A distribution from a limited liability company (LLC) is a payment of cash or property made by an LLC to the LLC’s owners, also known as members. Although state law sets forth certain default rules, LLC members can specify in the LLC’s operating agreement when and how profits are allocated, distributed, and taxed.
Distribution Method and Timing
Under the default rules provided by most state LLC statutes, an LLC is not required to make any distributions to members before they withdraw from the LLC or it is dissolved. It is prudent for LLC members to create an operating agreement that specifies the method and schedule of distributions. Distributions can be made on a regular basis, such as monthly, quarterly, or at the end of the fiscal year; or based on specific events, such as the sale of assets or the liquidation of a member’s interests.
When determining the timing and size of distributions, the compensation needs of members must be considered alongside the needs of the business to grow earnings, cover expenses, and retain sufficient cash reserves. Often, distributions are made to enable members to pay taxes they owe on the LLC’s profits: because LLCs are generally pass-through entities, their members must pay taxes on LLC profits regardless of whether they receive a distribution of those profits.
Proportionate versus Disproportionate Distributions
Distributions can be made in direct proportion to how much of the LLC each member owns—an amount that is typically based on an owner’s capital contribution to the business. This is not required, however. Although state LLC laws may provide a default rule that members must share income distributions equally regardless of how much each member invested, the owners can override this in the operating agreement.
Profit Allocations versus Profit Distributions
Profit allocation and profit distribution are not the same thing in an LLC.
- Profit allocation is how the profits and losses are divided among LLC members, regardless of how much the LLC pays the members.
- Profit distribution is the payment to each LLC member in cash or property by the LLC out of its profits.
As mentioned, LLC members may need to receive regular LLC profit distributions to cover the tax liabilities on their profit allocations.
Note: Members should talk with their professional advisors about the LLC tax election that is most advantageous for their business model.
Recordkeeping
It is very important for the LLC and its members to maintain accurate records of distributions, such as a copy of the payment check or a printout of the bank transfer. This information should be kept with other business accounting records such as financial reports, cash flow statements, accounts receivable, payroll, and tax documents.
Further, to keep track of each member’s interest in the LLC, LLCs should keep records called capital accounts to track their members’ initial investments in the LLC, subsequent contributions to the company, distributions they receive from the LLC, and the percentage of profit attributable to each member according to their membership interest percentage.
A capital account is not an actual, physical bank account. It is a recordkeeping account that exists only on paper, such as a spreadsheet, and effectively serves as a ledger. As with all recordkeeping, details matter. Detailed recordkeeping is important not only at tax time but also when a member leaves or the LLC is dissolved.
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From initial investments and fundraising to profit allocations and distributions, tax election status, and recordkeeping, LLCs have a lot of moving financial parts. Professional help can keep your business machine running more smoothly. Please reach out and schedule a meeting with our small business attorneys.
