Distribution Provisions in LLC Operating Agreements

At the formation of a limited liability company (LLC), an important consideration is the writing and adopting of the LLC operating agreement. One aspect that should be included in the operating agreement is how the profits (or losses) will be distributed among the members of the LLC. Determining each owner’s financial interest at the outset of participation in the LLC is critical in avoiding disputes as the company begins to operate.

Operating Agreements

Among numerous other things, LLC operating agreements structure the financial relationships between owners of the LLC. The operating agreement establishes each owner’s percentage of ownership, including their distributive share of any income, gain, loss, deduction, or credit. In most LLCs, the distributive share corresponds to the percentage of ownership that the owner has in the LLC. The percentage of ownership is usually reflective of the owner’s financial contributions of cash, property, or services to the business in order to get it started. However, owners can choose to allocate distributive shares in a way different from ownership interest.

If LLC owners assign the percentage of distributive shares in a way different than in proportion to the percentage of ownership interest in the LLC, it is known as a special allocation. These are of particular interest to the IRS due to the possibility of using a special allocation to hide tax dollars. The IRS may reject a special allocation and tax the owners as if the distributive share was divided in proportion to ownership interest.

Under the Internal Revenue Code, a partner’s distributive share will be determined in accordance with the owner’s interest in the LLC if the allocation of the distributive share does not have substantial economic effect. An allocation has an economic effect if it is consistent with the underlying economic arrangement of the owners. An allocation is substantial if there is a reasonable chance that the allocation will substantially affect the money to be received by the owners from the LLC, independent of tax consequences.

The following issues should also be addressed in the operating agreement:

1. The amount of profits that will be distributed to owners each year;
2. Whether the members will receive enough money to cover income tax payments that they owe on each year’s allocation of LLC profits (“tax distributions); and
3. Whether the distributions will be made on a regular basis or whether owners are allowed to withdraw at will from profits.

These are important considerations because each owner’s financial situation will be different. By addressing these issues in the operating agreement, the chances for future disputes between LLC owners can be lessened.

Assistance Developing Operating Agreements

An LLC with a well-developed operating agreement will help you avoid issues in the future. The above addresses just one aspect that should be included in all operating agreements. If you have questions or would like help in developing your LLC operating agreement, contact the Royse Law Firm at any of our offices today.

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Roger Royse

Roger Royse, the founder of the Royse Law Firm, works with companies ranging from newly formed tech startups to publicly traded multinationals in a variety of industries. Roger regularly advises on complex tax structuring, high stakes business negotiations and large international financial transactions. Practicing business and tax law since 1984, Roger’s background includes work with prominent San Francisco Bay area law firms, as well as Milbank, Tweed, Hadley and McCloy in New York City.
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