The Canal Street Blog

The Canal Street Blog

Business-focused legal discussion

LLC Operating Agreement series: Economic Structures

The economic structure of a limited liability company (LLC) determines the amount and timing of the distributions to the members (remember that LLC owners are called “members”). Distributions may occur periodically during the operation of the LLC, when the LLC either redeems (or buys back) the member’s interest, or when the company chooses to liquidate. In this next installment in our series on LLC Operating Agreements, we’ll explore how to structure the distributions and profits and losses for your LLC.

Washington Law
The default rule under Washington law provides that members will receive distributions and allocations of profits and losses in proportion to the amount of capital each member contributed to the company. To clarify some of the terms: a distribution is any cash or property a member actually receives from the LLC; an allocation of profit or loss is a tax and accounting concept that relates to the division of profits and losses for tax purposes.

It’s important to note that Washington LLCs are different than corporations since (generally) no stock is issued to members (or owners) of an LLC. By default, ownership rights are determined by the percentage of contribution to the LLC rather than by the amount of stock held by an owner. However, if an LLC’s members determine that they would like to have stock rather than just capital accounts, the framework for the issuance and authorization of stock can be included in the LLC operating agreement.

Flexible Distribution Rules
In drafting the economic structure of an LLC operating agreement, members have the freedom to choose the frequency of distributions and the process by which distributions will be made. A common provision may provide that distributions will be made at least monthly, and all distributions shall be approved by members with more than fifty percent ownership (according to the agreed value of the contributions made).

Limitations on Distributions
It is important to note that RCW 25.15.235 provides limitations on distributions. Most notably, an LLC may not make a distribution if such a distribution would prevent an LLC from being “able to pay its debts as they became due in the usual course of business.” These limitations protect creditors from not being paid by LLCs that continue to distribute cash to members without adequate funds to pay creditors as well.

Allocations of Profits and Losses
An operating agreement should also detail how profits and losses will be allocated between members. These allocations will be reflected not only in the actual distributions received by each member, but also in each member’s tax returns. Depending on the circumstances, it may be beneficial for one member to receive more losses than another member, but the Internal Revenue Service (IRS) has issued detailed regulations limiting the extent to which losses can be disproportionately allocated among members. Without going into significant detail, here are the basic limitations: (a) that allocations of profits and losses may have significant tax consequences, and (b) that the IRS limits the flexibility of allocating profits and losses if the purpose is solely for limiting tax liability. The IRS regulations are complex and you should always consult a tax attorney in order to ensure your allocations are proper.

Stay tuned for the next post in our LLC Operating Agreement series!

If you have any questions about forming a LLC or drafting an operating agreement for your LLC, please don’t hesitate to contact us today.

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