LLC has a choice of when it wants to take distributions, and it may refrain from making them if members agree. Likewise, the members may agree to give more frequent distributions, as well. By default, the IRS considers all single-member LLCs as sole proprietors, and multi-member LLCs are considered general partnerships. If the business wants to be taxed as a corporation, it can file IRS Form 8832 to make the election.
Once you file the election, it is good for 60 months, and the business is taxed under the election until then, when it reverts back. When electing corporate taxation, the members pay personal income tax the same way they handle a dividend. Every other entity uses pass-through taxation. Every member is solely responsible for reporting allocations and paying taxes on them. However, they are not responsible if others fail to comply.
Managing LLC DIstributions
The ownership interest of an LLC is tracked in the members' capital accounts. Capital accounts must include a member's allocated profits and capital contributions. Distributions are subtracted from the account balance. So, the member's ownership is easily identified. Each state governs the LLCs formed in that state. By default, the state's laws allow for the allocation of the LLC's profits to members based on the percentage of ownership that the member holds.
So, if you and a friend own a two-member LLC with you owning 30 percent interest and your friend owning 70 percent interest, you receive 30 percent of the allocation and your friend receives 70 percent.
If the members make personal contributions, the LLC may make different arrangements allowing those members to receive a higher percentage of the profit upon return. This is where the flexibility in management comes into play and why it is important to clearly list the allocation amounts in the LLC Operating Agreement. Another common practice is "preferred returns." This is when a contributing member receives a higher amount of a return and receives his/her portion first.
Liability for Improper Distribution
When it comes to distribution, there are some laws that prohibit LLCs from completing a distribution if it will make it impossible to pay debts that come up and when the business is showing more liabilities than assets, especially when the business reports losses for several years. The LLC manager or member who completes the distribution is responsible if it is incorrect. However, when another member knowingly accepts, they are also held liable.
Distributions Upon Dissolution
The following distributions must take place after dissolution:
- An LLC must distribute all funds when it wishes to terminate the business entity.
- Creditors must be paid first.
- Then, the member's owed a prior distribution are paid.
- After, the LLC must return all excess funds to each member who made a contribution to the company.
- Finally, each member receives a fair share of excess in the form of profit distribution. They are dispersed according to the operating agreement, as well as state laws.
Draw vs. Distribution
For taxes, a distribution and a draw are totally different. A single-member LLC is able to draw money from the company. However, the accounting transaction does not appear on the owner's return. On the other hand, a distribution does appear on the owner's return. So, you are not an employee if you own a single-member LLC and do not receive a regular "paycheck."
There are many other restrictions, laws, and regulations governing LLC distributions, so it is a good idea to consult a business attorney. If you need help with your LLC's profit distribution, you can post your legal need on UpCounsel's marketplace. UpCounsel accepts only the top 5 percent of lawyers to its site. Lawyers on UpCounsel come from law schools such as Harvard Law and Yale Law and average 14 years of legal experience, including work with or on behalf of companies like Google, Menlo Ventures, and Airbnb.