LLC Operating Agreement series: Economic Structures
The economic structure of a limited liability company relates to how and when distributions will be made to the owners (referred to commonly as “members”). Distributions may occur on a set schedule in regular intervals, when the LLC either redeems (or buys back) the member’s interest, or when the company liquidates. In this next installment in our series on LLC Operating Agreements, we’ll explore some considerations when structuring the distributions and allocation of profits and losses for your LLC.
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 these terms: a distribution is any cash or property a member 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 that are reported on the members’ tax returns.
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 from time to time as approved by a majority of the members. This allows the members the ability to agree to distributions without having rigid requirements for when and how much will be distributed. Other operating agreements include specific requirements on when the company will make distributions. How you structure cash distributions in your LLC will depend on the nature of the business and the goals of the members.
Limitations on Distributions
It is important to note that RCW 25.15.231 provides limitations on distributions. Most notably, an LLC may not make a distribution if the distribution would prevent an LLC from being “able to pay its debts as they became due in the usual course of business” (or become insolvent). 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. The members in a member-managed LLC or the manager in a manager-managed LLC can be personally liable for any improper distributions if that member or manager failed to exercise the duty of care in making the distribution in violation of the limitation discussed above (found in RCW 25.15.231).
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 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 your tax advisor to ensure your allocations are proper.
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.