Limited Liability Companies For Dummies
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If your limited liability company (LLC) elects a form of pass-through taxation — for example, partnership taxation, s-corporation taxation, or a single-member LLC electing disregarded taxation — then the LLC itself will not pay taxes.

For example, you and your partner are the members of Good Times, LLC.

You have a 20 percent membership interest and your partner has 80 percent. If Good Times, LLC's profits and losses are divided or allocated between you and your partner based on the percentage of membership interest, then they will be split 20/80. This year, Good Times, LLC made a profit of $1,000, so $200 is allocated to you. Regardless if you ever received the actual cash (called a distribution), you have to report the $200 as income on your individual tax return and pay the taxes.

To safeguard against forcing members to dig into their own pockets to fork over taxes on the company profits, an LLC can choose to require mandatory tax distributions to the members. This tax distribution will cover whatever you owe to the IRS based on your share of the company's profits. In the case of the Good Times, LLC example, your distribution would equal whatever taxes you are forced to pay on your $200 share of the company profit.

If you and your partners make this a firm requirement in your company's operating agreement, you won't be able to take full advantage of your LLC's charging order protection and force any creditors to pay your LLC's taxes, while withholding distributions.

Another thing you need to know about mandatory tax distributions is that, by law, a distribution is considered improper if it results in the LLC not being able to pay its debts. If Good Times, LLC needs every penny of its profits, then it is unwise to make any distributions to the members. If you approve or receive an improper distribution, then you could be held personally liable.

When drafting your LLC operating agreement, it's a good idea to address the idea of tax distributions, however, make them optional. That way, when the time comes, depending on the financial state of your LLC, you and your partners can decide whether or not to take one for the team, or to be reimbursed for your tax burdens.

About This Article

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About the book author:

Jennifer Reuting founded InCorp Services, a corporate structuring firm specializing in LLCs, in 2001. It is currently the fourth largest national registered agent service provider in the country, with thousands of clients nationwide and offices throughout the U.S.

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