LLC Profit Distributions

[Puglife]

I set up an LLC with 6 other people, and we all have unequal contributions. For the profit distribution, we were going divide it between the members based off the capital contributions, but then a huge problem came up. Their was a major in balance of work being done. Those with the most interest are doing the least amount of work, but are getting a significantly higher percentage of the money. I did research, and they said that you can set up your operating agreement to account for inactive members, and I was wondering, Can we change our percentages every year, based on the work done by each member done, and do this right before the taxes are due, so that people do not lose their incentive to work? Do the percentages have to be set in stone? Is their another way to pay the members of a LLC without having to do it via percentages?

Another somewhat related question is does all the money your company makes have to be paid out to the members at the end of the year, so it can be taxed, or can it go into a company fund, like a reserve fund, without it needing to be taxed first, or run through the members taxes?

[Owen]

I set up an LLC with 6 other people, and we all have unequal contributions. For the profit distribution, we were going divide it between the members based off the capital contributions, but then a huge problem came up. Their was a major in balance of work being done. Those with the most interest are doing the least amount of work, but are getting a significantly higher percentage of the money. I did research, and they said that you can set up your operating agreement to account for inactive members, and I was wondering, Can we change our percentages every year, based on the work done by each member done, and do this right before the taxes are due, so that people do not lose their incentive to work? Do the percentages have to be set in stone? Is their another way to pay the members of a LLC without having to do it via percentages?

Another somewhat related question is does all the money your company makes have to be paid out to the members at the end of the year, so it can be taxed, or can it go into a company fund, like a reserve fund, without it needing to be taxed first, or run through the members taxes?

When you set up a company, it doesn't matter how much "work they do". If they invested more money, it doesn't matter if they do nothing, they're there to invest and receive money from the operation. If you decide to compensate people at the end of the year, you're going to run into issues. Some people may feel misrepresented and if the money is high enough, that's how you end up in court. If you don't like that they're doing nothing and making more money than you, invest more money and start owning more of the company. If you invest more money into the company, they'll have no reason to argue the fact you own more. Imagine it like this: A muscular guy has obviously put more work into the gym than you. He's obviously going to have more chicks than you, the guy who goes for an hour a day maybe 3 days a week.

[BizAdvisor]

*What state is your LLC located? For the most part, the roles of each member as well as the method in which each member is compensated; i.e. percentage, salary, wage... is all up to the members, as agreed upon and written in the operation agreement. An operation agreement can be amended at anytime, *though rules for amending the agreement may differ depending on state.

A bottom line; reserve fund, company fund... Whatever you wish to call it, is created when profit exceeds expenses (including payroll). If each member receives payment that equals 100% of the company's earnings, there is no bottom line. This is why it's important to not confuse percentage of ownership with percentage of compensation a member receives.

[Evan]

I set up an LLC with 6 other people, and we all have unequal contributions. For the profit distribution, we were going divide it between the members based off the capital contributions, but then a huge problem came up. Their was a major in balance of work being done. Those with the most interest are doing the least amount of work, but are getting a significantly higher percentage of the money. I did research, and they said that you can set up your operating agreement to account for inactive members, and I was wondering, Can we change our percentages every year, based on the work done by each member done, and do this right before the taxes are due, so that people do not lose their incentive to work? Do the percentages have to be set in stone? Is their another way to pay the members of a LLC without having to do it via percentages?

Even if the percentages of compensation vary from year to year, the formula for determining it should be relatively fixed. As long as the LLC is disregarded and taxed as a partnership and not an LLC, you can split the profits however you want. Quite frankly though, if they chalked up more in cash, they should get a higher percentage. At the same time, you should also be compensating those working the hours for the profits -- satisfying both of your problems.

What the partners who are active should be doing is taking the partnership term for a salary -- guaranteed payments. For tax purposes, it's considered an "expense" of the business in terms of figuring out net income that is then further split. For the individual partner/members, the guaranteed payment is subject to self-employment taxes in addition to any other profits earned.

So let's assume we earned $100K before any of the partners paid themselves. We allocate according to capital contributions, and for simplicity, we're using an 80/10/10 split and assuming just 3 partners. Two 10% partners are who do all the work. By taking a $30K guaranteed payment for those two partners who are putting in the sweat labor, amounts that you'd want to make sure everyone agrees on, the net income we split is based on $40K. So partner A gets 80% of $40K, B gets 10% of $40K and C gets 10% of $40K. In addition, B and C end up reporting the additional $30K of guaranteed payments. For tax purposes, A is taxed on $32,000 ($40K x 80%), B and C are each taxed on $34,000 ($40K x 10%, plus the $30K of guaranteed payments).

Had you just split it before guaranteed payments, and it's sounding like you're complaining about is currently the split now would be $80K, $10K, $10K, and B and C aren't happy with it, while A may think everything is okay.


Another somewhat related question is does all the money your company makes have to be paid out to the members at the end of the year, so it can be taxed, or can it go into a company fund, like a reserve fund, without it needing to be taxed first, or run through the members taxes?
None of it is paid out unless you decide to pay it out via a guaranteed payment OR if a member withdraws from their capital account. So using the example above, at year-end, you'd allocate the net income $32K, $4K, and $4K to A, B, and C respectively, and that gets "added" to their capital account with other contributions. They can't (or shouldn't) be withdrawing more than they've contributed and earned. You do run into basis issues if everything is distributed, and that's where it can get a bit more convoluted. Get a good tax CPA, I wouldn't do this alone.

