How Are Profits Split in an LLC?

By Larissa Bodniowycz, J.D.

How Are Profits Split in an LLC?

By Larissa Bodniowycz, J.D.

Limited liability companies (LLCs) are a popular choice of business entity for small businesses. They provide the personal liability protection of corporations with increased flexibility and fewer administrative requirements.

Businessman typing at laptop at desk while looking at documents

One of the areas of flexibility for LLCs is the ability to structure how owners, called members, split profits. Unlike corporations, LLCs can opt to allocate profits in virtually any manner they choose, as long as they are taxed like a partnership and explain the profit-splitting in their operating agreement.

Default Method for LLC Profit Allocation

Each state has a set of default rules that apply if the LLC members do not reach an alternative agreement. By default, an LLC's profits are allocated in proportion to ownership interests. For example, if two LLC members each own 50 percent of the LLC, half of the profits is allocated to each owner. If an LLC does not specify an alternative method, this is how the company must allocate its profits.

Changing the Method of LLC Profit Allocation

In many cases, the default rule for profit allocation is fair. However, there are situations in which an LLC might want to distribute profits in a manner that does not match ownership interests. For example, if some owners contributed cash to start the business while others contributed only services, the LLC might want to give the cash-contributing owners a greater percentage of profits.

Whatever the reason for the choice, LLCs that want to opt out of the default profit-allocation rules can do so by agreeing to a different structure for distributing profits. The agreement needs to be in writing and should appear in the LLC's operating agreement.

When the Default Method Is the Only Option

There is one important situation when an LLC cannot elect to have unequal profit allocation: when it is taxed by the Internal Revenue Service (IRS) as a corporation. Fortunately, an LLC has full control over this.

The IRS does not have a separate tax designation for LLCs. This means that LLCs must choose whether they want to be taxed like a partnership or like a corporation. By default, LLCs are taxed like partnerships, meaning LLC profits are passed through to the owners and taxed with the owners' income taxes. If LLCs complete proper IRS forms on time, they can choose to be taxed like corporations, meaning they are taxed twice: once on profits at the corporate level and again on any distributions at the individual ownership level.

The Difference Between Allocation and Distribution

Business owners may notice that when they ask legal or tax professionals about splitting profits, they receive answers that use the terms "allocation" and "distribution," rather than profit-splitting.

The first part of profit-splitting, allocation, is how profits are divided among owners on paper for tax purposes. Distribution, on the other hand, is how profits are handed out. For business reasons, such as ensuring sufficient funds for operations, an LLC may choose to retain some or all of its profits in accounts for use by the LLC. Even though the retained profits are not distributed to the owners' personal accounts, the owners must still pay taxes on the amount of profits allocated to them.

To avoid future disagreements, be sure that your LLC operating agreement includes details on how members share profits. It could save you a lot of headache down the road.

This portion of the site is for informational purposes only. The content is not legal advice. The statements and opinions are the expression of author, not LegalZoom, and have not been evaluated by LegalZoom for accuracy, completeness, or changes in the law.