LLCs are a popular choice of business structure for small business owners. LLCs combine the benefits of asset protection (like a corporation) with the flexibility of a partnership. For example, owners of LLCs have the flexibility to enter into agreements that dictate how profits and losses are allocated to best suit their business model.
In this article, we explore how profits are split in an LLC, plus other profit allocation and distribution related questions.
How are profits divided amongst the owners of an LLC?
LLCs have significant flexibility around profit allocation. LLC owners, also known as members, can allocate profits and losses in direct proportion to their ownership stake or percentage interest. They can also distribute profits in different proportions to owners – this is known as a special allocation.
A special allocation* is typically granted to an LLC shareholder or members who made a significant initial investment by giving them a higher profit share than their percentage ownership allocation.
How profits are divided and distributed among members is outlined in the LLC operating agreement. If you do not have a signed operating agreement, your LLC is governed by the default rules of the state(s) in which you operate. Generally, the default rule stipulates that members must share income distributions equally, no matter how much capital each party contributed.
*Note: For a special allocation to be legitimate, the IRS checks whether it has "substantial economic effect. To make sure that the allocation of income, losses, deductions, and credits among partners isn't just an artificial arrangement for tax purposes, but reflects a genuine economic arrangement between them, the IRS applies the principle of substantial economic effect. Regardless of what your operating agreement says, if the IRS denies your special allocation, it will tax you and your co-owners as though you had split profits and losses proportionately to ownership interests.
Profit allocation vs. profit distribution
What is the difference between profit allocation and profit distribution?
- Profit allocation: If your LLC is treated as a partnership for tax purposes, profit allocation refers to how the profits and losses are divided among LLC members.
- Profit distribution: Distributions are the disbursement of cash or property earned by the LLC that is then paid to the LLC’s owners.
Allocation of profits to an LLC member (owner) does not necessarily imply the receipt of any distribution of funds or property by the member. Because members are subject to taxation even if they do not receive any distributions from the LLC (a problem that is usually referred to as “phantom income”), they will generally prefer to get regular tax distributions from the LLC to cover their tax liabilities.
Profit allocation and profit distribution provisions should be addressed in the LLC operating agreement.
How does LLC profit allocation differ to S corp profit allocation?
S corporations differ from LLCs in that they have no flexibility in allocating income and deductions.
An S corporation cannot issue different classes of stock with different financial rights – for example, making some shareholders eligible for distributions before others. An S corporation shareholder receives profits and losses in proportion to their ownership (e.g., a 50% owner receives 50% profits), whereas profits and losses can be distributed disproportionately among LLC owners.
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