Profit Distribution LLC: Everything You Need to Know
Profit distribution LLC rules require the limited liability company to be treated as a pass-through entity for tax purposes. 3 min read
2. Default LLC Profit Allocation Follows Ownership Interest
3. Establishing Alternate Profit Allocation Arrangements
4. Documenting Profit Allocation in the Operating Agreement
5. Allocation vs. Distribution of Profit
6. Improper Distribution Liability
7. Dissolution Distributions
8. Taxing Distributions
Updated November 2, 2020:
Taxation as a Partnership LLC
Profit distribution LLC rules require the limited liability company to be treated as a pass-through entity for tax purposes. This means that the income from the company is reported on the individual tax returns of the owner or owners. The ownership interest of each LLC member is recorded in the respective capital account, which includes both allocated profits and capital contributions. Distributions made to members are drawn from these accounts, allowing for easy identification of each member's ownership interest.
Default LLC Profit Allocation Follows Ownership Interest
An LLC is governed by the state laws where it is created. Each state has its own rules about allocating LLC profit based on ownership interest. According to the default rules, which apply to most states, profits are allocated in the same percentage as ownership interest. If one member has a 75 percent membership stake and another holds 25 percent of the LLC, the profits of the business would be distributed in the same ratio. However, many states allow LLCs to develop their own profit allocation arrangement that does not depend on ownership percentage.
Establishing Alternate Profit Allocation Arrangements
Members may have various reasons for establishing an alternative profit allocation agreement. For example, some owners may have made capital contributions consisting of property or services while others have contributed cash. In this instance, owners may decide that those who contributed cash receive a higher profit percentage until their initial contribution has been repaid. When establishing an alternative profit allocation agreement for any reason, consult a tax attorney to ensure the legality of this arrangement in your state and with the IRS.
Although flexible profit allocation is one of the benefits of forming an LLC, this option is not available if you have elected to be treated as an S or C corporation for taxation purposes. You must distribute profits strictly according to ownership percentage per IRS rules.
Documenting Profit Allocation in the Operating Agreement
No matter what profit allocation structure is agreed upon by your LLC members, it must be recorded in the company's operating agreement. If an alternate agreement is not documented, the state's default rules will apply even in the presence of a verbal agreement.
Allocation vs. Distribution of Profit
Members must receive allocations of LLC profits every year. However, the allocation of profit is separate from the distribution of profit. Even when profit is not distributed, the member must report his or her allocated profit share to the IRS on the individual income tax return.
LLCs are not required to periodically distribute profits to members. If profits are distributed, a member still has an equal claim for future distributions.
Improper Distribution Liability
Despite the profit distribution procedure outlined in the operating agreement, in most states LLCs may not distribute profits when doing so prevents them from paying debts or creates excessive liability without assets. If the LLC distributes profits improperly, the responsible member or manager is personally liable for the amount in question. The member who received the distribution is also partially liable if they had knowledge of its impropriety.
The following steps are taken during dissolution distributions:
- All assets must be distributed when an LLC is dissolved.
- Creditors who are owed payment must receive priority.
- Remaining assets are distributed to members and capital contributions are returned to members.
- Excess funds are given as profit distributions to members based on the procedure outlined in the operating agreement or by state law.
When an LLC is formed, it is automatically designated as a sole proprietorship or partnership by the IRS depending on the number of members. To elect treatment as a corporation for tax purposes, submit IRS Form 8832. Once an election is made, it is valid for 60 months before it can be reverted or changed.
When an LLC is taxed as a corporation, distributions are reported and taxed on each member's individual tax return. Those that are subject to pass-through taxation must report profits and losses on the members' tax returns. Each member in a sole proprietorship or partnership has sole responsibility for correctly reporting LLC profits and losses as well as distributions each year.
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