A contribution is an amount of money that you deposit into your business. A distribution is a withdrawal of funds from your business.
LLC Contributions & Distributions
You can easily lose track of where your responsibilities lie in an LLC since there are few restrictions on the member status of LLC companies. In fact, when a member of the LLC makes a contribution, you should know what its ownership will entail in the long run.
Who are the Owners of an LLC?
The owners of an LLC company are known as members. In fact, an LLC member is any person who has contributed capital to the company. An LLC company can be owned by one individual or many. On the other hand, an LLC can be owned by any other organization including another LLC, a corporation, or a holding company. There is no restriction on the number of members an LLC company can have or their citizenship and country. The only limitation placed on an LLC member is he or she should be over 18 years old.
What Counts as a Capital Contribution?
A capital contribution is really an investment that an LLC company member makes in the LLC company. Each member of the company will make a capital contribution to cover the start-up expenses when an LLC company is formed. The contribution can be for any amount. In fact, the capital contribution is made in the form of cash, property, or services. If you plan to make a non-cash contribution, you should determine the market value of the property or service before you decide to contribute to the company. You should also set up a capital account for each member for their contributions.
Types of Capital Contributions
There are 3 main types of capital contributions to your LLC company such as debt investments, equity investments, and convertible debt.
Equity investment – The investor will contribute funds to your LLC in exchange for a stake in your newly formed LLC when you receive an equity investment. Equity investments don’t need to be repaid. Hence, they are an attractive funding option for your new LLC company. You will be giving a part of your LLC’s earnings to the investor while bringing in well-qualified partners who can help grow your business.
Debt investment – Debt investment is a loan you accept simply to start up your business and get it running. It is considered the most common form of capital for new businesses. The owner of the business will set an interest rate and a time frame for repayment of the loan when choosing debt investors. You need some sort of collateral to back up your loan when seeking debt investment. Even though you can get a loan without collateral, it may limit the amount of money you are able to secure for your LLC company.
Convertible debt – Convertible debt is probably a combination of the above-mentioned options. If you agree on convertible debt, you are accepting a loan while agreeing to repay the loan or convert it into equity at some point in time in the future. Most business owners offer a discount of 20-25% when the loan is converted to equity. For example, a $1-million investment can potentially yield $1.25-million worth of equity at the time of conversion.
Capital Contributions and Ownership Details
If you make an equity investment into an LLC company, you become an owner or member of the company. In fact, an LLC member has rights to the profits and losses of the company. They also can vote on member resolutions and have a series of other rights and responsibilities as stated in the LLC’s operating agreement. In fact, the operating agreement will outline each member’s contribution, profit allocation, percentage of ownership, and what will happen to him/her if he/she decides to leave the LLC.
Percentage of Ownership
Each member’s percentage of ownership in an LLC company is known as a unit. While each member’s percentage of ownership in the LLC is based on how much capital he or she contributes, it isn’t required. In fact, unlike a corporation, an LLC company can allocate membership in any way it prefers.
Members of an LLC should consider a number of factors other than capital contributions. These factors include the role each member plays in running the company and more. An LLC company will establish numerous classes of ownership to shape voting rights or profit allocation. All these decisions should be laid out in the operating agreement of the LLC.
There are two main choices when deciding the structure of an LLC company: manager-managed and member-managed. In a member-managed LLC, the members of the company will play an active role in the business and act as agents of the company.
On the other hand, in a manager-managed LLC company, members will appoint a manager to operate the business as well as act as an agent of the LLC. The role of the manager can be given to one or more members of the LLC or a third party. The third-party manager can be a corporation or another LLC depending on the state regulations.
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Profits are usually allocated at the end of the LLC’s fiscal year in multi-member LLC companies. Ownership percentage is considered the default method of determining profit allocation. If a particular member has a 25% ownership interest, he or she will be allocated 25% of the profits of the company at the end of the fiscal year. This method of allocation is not a legal norm in the state. In fact, LLC members can choose a different method of allocating LLC profits. For example, in case an LLC accepts cash & service contributions, LLC members can decide to pay out a higher percentage of profits to the cash contributors of the company until their money is repaid. As the LLC grows, members can make changes to how its profits are allocated.
Member Exit Procedure
LLCs spend a lot of time pinning down the details of membership rights and responsibilities. While it is perfectly fine to pay attention to membership rights, it is also important to lay out the procedure involved when an LLC member wishes to exit the company. There are basically three techniques of withdrawing from an LLC company, which are usually addressed in the operating agreement of the company.
Membership transfer – The operating agreement can allow a departing member to transfer all or part of his/her membership to another member of the company.
Membership sale – You can also provide for the sale of an LLC membership stake to another member/members of the company or other individuals or companies. The current members are given the right of first refusal before the sale should be open to external buyers. The operating agreement of the LLC will outline the requirements for membership sales.
Death or incapacitation – Lastly, every LLC operating agreement should state what happens if a member becomes incapacitated or dies. It should include how the incapacitated member’s ownership interest will be distributed or if it will be inherited through the particular member’s estate. Even though the process for withdrawing from an LLC company varies, a withdrawing member is required to:
- Review the LLC’s operating agreement
- Provide written notice to the other members of the LLC citing the applicable provisions of the operating agreement he or she is following.
- State desired compensation and how it will be distributed.
- Provide the date and time of withdrawal.
- Request a vote from the other members of the LLC in order to approve the withdrawal.
- Accept the compensation.
- Sign a release confirming that he or she has received proper compensation.
When and How Can I Take Out Money?
How and when a member of an LLC could take money out of the business will depend on how the business chooses to be taxed. In fact, an LLC company can be taxed as a partnership, an S corporation, a sole proprietorship, or a C corporation.
Sole proprietorship/partnership – This is considered the default tax setting for an LLC company. Each member of the company will accept distributions from their individual capital accounts rather than taking a salary. These are the accounts where individual members’ portion of business profits is held. The operating agreement will reveal how much and how often funds could be withdrawn from the company. The owners of single-member LLC companies can easily make withdrawals as they seem fit. But they need to leave enough money in the business to cover day-to-day operations. No federal or state taxes are deducted since these distributions ate not considered paychecks. But all distributions will be considered personal income and be reported on the personal tax return of each member. All these earnings are subject to state, federal, and self-employment tax at the time of filing.
C Corporation – If you elect to be taxed as a C corporation, LLC members can be hired as employees and paid a reasonable salary according to industry standards. Business income paid out as a salary is usually deductible for corporate tax purposes. But any payout beyond this salary is taxed as dividends.
S Corporation – An S corporation allows LLC company members to be paid as employees of the LLC company – who will receive a reasonable salary subject to all employment and payroll taxes. Any additional dividends paid to members are subject to pass-through taxation rather than corporate taxation. It means that employees will report all dividend earnings on their personal tax returns. But they won’t be required to pay additional corporate taxes or self-employment taxes on this income.
The taxation structure and payment method your LLC chooses depends on which option provides the best benefits to your company. It can be a complicated decision and should be made under the advice of a tax professional.