In most states, the owners of a limited liability company can determine a legitimate method of splitting profits that makes sense for their membership and their business. If a company doesn't specify a profit sharing formula, the profit is shared according to each member's ownership percentage as determined by his relative capital account balance.
Federal Taxation as a Partnership
Unless a multimember limited liability company files Form 2553 with the Internal Revenue Service and requests to be taxed like a corporation, the IRS considers the company a partnership for income tax purposes. This means that the company doesn't pay any tax to the government on the profits it makes. Instead, it distributes the profits at the end of each year to the company's owners, who pay individual income tax and self-employment tax on their shares of the profit.
LLC Member Interests
The owners of a limited liability company are called members. When a member joins the company, he typically makes an investment in the company in cash, property or sometimes services performed for the business. In return, the member receives a membership interest in the company.
The company maintains a capital account for each member that tracks the member's contributions and withdrawals. The relative proportion of each member's capital account balance represents his ownership percentage and, absent other guidelines, is the percentage of profit or loss to which he's entitled. That percentage can vary during the year as new members join the company or as members contribute to or withdraw from their capital accounts.
LLC Flexibility and Operating Agreement
One of the advantages of an LLC is the flexibility that members have in most states to determine how the company operates, including how it distributes profits to its members. In most states, LLC members can decide they want to distribute profits using a method other than each member's ownership percentage. For example, if one member contributed cash and the other members contributed property and services, the members might decide to allocate 50 percent of the profit to the member who contributed cash until his contribution has been refunded and then to share profits according to ownership percentages. Provided that it's specified in the company's operating agreement, an LLC can typically use any alternate method of distributing profits that the IRS would regard as legitimate during an audit.
Allocating Profit to Company Members
At the end of each year, an LLC is required to distribute the profit or loss to its members. Once it determines the percentage that each member should receive, the company usually adjusts each member's capital account balance accordingly and provides each member with an updated account statement and IRS Form K-1 that specifies the amount of her allocation. Each member is responsible for paying income tax and self-employment tax on the profit allocated by the company, even if the member doesn't withdraw any cash and reinvests the profit in the company by keeping it in her capital account.
Example: An LLC has three members who made contributions during the first year. The combined contributions of all three members was $250,000.
- Member A contributed $100,000 and has a 40 percent ownership percentage.
- Member B contributed $75,000 and has a 30 percent ownership percentage.
- Member C contributed $75,000 and also has a 30 percent ownership percentage.
At the end of the year, the company has $10,000 in profit to share. Member A receives $4,000 and has a new capital account balance of $104,000. Members B and C each receive $3,000 and have new capital account balances of $78,000. If Members B and C request a withdrawal of their profits and Member A does not, Member A's profit percentage increases to about 41 percent.
Employment and Guaranteed Payments
Suppose the members agree that Member C will run the company and the company will pay her $5,000 a month. The $5,000 is called a guaranteed payment. It's similar to a salary, but since a member can't be an employee of the company, it's paid like a fee to an independent contractor. As long as the company doesn't earn its profit from capital transactions, the guaranteed payment does not have any effect on Member C's membership interest, capital account balance or profit percentage. However, Member C is responsible for filing quarterly estimated income tax returns and paying income tax and self-employment tax on the income from the guaranteed payment.
Steve McDonnell's experience running businesses and launching companies complements his technical expertise in information, technology and human resources. He earned a degree in computer science from Dartmouth College, served on the WorldatWork editorial board, blogged for the Spotfire Business Intelligence blog and has published books and book chapters for International Human Resource Information Management and Westlaw.