How are Profits Split in an LLC?

If you’re forming a limited liability company (LLC) with other members, it’s vitally important that you understand how profits and losses are allocated to members. 

An LLC is an increasingly popular business structure for startups, offering liability protection for ownership and greater flexibility than a corporation, particularly in terms of taxes. The LLC itself does not pay taxes. As a “pass-through” entity, income passes through the business to the owner or owners, who report it on their personal tax returns. An LLC is created by filing paperwork with your state, and nominal fees are involved. 

How Profits Are Split

When it comes to profit sharing, LLCs are very flexible. No matter what the ownership structure, you can split profits however you choose. But if you don’t specify a distribution plan in your operating agreement, by default, profits are split based on ownership share. For example, if you own 80% and another member owns 20%, you would get 80% of the profits and the other member 20%. 

You can choose any allocation you like, but again, this must be specified in your operating agreement. An operating agreement is not usually required but is highly recommended. The operating agreement should clearly define the following:

• The percentage of each member’s interests in the LLC
• How profits and losses will be allocated to each member
• Each member’s rights and responsibilities
• The management structure and management roles of members
• The voting rights of each member
• Rules for meetings and voting
• What happens when a member sells their interest, becomes disabled, or dies

It’s a good idea to have an attorney’s help when creating your operating agreement so that you can be sure you’re covering all bases to protect all members and avoid future issues.

When You Must Use Default Allocation

If you have elected to be taxed as a corporation, you cannot change the distribution of profits. Profit allocation must coincide with the ownership percentages.

LLCs are unique in terms of taxation as their owners have a choice about how the company will be taxed. By default, an LLC is taxed like a sole proprietorship if it has one member and a partnership if it has more than one member.

In both cases, business income “passes through” to the members, who report profits and losses on their individual tax returns. The LLC itself is not taxed, which simplifies the process for members. Also, losses and operating costs can be deducted personally by members. Taxes are paid at the personal tax rate of the members, although the owners may also have to pay self-employment taxes. 

Note that a multi-member LLC must also file form 1065 with the IRS, which is the U.S. Return of Partnership Income. Attached to this will be form K-1s for each member showing their share of the business income. 

But LLCs owners can instead choose to be taxed as a corporation. To do so, the LLC must file a document, referred to as an election, with the IRS. The LLC must then decide if it wishes to be taxed as an S corporation or a C corporation.

C-Corp status means profits are taxed at the current rate for corporations (21% as of early 2022), which is significantly lower than the typical individual taxpayer rate. But keep in mind, C-Corp shareholders, which includes members, must also pay taxes on their distributions (but not self-employment taxes). Thus, a C-Corp is subject to what is sometimes referred to as double taxation. 

As with sole proprietorship and partnership status, S-Corp taxation considers the LLC a pass-through entity, which means income passes through the company and into the hands of the owners. At this point, taxes are applied at the same rate as those of individual taxpayers.

S-Corps use Form 1120S to file their taxes, which is used to report the income, losses, and dividends of shareholders. S-Corp shareholders do not pay self-employment taxes, which is the primary advantage of S-Corp status compared to sole proprietorship or partnership. 

Generally, S-Corp tax status is beneficial if the company is profitable enough to pay the owners a salary and at least $10,000 in annual distributions so the owners can be taxed as employees and not pay self-employment taxes. It costs more to run an S-Corp than an LLC due to additional bookkeeping and payroll expenses. Thus, the tax benefits should outweigh the additional costs for S-Corp status to make financial sense. 

Distribution vs. Allocation

Allocation of profits refers to how profits are allocated for tax purposes. Distribution refers to the money that actually goes to the LLC members. All profits do not have to be distributed. Money can be left in the LLC for operating purposes. However, members must pay taxes on all profits, regardless of whether or not they are distributed. 

For example, let’s say your LLC has two members, with one owning 60% and the other 40%, and its annual profit was $10,000. For tax purposes, one member will automatically be allocated $6,000 (60%) and the other $4,000 (40%), and each must pay income tax on those respective totals. But the members also decide not to distribute all of the profit, and instead leave half of it in the business. So one will receive 60% of $5,000, which is $3,000, and the other 40% of $5,000, which is $2,000. 

In Closing

When determining how profits are split in an LLC, it’s important to seek the advice of a tax advisor to figure out what makes sense for the company and for members. It’s also highly recommended that you have an attorney draft your operating agreement to make sure that all bases are covered.