A properly drafted LLC operating agreement will contain both allocation and distribution provisions. Although these provisions both deal with income, they have different purposes. This article explains the differences between LLC distributions and LLC allocations.
Unless the members elect to have the LLC taxed as a corporation, the LLC is taxed as a passthrough entity (also known as a flow-through entity) by default. If the LLC has only one member, it is taxed as a sole proprietorship. Otherwise, it is taxed as a partnership. In both cases, the income is taxed to the owners when earned.
Designating an LLC as a passthrough entity distinguishes it from C corporations. C corporations are taxed twice on their income: The corporation is taxed when the income is earned, and the shareholders are taxed when the income is distributed to the shareholders. Most people choose LLCs to avoid this double taxation. Unlike a C corporation, an LLC pays no entity-level tax. All income is taxed to the members when earned.
Understanding LLC Allocations
Allocations are a tax accounting tool. Because income earned by the LLC is passed through to the members, the members must pay tax on the income when earned. The LLC (and the IRS) needs a way to assign the income tax items—taxable income, deductions, and credits—among the members so that each member picks up a proportionate share. The purpose of allocation provision is to allocate the tax items among the members.
Each member of a multiple-member LLC has a capital account. The capital account is used to track the member’s economic interest in the company. The member’s initial capital account balance is the amount of the member’s contribution to the LLC. As the LLC operates, the member’s proportionate share of LLC income increases the member’s capital account. The member’s proportionate share of LLC losses and deduction decreases the member’s capital account. This system tracks the allocation of tax items among the members and identifies which members are responsible for the LLC income.
By default, allocations are made in proportion to the member’s interest. If Owner A has a 75 percent interest in the LLC and Owner B has a 25 percent interest in the LLC, then Owner A is responsible for 75 percent of the income and Owner B is responsible for 25 percent of the income. This default rule can be changed by making special allocations that distribute income tax items disproportionately among the members. The rules governing special allocations present tax planning opportunities, but are complex and technical and require special planning.
Understanding LLC Distributions
A distribution occurs when the LLC distributes cash or other property to its members. Where LLC allocation provisions deal with allocating tax items among LLC members, LLC distribution provisions deal with the distribution of cash to the members. A distribution to a member will decrease the member’s capital account.
By default, distributions are made in proportion to the member’s interest in the company. In a 75/25 split, the member with a 75 percent interest would be entitled to 75 percent of each distribution and the member with the 25 percent interest would be entitled to 25 percent of each distribution. There are often good reasons to change this default allocation—for example, to give a partner a distribution preference to recoup his or her investment more quickly. A well-drafted operating agreement can provide a great deal of flexibility in creating special distributions.
The rules governing taxation of LLC distributions are designed to ensure that the income is only taxed once, when it is earned, and not double-taxed when the income is distributed. Because the members have already paid their proportionate share of tax on the company’s earnings, distributions are—with some exceptions—treated as a non-taxable return of the member’s investment in the company.
Allocations, Distributions, and Phantom Income
Allocations are independent of distributions. An LLC will allocate its income to its members every year, and the LLC members must report their share of the LLCs profits on their tax return. This is true even if the LLC makes no distributions to the members. This creates the problem of phantom income—income that is taxable to the member even though the member has received no cash to pay the taxes. See our discussion of phantom income for more strategies for dealing with phantom income.