Tuesday, September 16, 2008

Dividing LLC Profits and Losses On Other Than A Straight Percentage Basis

Question from Ali: "I want to form an LLC and I'll own 95% and a friend 5%. However when we take a contract - Profit won't be split like that. In fact, it'll fluctuate depending on time contributed. We want to avoid doing payroll taxes but will get a EIN for the purpose of getting a bank account, etc.

1) Can an LLC (Delaware) pay "members" who do work through a 1099?

2) Can profit be taken in and split on an arbitrary basis?

What's the best way to outsource work (if we cannot use a 1099) to a "member" and what about a non-member?

Thanks - it'd be a big help!"

I generally eschew blogging about tax issues but I'll make a few comments here. In responding, I'll assume your LLC plans to elect partnership tax treatment (as opposed to the rare election to be treated as a corporation). The term "payroll taxes" generally refers to both federal income tax withholding done by employers and FICA taxes reported on IRS form 941 along with the state / local equivalents of the 941. When an LLC pays members, it is generally treated as one of two things: (a) a capital withdrawal or (b) a member loan (or repayment of a loan). Put another way, payments to members are not wages. At the end of the year, the LLC files a federal form 1065. Each member of the LLC receives a K-1 from the LLC as part of the LLC form 1065 that allocates LLC income-loss between the two members. Each member, in turn, reports that income or loss on his (or her) individual income tax return (IRS form 1040). As part of the individual 1040 return, income allocated to the member from the LLC is subject to self-employment tax which equals FICA paid by employers. The members are required to pay estimated tax to the federal government upon the expected income from the LLC.

"Can (LLC) profit be taken in and split on an arbitrary basis?"

I think arbitrary is not the word you meant here. I assume you are asking whether LLC income-loss can be allocated between the members in other than a straight percentage arrangement. The answer is "yes", formulas are allowed. LLCs are allowed to allocated the profits between the members in any fashion they desire so long as the formula has "substantial economic effect" (or at least this was the case when I last studied partnership taxation almost 20 years ago). A discussion of what that means is well beyond the scope of a short blog post. Getting back to the division of profits and losses, you can have a formula or I have even seen agreements that delegated division of profits and losses to a compensation committee. These sorts of arrangements are most often found in professional services LLCs. The operating agreements for PLLCs are a complicated matter. What you have described is not an easy thing to draft.

I think you would be well advised to sit down with a tax accountant to get a thorough understanding of how the LLC you envision will work from a tax standpoint. Also, the agreement on division of profits will, by necessity, be difficult to draft. Advice of legal counsel is highly recommended.

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