How Partnerships and LLCs Distribute Profits
A partnership treats salaries paid to partners (at least to its general partners) as distributions from profit. In other words, profit is determined before the deduction of partners’ salaries. LLCs are more likely to treat salaries paid to owner-managers as an expense (as a corporation does).
Accounting for compensation and services provided by the owners in an LLC and the partners in a partnership gets rather technical.
The partnership or LLC agreement specifies how to divide profit among the owners. Whereas owners of a corporation receive a share of profit directly proportional to the number of common stock shares they own, a partnership or LLC doesn’t have to divide profit according to how much each owner invested.
Invested capital is only one of three factors that generally play into profit allocation in partnerships and LLCs:
Treasure: Owners may be rewarded according to how much of the treasure — invested capital — they contributed. So if Jane invests twice as much as Joe, her cut of the profit may be twice as much as his.
Time: Owners who invest more time in the business may receive more of the profit. Some partners or owners, for example, may generate more billable hours to clients than others, and the profit-sharing plan reflects this disparity. Some partners or owners may work only part-time, so the profit-sharing plan takes this factor into account.
Talent: Regardless of capital and time, some partners bring more to the business than others. Maybe they have better business contacts, or they’re better rainmakers (they have a knack for making deals happen), or they’re celebrities whose names alone are worth a special share of the profit. However their talent impacts the business, they contribute much more to the business’s success than their capital or time suggests.
A partnership needs to maintain a separate capital (ownership) account for each partner. The total profit of the entity is allocated into these capital accounts, as spelled out in the partnership agreement. The agreement also specifies how much money each partner can withdraw from his or her capital account.
For example, partners may be limited to withdrawing no more than 80 percent of their anticipated share of profit for the coming year, or they may be allowed to withdraw only a certain amount until they’ve built up their capital accounts. The capital that remains in the partnership is used to operate the business.