Once you get your business operations off the ground, you will need to consider some of the financial aspects of operating an LLC. This includes managing capital contributions and distributions in your newly formed company.
As a small business owner or aspiring entrepreneur, it’s essential to understand these processes to ensure your LLC’s success. In this article, we cover how to navigate capital contributions, distributions, and some key considerations for managing your LLC’s finances.
What is a Capital Contribution?
A capital contribution refers to the cash or property that owners provide to their business. LLC members typically make initial capital contributions when opening the business and may contribute more throughout the company’s lifetime.
Initial capital contributions often play a significant role in determining a member’s ownership percentage in an LLC. Members can split LLC ownership proportionately based on each member’s contribution, but this isn’t a requirement. In some businesses, one member contributes more capital while another concentrates on operating the business, a concept called “sweat equity.”.
An LLC should have a written Operating Agreement detailing the company’s ownership structure and each member’s initial capital contribution.
How to Distribute Profits in an LLC
A primary goal for most businesses is to generate profits and pay them out to the owners. LLC members usually receive returns through compensation (taking a salary), capital gains, or distributions.
Members should include provisions in the LLC Operating Agreement that dictate the process for making distributions. Distributions generally fall into two categories:
1.) Tax income/loss (deemed distributions): These are allocations of the company’s income, gains, losses, deductions, and credits provided to LLC members. Each member reports these distributions on their personal income tax return.
Even if the members don’t actually receive any money, they still owe taxes on their respective shares of the LLC’s income. People often call this concept “phantom income” because members have to pay taxes on income they haven’t received in cash.
2.) Money actually paid from the LLC to the member: These are cash distributions made to the LLC member’s from the company’s profit or capital. Members can choose to make cash distributions periodically, such as quarterly or annually.
Distributions can be prorated by capital invested, interest ownership, or follow more complex formulas.
How is LLC Income and Distributions Taxed?
The IRS taxes LLCs as “pass-through” entities by default, meaning the LLC’s business income passes through to the members and appears on their personal tax returns.
For single-member LLCs owned by an individual, the single member reports tax distributions on their IRS Form 1040 Schedule C as self-employment income. Multi-member LLCs follow a similar process, filing an informational partnership tax return on IRS Form 1065 and providing each member with an IRS Form K-1.
LLC cash distributions may have different tax treatment than deemed distributions. Because LLC members already pay taxes on the LLC’s income through deemed distributions, they treat cash distributions as a return of capital or a reduction in the Member’s tax basis in the company.
Preferred Returns in Multi-Member LLCs
LLC Operating Agreements may include provisions for members who contribute more capital proportionate to their percentage ownership interest. Members can earn a “preferred return” on their additional contributions before distributing other pro-rata payments. The LLC Operating Agreement should also address any distributions of operating cash flow and capital transactions separately, with different distribution priorities.
What is a Waterfall Distribution Structure?
Some LLCs have different classes of members with priority over distributions. Classes of members can be organized in a “waterfall” structure where distributions are made based on tiers. Promoters of a project may receive generous distributions if the project exceeds expectations, incentivizing their performance.
A tax lawyer should review waterfall provisions in the LLC Operating Agreement to ensure they operate as intended.
Addressing Additional Capital Needs
An LLC may require additional capital in the future, either for growth or to stay afloat. The Operating Agreement can outline preferences for how the LLC should raise additional capital, whether it be borrowing from third-party lenders or admitting new equity investors.
If third-party sources aren’t available, the Operating Agreement should specify how additional capital needs will be met, including potential mandatory contributions from members.
Considerations for Mandatory Additional Contributions
The Operating Agreement should address several key issues regarding mandatory additional contributions:
- 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?
If an existing member fails to contribute additional capital, the Operating Agreement should outline the consequences. Some possible consequences include:
- Allowing performing members to loan the defaulting member’s share to the company at a high interest rate, with repayment coming from the defaulting member’s future distributions
- A “squeeze-down” or “cram-down,” reducing the defaulting member’s interest in the company and increasing the performing members’ interest
Understanding and managing capital contributions and distributions are crucial aspects of successfully operating an LLC. Business owners and aspiring entrepreneurs should know how to navigate some of these financial processes to protect their ownership interest while helping the business grow. Always consult with a tax lawyer or CPA.