LLC is the abbreviation for limited liability company, which is an unincorporated business structure created under and governed by state law. If formed correctly in accordance with state law, the LLC is a legally recognized entity that allows the owners, who are called members, to enjoy limited liability and tax treatment similar to that of a partnership. This means that members incorporate business revenue into their personal income taxes. This is called flow-through taxation because the revenues and deductions flow from the business entity to the individual members. Given membership structure and tax treatment, to determine how to allocate profits, deductions, expenses and losses, many LLCs provide for distribution based on a member’s pro-rata share.
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Allocation of Financial Interests
Laws governing LLCs differ by state and each state provides default rules that will govern the operation of an LLC, in the event the LLC’s operating agreement is silent on a certain topic. For example, many states provide for equal allocation of financial interests among the members of an LLC, whereas other states provide for a pro rata share of financial interests among members.
To become a member in an LLC, typically, an individual makes a capital contribution. Pro-rata shares of an LLC are based upon the amount of capital contributed to the LLC, since members often contribute varying amounts. Sometimes, members must make additional contributions of capital during the operation of the LLC. These contributions may increase the voting or financial rights of the member who is making these additional contributions, as well as increase the member’s pro-rata share.
Profit and Loss Allocation
Member contributions are often the basis for how an LLC allocates profits and losses among the LLC's members. The founders of the LLC can determine whatever particular allocation of financial interests among members they wish to, provided it is explicitly laid out in the LLC’s operating agreement.
Members' Liability to Creditors
One of the primary benefits of an LLC is that its members’ liability is limited to their investment in the LLC. However, similar to a corporation, members may be liable to creditors in excess of their contributions if they are able to “pierce the corporate veil” in court when members of the LLC have wronged creditors. For example, if the members were to distribute profits excessively to the detriment of paying the creditors and the creditors successfully raised this point in litigation, a member may be held personally liable above and beyond his investment in the LLC.