When discussing the advantages of an LLC, or limited liability company, many people will bring up the LLC's relative ease of formation and the limited liability protection afforded to LLC members.
However, there's another advantage to an LLC that can be quite significant—depending on the circ*mstances—and that's the flexibility of LLC profit distribution.
Taxation as a partnership: Partnership LLC
From a tax perspective, an LLC is known as a pass-through entity.That means that rather than being taxed on the income it makes, this income passes through to its members, who are then taxed on this income individually.
Unless it elects to be taxed as a corporation, a multi-member LLC is treated as a partnership.The LLC's members include their share of the LLC profits on their personal tax returns.
An LLC member's ownership interest is tracked in that member's capital account.The capital account will include a member's capital contributions, as well as allocated profits. Any distributions that are made to the member are subtracted from the balance of the account. In this way, a member's ownership interest in the LLC can be readily identified.
Default LLC profit allocation follows ownership interest
LLCs are governed by the rules of the state in which they were formed. State rules provide for the allocation of LLC profit according to each member's percentage of ownership interest.
For example, if Peter and Mary are members of a two-member LLC, and Peter has a 40 percent ownership interest, and Mary has a 60 percent ownership interest, then, under state rules, Peter would be allocated 40 percent of the LLC profits, and Mary would be allocated 60 percent. If no distributions are made, each member's capital account would be increased by the amount of profit they've been allocated.
However, these state rules are default rules, and with an LLC, it's possible to provide for a profit allocation arrangement that's not dependent on ownership interest.
Establishing alternate profit allocation arrangements
There are numerous reasons why members may wish to have a profit allocation arrangement that differs from their ownership interests.
For example, some members' capital contributions may consist of cash, while other members may make their capital contributions in property or services.
In such a case, the members may decide on a profit allocation arrangement that provides the members who made cash contributions with a higher percentage of profits than their actual ownership percentage until their contributions have been paid back, after which profits would be allocated based upon ownership interests.
Documenting profit allocation in the operating agreement
Regardless of the type of profit allocation arrangement the members agree on, it's crucial to document the arrangement itself in the LLC's operating agreement.
A verbal agreement will not do the trick; the operating agreement must contain provisions governing how profits are to be divided among members.
If a profit allocation arrangement is not outlined in the operating agreement, then the state's default profit allocation rules will apply.
Allocation and distribution of profit are not the same
If you and your co-members have agreed to a profit allocation agreement that feels fair, and your LLC's operating agreement has been drafted to include details of this arrangement, how are the profits split in an LLC?
An LLC's profits must be allocated among its members every year. As long as the operating agreement contains provisions governing how profits are to be allocated, the profit allocation rules as set out in the operating agreement will be followed, rather than the default state rules.
It's important to note, though, that the allocation of profit doesn't have anything to do with the actual distribution of profit. While members are allocated their share of an LLC's profit, they might not actually receive a profit distribution. Regardless, they must include the percentage of the profit they've been allocated in their taxable income for the year.
Because an LLC is a pass-through entity, it's this allocation of profit that ensures that the LLC's profits are taxed in the hands of LLC members.
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FAQs
LLCs have significant flexibility around profit allocation. LLC owners, also known as members, can allocate profits and losses in direct proportion to their ownership stake or percentage interest. They can also distribute profits in different proportions to owners – this is known as a special allocation.
How does an LLC show profit? ›
While multi-member LLCs must file an informational tax return, single member LLCs do not. In both cases, the profits or losses are “passed-through” the business and reported on the owners' tax returns. Any tax due is then paid by the owners at the individual tax level.
How to split profits in a business? ›
💸 Agree on a profit-sharing ratio
As a general rule, if there are two people in the partnership, it's 50/50, and if there are three people, it's a ⅓ split. The biggest thing to remember is that no matter how you split your profits, the percentage must equal 100. For example, imagine you have three business partners.
How do you split shares in an LLC? ›
Divide ownership of the LLC by calculating total cash investment by the members. Give each member an ownership stake equal to his cash investment. Four members contributing $25,000 apiece would each receive a 25 percent stake in the company.
How are profits shared in a company? ›
Profit shares may be distributed on a current or deferred basis or by some combination of the two. Under current distribution, profits are paid to employees in a lump sum of cash or as company stock. In deferred-payment plans, profit shares may be paid into a managed fund from which employees can draw later.
How do you calculate profit split? ›
This ratio is usually based on each partner's investment, effort, or other factors agreed upon by the partners. Divide the total profit by the sum of the ratio values to find the value of one share. Multiply the value of one share by each partner's ratio value to find their individual profit share.
How do LLC profits avoid taxes? ›
The good news is that your LLC doesn't pay taxes or file federal tax returns. Instead, you report the income you earn or the losses you incur from your LLC on your personal tax return (IRS Form 1040). If you earn a profit from your LLC, that money is added to any other income that you've earned.
What if my LLC never makes a profit? ›
LLC Partnerships
If an LLC elects to be treated as a partnership for tax purposes, and the business did not generate any income during the taxable year, it is generally not necessary to file a tax return, unless there are business expenses to be treated as credits or deductions.
How should I pay myself from my LLC? ›
You have several options to pay yourself from an LLC, including salary, wages, profit distributions and independent contractor pay. You can also abstain from taking any pay if you want to keep the money in the business or the business isn't generating enough revenue to pay you.
How to split profits fairly? ›
The simplest route is to form a “general partnership”, simply register your “doing business as (DBA)” name and open a bank account in the business' name. This structure assumes that all profits, liability, and management duties are equally divided among the partners.
Profit split is a method to divide the profit of an external sales transaction between the entities involved in the transaction. In LN, this applies to sales transactions in which two entities are involved. For example, the profit gained from a sales order is divided between the sales office and the warehouse.
How does a 70/30 partnership work? ›
For example, if one partner owns 70% of the business and the other partner owns 30%, then any profits will be distributed accordingly (70/30). Once all partners have agreed on the profit-sharing ratio, including this in writing in your partnership agreement is important.
Can an LLC hold profits? ›
Distribution of LLC Profits is Discretionary
That authority can be in a binding decision of the members or managers of the limited liability company or in the terms of the operating agreement. Without such authority, a limited liability company may choose to retain profits for reinvestment or future business needs.
How to determine ownership percentage in LLC? ›
A good starting point for establishing ownership percentage for an LLC is to first settle on what amount of capital that is required to start the business. After you have this reference point, you can simply divide from each members' initial contribution to calculate their respective ownership positions.
How to give equity in an LLC? ›
There are 3 different ways for an LLC to grant equity to employees: unit / membership interests, profits interests, and unit appreciation rights (shadow equity). Each type of equity interest is taxed differently by the IRS. Unit / membership interests are the LLC equivalent of stock.
Who keeps the profits of LLC? ›
By default, LLC profits are split according to ownership percentage—if you own 50% of the LLC, you get 50% of the profits. However, you can override your state's default requirements for splitting LLC profits by making another arrangement in your operating agreement.
Are profits from an LLC taxed twice? ›
Most states tax LLC profits the same way the IRS does: The LLC members pay taxes to the state on their personal returns, while the LLC itself doesn't pay a state tax. Additional taxes in some states.
How is the percentage of ownership determined in an LLC? ›
Most of the time, the ownership percentage is determined by the amount a member gave at the start of the business, compared to the total amount given by all members.
Are LLC profits earned income? ›
If you earn a profit from your LLC, that money is added to any other income that you've earned. This includes interest income or your spouse's income if you're married and filing jointly. The total amount earned is then taxed.
