If you’re forming a limited liability company (LLC) with other owners, you’re probably thinking about how profits will be split. The good news is that, in many cases, the owners, known as members of an LLC, can decide for themselves. The catch is that approval must be unanimous.
This handy guide details all you need about LLC profit distribution and the best way to do it.
Distribution vs. Allocation
In an LLC, profits are usually distributed to members, meaning that members get paid a share of the money made by the LLC. But businesses only sometimes distribute all their profits; sometimes, they might hold onto some of them and use those funds to add products or relocate to larger offices.
As a result, profits must be allocated to members for tax purposes. This is because taxes must be paid on all profits, whether or not they are distributed. Thus, an LLC with three owners might make $9,000 in profits one year and hand out $2,000 to each member while allocating $3000 to each member.
The members will then need to pay taxes on the allocation, not their distributed amount of $2000.
The Operating Agreement
Distribution and allocation percentages should be specified in your LLC’s operating agreement.
Most states do not require an operating agreement, but it’s a very important document. It defines the ownership percentages of members and how profits and losses are distributed. Those are the most important elements of the operating agreement, but it should also include the following:
- Each member’s rights and responsibilities
- Management structure and roles
- Voting rights of each member
- Rules for meetings and voting
- What happens when a member sells their interest, becomes disabled, or dies
You can find operating agreement templates online, but it’s best to have them drawn up or reviewed by an attorney. The language of an operating agreement is crucial and can determine how member disputes will be resolved.
Usually, distributions and allocations are based on members’ ownership shares. Thus, if the LLC has two members and profits are allocated equally, you will also choose to distribute equally.
However, you may allocate equally but have one member receive a higher percentage of the distributed amount. For example, this may be done when one member has more of a role in the business’s day-to-day operations.
At the same time, in such cases, you might instead choose the same allocations and contributions. Your LLC can determine any allocation and distribution structure it wants; just be sure to spell it out in the operating agreement.
If you don’t have an operating agreement or the operating agreement does not specify profit distribution and allocation percentages, they will default based on ownership percentages.
When You Don’t Have a Choice
If you have elected to have your LLC taxed as a corporation, you must distribute and allocate profits based on ownership percentages.
LLCs are pass-through entities, which means income passes through to the member or members. If the LLC has only one member, it’s taxed as a sole proprietorship. If the LLC has more than one member, it’s taxed as a partnership.
However, LLCs are unique because they can elect to be taxed as a corporation if the members decide it makes financial sense. This is done by filing an election form with the IRS. In addition, you can choose to be taxed as a C-Corp or an S-Corp.
C-Corp status means income is taxed at the current rate for corporations (21% as of late 2022), which is lower than the usual individual taxpayer rate. But keep in mind that C-Corp shareholders – who are members in the case of an LLC – must also pay taxes on their distributions. This is called double taxation.
However, members are subject to self-employment tax in an LLC taxed by default as a sole proprietorship or partnership. Once such LLC switches to being taxed as a corporation, self-employment taxes no longer apply.
Similarly, self-employment taxes do not apply to members with S-Corp status, which is the main advantage of electing S-Corp status. However, with S-Corp status, members are generally paid as company employees, which means more accounting and payroll expenses. Therefore, S-Corp status is only beneficial when the self-employment tax savings exceed those additional expenses.
Taxing as a C-Corp or S-Corp comes with additional rules, including profit distributions and allocations. Remember that if your LLC has elected to be taxed as a C-Corp or S-Corp, allocations and distributions must be based on ownership percentages.
LLCs offer considerable flexibility, including how profits are split. You just need to have a detailed operating agreement that all members approve.
It might be hard to imagine a business dispute, but money is often a divisive issue, and the slightest disagreement can suddenly develop into a lawsuit. So look out for your LLC, and the interests of all its members, with a complete operating agreement and a clear plan for allocations and distributions.