[Puglife]

We are located in Maryland. So can we pay our members salaried? and as for the reserve fund, I want to make this clear, the members do not need to receive 100% of the companies earnings, they can receive an amount deemed by someone in the company, as long as they are getting their percentages that are granted by the operating agreement.

[Puglife]

I am actually the majority interest owner, I own about 3 times more than anyone else, thats not the issue. The issue is that the members in our company, are upset that they are working every day from 9 to 5, even on weekends, while someone with a hire percentage then them is doing nothing, and is not active at all in the company, and still making more than them. I am nearly certain that this will cause more court issues than if we were to determine the amount people got paid based on members being active or inactive. Is their any way we could do it?

[Fulcrum]

The issue is that the members in our company, are upset that they are working every day from 9 to 5, even on weekends, while someone with a hire percentage then them is doing nothing, and is not active at all in the company, and still making more than them ... Is their any way we could do it?

You need to sit down with all the partners and figure this out earlier than last week.

As I understand this, it appears that every member has forgotten about wages/salary and instead confused it with ownership interest. You can get away with this as a one man show to a certain extent, but in a multi member ownership structure you need to clearly define payment for services performed.

If you're working 40 hours per week than set a reasonable ($20ish?) wage and either payout on a regular basis or bank the time until payouts can be made. No one gets to take a profit/distribution until all banked wages get paid, all high risk debts are paid off, and there is a reasonable cash reserve in the operating account.

If you have silent members that oppose this idea, than buy them out and get rid of them. Odds are they will only cause you trouble down the road.

[Evan]

We are located in Maryland. So can we pay our members salaried?

No, partners do not take salaries, they take a guaranteed payment. The difference is that there are NO taxes withheld and they are solely responsible for making estimated tax payments on that amount. So if they take out $1K, they should likely be saving about 40% for self-employment and income taxes, plus perhaps more for the income they have that isn't guaranteed payments.


and as for the reserve fund, I want to make this clear, the members do not need to receive 100% of the companies earnings, they can receive an amount deemed by someone in the company, as long as they are getting their percentages that are granted by the operating agreement.

There are no "reserve funds" in an LLC. All income is allocated to the membership accounts at year-end. I'm unaware of any companies that pay 100% of a company's net earnings, as that's not practical.

[Puglife]

you kind of just said, what I am understanding is contradictory information. You said that their are no reserve funds in a llc, which by its own definition, is all money after operating costs, that is not distributed amounst owners, but instead put asside for later expansion. You then said that All income is allocated to the membership accounts at the end of the year, but that companies do not pay out 100% of their earnings. I agree with it not being practical, its a horrible idea to, but if all income is allocated to the members, and their is no reserve funds, which is by definition the funding set aside for later expansion, then how is it that not 100% of the companies net earning is paid out?

I thank all of you for your help, I just need to get this down.

[tallen]

The LLC is a pass-through entity, meaning that regardless of whether the company actually pays out 100% of net earnings to its members, the members still must pay taxes on their share of the company's earnings.

Example -- company with three members, A=45%, B=35%, C=20% shares;net earnings for the year $200,000. Company only pays out $100,000, retaining the other $100,000 in company accounts. Member A receives a payout of $45,000, Member B gets $35,000, and Member C $20,000. But Member A pays taxes on $90,000, Member B is taxed on $70,000, and Member C pays taxes on $40,000 -

So yes, all income is allocated to the members according to their share -- for taxation purposes. That does not mean that all income necessarily must actually be paid out to the members... The members own the company, according to their share, which includes retained earnings.

[Puglife]

Thank you so much for the clarification, if I have any more questions, i will post them on the forums. Thank you all for your input.

[Owen]

The issue is that the members in our company, are upset that they are working every day from 9 to 5, even on weekends, while someone with a hire percentage then them is doing nothing, and is not active at all in the company, and still making more than them.

Welcome to business.

[Evan]

you kind of just said, what I am understanding is contradictory information. You said that their are no reserve funds in a llc, which by its own definition, is all money after operating costs, that is not distributed amounst owners, but instead put asside for later expansion. You then said that All income is allocated to the membership accounts at the end of the year, but that companies do not pay out 100% of their earnings. I agree with it not being practical, its a horrible idea to, but if all income is allocated to the members, and their is no reserve funds, which is by definition the funding set aside for later expansion, then how is it that not 100% of the companies net earning is paid out?

I thank all of you for your help, I just need to get this down.

It's not contradictory information. "Reserve funds" is not any terminology used by for-profit businesses. You have income and expenses, and net income at year-end that is retained is allocated to the capital accounts of the members. None of that has to be distributed. It's equity. You need to know what each member respectively has equity wise because if I was to sell, you need to know what my equity balance is internally. Capital accounts increase for contributions, increase for earnings allocated to you, and decrease for withdrawals and losses allocated to you.