Owners who invest in a limited liability company and become members obtain returns on their investments through appreciation in the value of the business and through the earnings and profits of the LLC. The members may receive periodic distributions of LLC profits throughout the year. However, if members agree, the LLC may retain all earnings and refrain from issuing a distribution.
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States do not impose a requirement that an LLC must provide members with periodic profit distributions. However, the decision by management to distribute earnings does not diminish a member’s rightful claim to an equal share of those earnings for future distributions. The operating agreement of the LLC may require any profit allocation that members agree on. Rather than using the default rule of most jurisdictions to split profits equally, allocations can be made based on the contribution of each member.
Improper Distribution Liability
Regardless of what the operating agreement provides, most states prohibit all LLCs from making a profit distribution that hinders the LLC’s ability to pay debts as they become due in the ordinary course of business or that create an excess of liabilities over assets. The member or manager who has the authority to issue a distribution is personally liable for any amount that is improper. Additionally, if a member accepts the distribution with full knowledge that all or part of it is improper, that member is jointly liable with the issuing member.
If the LLC terminates the business and dissolves the legal entity, a complete distribution of all assets must occur. Creditors of the LLC receive first priority in receiving payment. Remaining assets are then distributed to members who are still due a prior distribution. The LLC must then use the excess funds to provide returns of capital to each member who has made a contribution to the business. Lastly, every current member receives his rightful share of the excess as a profit distribution in accordance with the operating agreement or state law.
The federal government treats an LLC differently than most other business entities. An LLC has discretion in choosing the method of business taxation it prefers. When an LLC completes formation, the IRS automatically designates a single-member LLC as a sole proprietorship and all other LLCs as a partnership for tax purposes. However, if members prefer corporate tax treatment, they can make an election on IRS Form 8832 to effectuate the change. An election is valid for 60 months before the LLC can revert back to its original designation from corporate status. If the LLC receives corporate tax treatment, profit distributions are taxable on a member’s personal income tax return in the same manner as a dividend. All other tax structures use pass-through taxation principles that require each member to report a share of all business earnings and losses on a personal income tax return. Each member is solely liable for reporting and paying the tax on his allocation of business earnings and incurs no personal liability for other members who do not comply with tax requirements.
References & Resources
- University of Pennsylvania Law School: Revised Uniform Limited Liability Company Act 2006
- “Wiley CPA Exam Review Volume 1”; O. Ray Whittington, Ph.D.; 2010
- IRS.gov: Publication 3402 – Taxation of Limited Liability Companies