When you create an LLC to start a business as a sole proprietor or with partners, you do not receive consistent payments in the same way an employee does. Instead, the payments you receive may be infrequent and for varying amounts, but they directly relate to the success of the business. Only when the LLC’s business activities prove profitable is a payment to owners appropriate and allowable.
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Compensation for Services
Every member of an LLC has the right to participate in the management of the business. However, members have no entitlement to compensation for services they provide in their capacity as an owner. Although a member does not receive compensation, the LLC must reimburse them for out-of-pocket expenses they incur while engaging in LLC business activities. A member may receive compensation for services if the operating agreement or other members allow for that member to take on a permanent management role. For example, if the LLC has 10 members and they all agree to have one member oversee daily operations, that member should receive compensation for taking on that role.
Most jurisdictions allow, but do not require, the LLC to provide its members with profit distributions. In the absence of an operating agreement clause governing the LLC’s distributions, most states require that profits and losses be split equally among the members. However, some jurisdictions, such as New York, require that profit allocations be made in reference to the value of each member’s monetary and property contributions to the LLC.
Improper Distribution Liability
If the LLC operating agreement authorizes a profit distribution, most jurisdictions require that its payment not hinder the LLC’s ability to pay its debts in the ordinary course of business or cause liabilities to exceed assets. In essence, distributions are only permissible when there are sufficient earnings. If a distribution exceeds these limitations, the person who authorizes the payment is liable to the LLC and other members for the amount that is improper. If the member who receives the distribution accepts it with full knowledge that it is improper, that member is jointly liable. However, both parties may rely on financial statements that are prepared in accordance with generally accepted accounting principles when determining the proper amount of a profit distribution.
Membership Interest Appreciation
In the event the LLC refrains from making a distribution of its profits, members may not require payment. However, a member’s interest in the LLC has value that may appreciate as the business progresses and retains its earnings. Although a member may not force the distribution, he still retains a claim on his rightful share of those earnings. This claim increases the value of the membership interest, which the member is free to sell at fair market value. However, when a member transfers their interest, the transferee only receives that member’s financial interest in the firm. The authority to engage in management activities does not transfer to the acquirer unless the operating agreement allows for it or all members unanimously agree.