Members of an LLC are subject to capital contributions, i.e. the amount of money or assets given to the business by one of the members, and profit distributions based on terms they agree to in the Operating Agreement. Below we talk through several key issues for you to consider as you receive and distribute capital for your LLC.
Managing LLC Profit Distributions
LLCs are formed usually for one reason: to make money. Sometimes the return can be in compensation in terms of salary or capital gains from a sale or other disposition; however, most of the time distributions are usually how members of an LLC realize the return on their investment. The distribution provisions are contained in the LLC Operating Agreement. These distributions can either be prorated by capital invested, prorated by interest ownership or distribute based on more complicated formulas.
Distributions generally fall into one of two categories: (1) tax income/loss (deemed distributions) and (2) money actually paid from the LLC to the member.
How Income and Distributions are Taxed
In the first category, the LLC defaults to pass-through tax status. In a single member LLC owned by an individual, by default, the LLC’s income and expenses are not reported on a separate tax return. The single member LLC is disregarded for tax purposes. The tax distributions from the LLC are reported on the member’s IRS Form 1040 Schedule C as self-employment income. Even if the LLC does not actually pay a dividend to its member(s) in cash, but retains the funds for cash-flow reasons or reinvestment purposes, the income still appears on the member’s income taxes. This often results in “phantom income,” a tax liability for income not actually received. Usually LLC agreements try to resolve this problem by requiring the LLC to distribute to its member a sufficient cash distribution to pay the tax liability on the deemed distribution.
In multi-member LLC agreements (even husband and wife two-member LLCs), the LLC again defaults to pass-through tax treatment. The 2+ member LLC must file an informational partnership tax return IRS Form 1065. This also results in an IRS Form K-1 for each member to report the tax profit or loss on each member’s 1040 tax return (for natural person taxpayers).
Although LLCs are permitted to make “check-the-box” elections for S-corp or C-corp tax treatment, neither of those two corporation tax elections are advisable for real estate ownership. To reduce the effective tax rate overall from purchase to sale, real estate should be held through an LLC that has not made a corporate tax election.
One advantage of the partnership tax treatment of an LLC is that distributions can be made disproportionate to ownership. In other words, regardless of capital contributions, a distribution provision can be added to allow the members who can use the tax losses more than others, to receive those first, then distribute the profits on another basis. This is part of the flexibility of the LLC’s Operating Agreement structure.
How LLC Owners Pay Themselves
Operating Agreements often provide that where members make capital contributions that are not proportionate to their percentage ownership interests, the members contributing extra amounts will get a return, called a “preferred return”, on their extra contributions, that will be distributed to them prior to payments made to the members on a pro-rata basis. In addition to receiving a preferred return on their excess capital, they may receive a return of their excess capital prior to other distributions.
Operating Agreements often have separate provisions regarding distributions of operating cash flow and distributions of proceeds of “capital transactions” such as a sale or financing. The distribution priorities may be different in the different categories. For example, preferred returns on capital may be payable from distributions of both operating cash flow and proceeds of capital transactions, but preferred returns of capital may be payable only from the proceeds of capital transactions. Furthermore, the order of payment of specific items may differ in the two categories.
Sometimes an LLC will have different classes of members with priorities that provide for a “waterfall”. In other words, in a real estate deal, in addition to mortgage or other secured debt, there may be equity investors and managers who participate in distributions based on the performance of the LLC. It is not unusual to have the promoters of a project receive generous distributions from a project if it exceeds expectations because although they may contribute less capital, they contribute more reputational risk, “sweat equity,” or and add value by creating synergies by introducing parties to each other and managing the relationships. This is a form of incentive to encourage performance on the part of the promoter.
The waterfall contains a formula of tiered buckets that fill first, then pour over into the next second level bucket and on down through the tiers. Sometimes the promoters are in the bottom bucket and get a disproportionate share of profits in the event of a run-away success. These waterfall provisions in the LLC Operating Agreement should be looked at by a tax lawyer to ensure they operate as you intend them to. Other categories of equity may provide for certain investors, to have preferred returns.
In sum, the LLC Operating Agreement should provide for distributions to the members and these provisions should be reviewed by a tax lawyer or CPA to ensure they will have the economic and tax affect you expect for your client.
Managing LLC Capital Contributions
Members are required to contribute capital to an LLC only in the amounts they agree to contribute in the Operating Agreement, at the times specified in the Operating Agreement. A member’s agreement to contribute may be enforced by the company in accordance with law. Some statutes permit a creditor to enforce the obligation if the creditor relied on it in extending credit to the company. It is good practice for the Operating Agreement to state the specific amounts due from members and timing of payment for amounts initially expected to be needed for the company’s business.
