Type of Entity
The IRS does not have a dedicated tax category for the LLC. Instead, it requires multiple-member LLCs that need to split profits to choose whether to be taxed as a partnership or a corporation. The most common choice is to be taxed as a partnership, because a company that wanted corporate tax treatment would simply form a corporation. An LLC that is taxed as a partnership is a disregarded, or pass-through entity meaning profits and losses are passed through to members for inclusion on individual tax returns instead of being taxed at the business level. A pass-through entity maintains a capital account for each member, and profits are split by allocating amounts to this account. A member's capital account equals the value of his contributions, plus allocated profits, minus allocated losses, minus distributions.
In a partnership LLC, profits are split annually at the end of the company's fiscal year. Splitting up profits between members is called an allocation. Profits and losses are allocated by default in the same ratio as each member's ownership interest. A member's ownership interest is initially equal to his capital contribution. So if an LLC has two members, and one contributed $25,000 to start the company and the other contributed $75,000, the first member would be allocated 25 percent of the profits. This method of allocating profits and losses is the default method established by the state law under which the LLC is formed. Each member's ownership interest is initially equal to the opening value of his capital account. Over time, further contributions, allocations and distributions into the capital account might change a member's ownership interest and percentage of the profits.
The default provisions of state law that mandate allocations of profits to members applies only in the absence of an agreement between the members. One of the benefits of the LLC is its flexibility in designing an owner profit-and-loss structure. By adopting an operating agreement, the members can decide to allocate profits or losses in a proportion that is not equal to the members' ownership interests. This may apply if certain members made their initial contribution to the LLC as cash, while other contributed services. The members might agree that the members who contributed cash will receive a high percentage of the profits until that initial cash contribution is paid back.
The allocation of profits in LLCs can turn into a complex accounting matter. Special circumstances can change the way profits are allocated. For example, the tax code makes a distinction between active and passive members, or members who work for the LLC versus those who don't. The active member can receive early distributions of profits as a salary. If the LLC's profits at the end of the year come from ordinary sales and revenue, the active member gets to keep his salary, and the balance of the profits are divided up in proportion to ownership interest. If the profits are derived from capital transactions, such as the sale of real property, the salary payments are treated as part of the member's total profit distribution, decreasing the amount he will get out of the pot as his share at the end of the year.