LLC Operating Agreements – Economic Structures
The economic structure of a limited liability company determines the amount and timing of the distributions of cash and property to the members (remember that in an LLC owners are called “members”). Distributions may occur periodically during the operation of the organization and at the time when the organization either redeems the member’s interest or liquidates.
Washington law provides a default rule that members will receive distributions and allocations of profits and losses in proportion to the amount of capital each member contributed to the company (RCW 25.15.205). (A distribution is something 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 is important to note that Washington LLCs are different than corporations in that no stock is issued generally to owners of LLCs. 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 provided for in an LLC operating agreement.
In drafting economic structures for LLC operating agreements, members should choose the frequency of distributions and the process by which distributions will be made. A common provision may provide that distributions will be made no less frequently than monthly, and that distributions shall be approved by members with more than fifty percent of the agreed value of the contributions made.
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.”
An operating agreement should also detail how profits and losses will be allocated. These allocations will be reflected not only in the actual distributions received by members but also in the members’ tax returns. It may be more beneficial for certain members to receive more losses than other members, but the Internal Revenue Service has issued detailed regulations limiting the extent to which losses can be disproportionately allocated. Perhaps a detailing of these regulations will be the subject of a future post, but for now it is just worth putting on your radar: (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 so as to limit tax liability.