How to manage LLC capital contributions and distributions?

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Members of an LLC are depending on capital contributions, i.e. the amount of capital or assets provided by one of the members to the business. The profit is basically distributed on the terms between all the members of LLC are agreed, according to the Operating Agreement

Following are some key issues for you to consider to receive and distribute capital for your LLC.

How to manage LLC Profit Distributions?

A reason to set up LLCs: to make money. In some cases the return can be in compensation in terms of wages or capital gains from a sale or other disposition; however, most of the time distributions usually indicate how LLC members realize the return on their investment. The distribution provisions are found in the LLC Operating Agreement. Such distributions can be prorated by investment capital, prorated by interest ownership, or distributed based on more complicated formulas.

Distributions are divided into two categories:

1) Tax income or loss and

2) Money paid to the member from the LLC.

How income and distributions are taxed?

In the first category, the LLC lacks pass-through tax status. In a sole member LLC owned by an individual, by default, the LLC's income and expenses are not recorded on a separate tax return. The sole member LLC is overlooked for tax purposes. The tax distributions from the LLC are recorded on the member's IRS Form 1040 Schedule C as self-employment income.

Even if a dividend is paid by the LLC to its members in cash, but keeps the fund for cash-flow or reinvestment purposes, the income still shows on the income taxes of the member. It results in phantom income, a tax liability for income which is not received. Generally, LLC agreements try to resolve this issue by requiring the LLC to distribute to its members a sufficient amount of cash distribution to pay the tax liability on the deemed distribution.

However, LLCs are allowed to make check-the-box elections for S-corp or C-corp tax treatment, neither of those two corporation tax elections is advisable for real estate ownership. To lower the effective rate of tax from purchase to sale, real estate should be held through an LLC that has not made a corporate tax election.

One of the benefits of the partnership tax treatment of an LLC is that distributions can be made disproportionate to ownership. In other terms, irrespective of capital contributions, a distribution provision can be added to permit the members who can use the tax losses more than others, to receive those first, then share the profits on another basis. This is a part of the flexibility of the LLC's Operating Agreement structure.

How does an LLC owner pay himself?

Operating Agreements often provide that where members make capital contributions that are not proportionate to their percentage ownership interests, the members contributing additional amounts will receive a return, known as a preferred return, on their additional contributions, that will be distributed to them before payments are made to the members on a pro-rata basis. In addition to receiving a preferred return on their excess capital, they can get a return of their excess capital before other distributions.

Operating Agreements have separate provisions regarding distributions of operating cash flow and distributions of proceeds of capital transactions i.e. a sale or financing. The distribution priorities can be different for different categories.

How to manage LLC capital Contributions?

Members need to contribute capital to an LLC in the amounts they agree to contribute, at the specified times in the Operating Agreement. An agreement to contribute may be enforced by the company by the law. Some statutes permit a creditor to enforce the obligation if the creditor relied on it in extending credit to the company.

Like any business enterprise, an LLC can have unexpected or unquantifiable requirements for capital in the coming years. To the extent the members wish that future capital needs are satisfied by lending from third party lenders, that preference can be set out in the Operating Agreement, that may contain provisions covering how much can be borrowed, who makes the decision (or who has a right to consent to it), and how the terms of the loan will be determined. In any situation, an Operating Agreement must cover how additional capital requirements will be satisfied when third party sources are not available or desirable on acceptable terms. An Operating Agreement can be provided for additional required capital contributions if the company needs additional funds.

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