A limited liability company (LLC) is a popular business entity type among budding entrepreneurs and small business owners alike. Aside from offering personal liability protection, it also has fewer administrative requirements. Additionally, it provides flexibility in many aspects.
One of those aspects is the ability of the owner to structure how they will split the profits. The members can choose to allocate profits, but you have to explain in detail the splitting of the profits in the operating agreement of the company.
You also need to make sure you are taxed like a partnership, which means that all the profits of the business are passed through to the members. The company will be taxed with the income taxes of the owners.
Partnerships and Their Contributions
When it comes to partnerships, the incorporation of the business is unnecessary. Dissolving is also not a requirement to end it. Generally, it will keep operating until one or more partners choose to leave the partnership.
In some states, the members of the LLC have the authority to develop a profit allocation agreement. However, every state may have its set of default rules when members do not reach an alternative agreement. In most cases, the company will divide profits and losses based on ownership interests. A partner will receive shares of profits and losses depending on their financial contribution.
For example, partner A has a 50% membership stake. Meanwhile, partner B has 30%, and partner C holds 20%. When you first started the company, each partner contributed an initial amount of money or property. The company should have a record of the fair market value of each of those properties. The initial contribution amount of each partner will determine their capital account in the partnership. For example, percentage of ownership in the partnership.
Splitting the Profits of the Partnership
When it comes to profit splitting, you need to understand two terms, which are allocation and distribution. Some people think that these two concepts are interchangeable, but they are different from one another.
- Allocation is how companies divide profits among the members on paper for tax purposes.
- Distribution is how the business hands out its profits.
To avoid confusion and disagreements, companies should include the details on how the members will divide profits in the operating agreement.
Calculating and Dividing the Losses
When the allowable deductions of a company exceed its gross income, it ends up having a net operating loss. To find out what the total is, you need to prepare an income statement for the partnership.
- Compute the total sales and cost of all sold products.
- Subtract the cost of sold goods from the total sales. Doing this will give you the amount of your gross profit.
- Make sure you include the total amount for each operating expense that you listed on the income statement.
- Subtract the expenses from the gross profit to find out how much the profit of the company is for the year.
- Add the interest that the drawing account of every partner has earned during the year. The drawing account records the amount of money that a partner takes out. When they do this, they reduce their ownership value. The company can charge an interest rate for these withdrawals. These interests will then be considered as additional business income.
- Subtract the salaries, commissions, and interests that are charged on the drawing accounts of every partner.
If the income statement shows that the company expenses exceed its income, then your business has incurred a net loss during the year. You will now have to divide that according to the percentage of contribution of each partner. Make sure the total of the portions for the partners is equal to the total cost of net loss.
To help you out, here is a sample computation:
The formula is net loss multiplied by the percentage. Let’s say that partner A has 50% of profits and losses. Partner B gets 30% and Partner C gets 20%, respectively. If the net loss of the business is $100,000, partner A will get $50,000. The amount of net loss for partner B is $30,000. Meanwhile, partner C will have $20,000.
Figuring Out Partner Liabilities
When the LLC members decide to end the partnership, you have to liquidate the assets of the company so that you can pay off all liabilities. However, if the total liabilities cost more than the assets of the company, the partners will have to pay the remaining unpaid obligations.
To compute the individual contributions for the settlement of net losses, you have to consider the percentage of shares of each partner. In case one of the partners does not pay his obligations, the others will have to share the responsibility for his contribution.