After a limited liability company (LLC) starts turning a profit, the members will no doubt want to benefit. After all, they didn’t invest their hard-earned money in the company for nothing — they want to see a return!
At certain times — usually at the end of the year, but sometimes at the end of each quarter — company profits can be calculated and doled out to each member, usually in proportion to her percentage of ownership. These payments are called distributions and are generally in the form of cash.
Now, as many of you savvy entrepreneurs know, growing a business is hard enough without draining it of its much-needed cash in the first few years. You’ll hold off on sending checks to the investors and instead use that revenue to grow the business. But what happens when your business is still showing a profit at the end of the tax year?
Maybe you’re saving up to purchase property or other assets pertinent to the business. Well, unfortunately, Uncle Sam still wants his share. And with the partnership form of taxation (how most LLCs elect to be taxed), the owners of the LLC are still allocated this revenue and must pay tax on it . . . even though they never saw the cash.
If you elect the most common form of LLC taxation — partnership taxation — then you need to understand the differences between allocations and distributions. Allocations are the profits on which you and your partners have to pay taxes. Distributions are the money you actually get, in your pocket, ready to be spent on that new backcountry snowboard you’ve been craving.
Unlike corporations, LLCs don’t necessarily have to distribute profits in proportion to the members’ percentage of ownership. The members can decide to vary the distributions however they want. The IRS generally allows this practice as long as you pass their tests (mainly to prove that you aren’t varying the distributions simply to avoid taxes).
This strategy gets complex; however, if used correctly, it can result in some huge incentives for powerful partners and investors to join your team.
Distributions also occur if your LLC goes out of business, but in this case they’re handled differently. The LLC’s assets are liquidated, the creditors are paid back (including any members to whom the business owes money), and then the remaining amount is distributed to the members according to their membership interests or, more specifically, their capital accounts.
Capital accounts can be, well . . . complex. But an easy way to think of them is how your percentage interest evolves over time, as more contributions to the company are made. They also tend to keep accountants in business.
The key takeaway here is this: When the final distributions are made, you can’t choose how the money is distributed — it must be doled out according to the balance of each member’s capital account.