Like any business enterprise, an LLC may have unexpected or unquantifiable needs for capital in the future. To the extent the members desire that future capital needs be satisfied by borrowing from third party lenders, such preference can be set forth in the Operating Agreement, which may contain provisions covering how much can be borrowed, who makes the decision (or who has a right to consent to it), and how the terms of the loan will be determined. Similarly, to the extent the members desire that future capital needs be satisfied by admitting new equity investors, that can be stated in the Operating Agreement, together with any desired limitations as to how much can be raised in this manner, and how the terms of the new investments will be determined.
In any case, an Operating Agreement should cover how additional capital needs will be satisfied if third party sources are not available or desirable on acceptable terms. An Operating Agreement may provide for additional required capital contributions if the company requires additional funds. Below we will help you navigate key issues to consider when requiring additional funds:
- What needs justify a mandatory additional contribution from the members?
- Who decides that additional funds are needed, and who may make a capital call for such funds?
- What happens if a member fails to contribute the required additional capital?
What needs justify a mandatory additional contribution?
An Operating Agreement may provide that members must contribute additional capital to meet non-discretionary cash needs necessary for the conduct of business. Examples include amounts needed to pay taxes, amounts needed to pay debt service on loans, amounts needed to comply with legal requirements, eliminate safety hazards or make necessary repairs, and amounts needed to discharge liens on the company’s property or to pay bills from contractors and suppliers, or pay cost overruns.
An Operating Agreement may provide that members must contribute additional capital in accordance with a budget that may be established in the future. Since budgets may be exceeded, the agreement may provide for contributions up to an agreed variance, such as 5% or 10% in excess of budgeted amounts.
If the Operating Agreement calls for fees to a member or an affiliate of a member for services (such as construction or management fees), and the fees cannot be paid from the company’s cash flow, then the Operating Agreement should state whether or not the members must make mandatory contributions to fund such fee obligations, or pay for these services from amounts that otherwise would be distributed to them.
Other mandatory items can be negotiated by the parties.
Who decides that additional funds are needed, and who may make a capital call?
Typically, the managing member(s) or manager(s) make this decision and are authorized to make a capital call for the needed funds. If there is more than one managing member or manager, the Operating Agreement should provide what happens if there is a disagreement, particularly if the decision-makers are deadlocked.
Some Operating Agreements provide that any managing member or manager may make a call for mandatory funds. Others provide for dispute resolution by arbitration.
While an Operating Agreement may provide mechanisms for addressing deadlock generally (as discussed under “Transfers and Exit Strategies” below), a dispute regarding mandatory capital contributions may need to be decided more quickly than those mechanisms permit in order to avoid default on the company’s obligations or loss of its property.
What happens if a member fails to contribute the required additional capital?
Generally, Operating Agreements will give the members a period of time to make required contributions, with notice and cure rights if they do not, but provide consequences if the contribution is not made within the applicable cure period.
Many Operating Agreements provide that the failure of a member to contribute required capital will permit the performing members to withdraw their capital contributions. However, this remedy is illusory since it will deprive the company of required funds and may lead to defaults on third-party obligations.
To prevent this result, an Operating Agreement should permit the performing members to provide the contribution of the defaulting member, with a penalty to the defaulting member.
One option is to permit the performing members to make a loan to the company of the defaulting member’s share, with a high rate of interest. The loan would be repaid, with interest, from the next distributions that would otherwise be payable to the defaulting member.
In drafting the Operating Agreement, it is important to provide that repayment of a penalty loan is payable from the defaulting member’s distributions and not by the company prior to the making of distributions. Otherwise, repayment would be made in part from funds that belong to the performing members, who in essence would be paying themselves.
Another option is to provide for a reduction in the interest of the defaulting member in the company with a corresponding increase to the performing members who provide the defaulting member’s share of capital. This is sometimes called a “squeeze-down” or a “cram-down”.
A squeeze-down can be computed by crediting the performing members with additional capital contributions and recalculating each member’s share based on the total capital contributed by each member, both previously and in connection with the present capital call, as a percentage of the aggregate capital contributions to the company.
Many squeeze-down formulas have a penalty factor in order to penalize the defaulting member and reward the performing members. In recalculating the members’ percentage interests in the company, the performing members may be credited with, for example, 125% or 150% of the defaulting member’s share of required capital when they provide the deficiency.