Economic issues when forming an LLC

Editor: Sheila Owen, CPA

A review of a limited liability company's (LLC's) organizational documents should address the LLC's relationship with its members, its operations, its capital structure, its management structure, tax issues, and the following economic issues. 

Compensation for capital


If the organizers of an LLC decide to pay interest on members' capital, the operating agreement should set the interest rate to be paid or provide a formula for computing the interest rate (for example, 2% over prime). When an interest rate is tied to an index, such as prime, the operating agreement should specify the index to be used (e.g., the prime index of First State Bank).

When setting the rate, the organizers should consider the opportunities for other investment, the risk associated with the LLC's operations, and the likelihood capital will be tied up for an extended period. If the articles and operating agreement permit the contribution of noncash assets, the agreement should specify how such contributions will be valued, establishing the amount on which interest will be computed and paid. When capital contributions can be made throughout the year, the agreement should include a provision that interest starts to accrue on the date the contribution is made. The agreement should also address how and when distributions reduce the amount of capital on which interest is accrued.

Compensation for services

If members will render services to the LLC, the operating agreement should provide that the LLC can compensate the members for services rendered. Any limits the organizers want to impose on the amount or timing of compensation should also be included. If member compensation is based on a standard or formula, such as hours worked or revenues generated, the terms and method used to determine the compensation should be spelled out in the agreement.

Allocation of income and loss


Many state statutes default to an allocation of income or loss based on capital. For many closely held businesses, this may be an appropriate allocation mechanism. However, if the organizers want to allocate operating income or losses in some other way or provide for special allocations of particular items (such as depreciation), the operating agreement should include provisions that govern the allocation of income and loss among the members. Any special allocations of gain or loss on the disposition of LLC assets also need to be included in the operating agreement.

Note: Many operating agreements do not distinguish allocations and distributions of income and cash flow from operations and from other transactions (e.g., a refinance of a commercial building). However, in many instances it is advisable to address in greater detail and sophistication the allocation and distribution of different types of cash flow. Practitioners should help ensure that the provisions are reasonable, coordinated with any separate definition sections of the agreement, and are carefully tailored to the particular transaction.

The income and loss allocations in most operating agreements for LLCs classified as partnerships will closely mirror those traditionally appearing in partnership agreements. Under Sec. 704(b), allocations to members must either be made in accordance with the members' interest in the LLC or have substantial economic effect. Generally, these rules are intended to ensure any allocations of tax items to the members reflect the economic substance of the members' relationship.

Since most LLCs are formed to provide limited liability for members, it is unlikely that a member would agree to restore a deficit capital account. Safe-harbor rules provide that certain allocations to members with no deficit capital account restoration obligation can still have substantial economic effect. To have substantial economic effect in such cases, the operating agreement must contain a qualified income offset. A qualified income offset requires the LLC to allocate gross income or gain to any member who has a deficit capital account in order to eliminate that deficit as quickly as possible. Drafting the appropriate provisions is a complex task, and the penalty for improper drafting is the reallocation of the income or loss by the IRS upon examination. Practitioners should review a qualified income offset provision carefully to make sure it complies with the Sec. 704 regulations.

Income and loss allocations for LLCs electing corporate classification and making a Subchapter S election are made under the rules applicable to S corporations (generally, the per-share, per-day rule). If the allocations for an LLC classified as an S corporation are not on a per-share, per-day basis, the S election could be lost. The income and loss of LLCs classified as C corporations or disregarded entities is not subject to allocation.

The operating agreement should address all possible allocation issues, not just the general income or loss allocation. Major controversies over the allocation of items such as cancellation-of-indebtedness income, capital gain or loss, and alternative minimum tax adjustments and preferences can all be avoided if the allocation of these items is included in the operating agreement. While an overall allocation of income and loss can arguably cover these items, specific provisions may better reflect the members' intent.

Compliance with the Regs. Sec. 1.704-2(e) safe harbor for the allocation of nonrecourse deductions requires that the operating agreement or articles of organization contain a minimum gain chargeback provision. LLCs that will be classified as partnerships should consider including this type of provision in the operating agreement.

It is especially important to define all of the terms used in describing the allocation of income and loss in the operating agreement. For example, in Imprimis Investors, LLC, 83 Fed. Cl. 46 (2008), a disagreement between two members about the meaning of the term "ordinary income" ended up in court when that term was not specifically described in the operating agreement. The issue was whether short-term capital gains were part of a special allocation of ordinary income.

If the LLC permits the assignment of members' interests, the operating agreement should specify whether the assignor or assignee will receive the income or loss allocation for the period after the assignment. This is crucial when the statute is unclear or when the LLC does not want the statutory default provisions to apply.

Distributions


Under many state LLC statutes, an LLC is not required to make distributions until it dissolves. These statutes also provide that distributions, if made, are to be made on the basis of members' unreturned capital contributions. If the members choose to make distributions on any other basis, the operating agreement should specify when distributions will be made and how they will be allocated.

Timing of distributions

Since an LLC has no statutory requirement in many states to make distributions, organizers must include a provision requiring predissolution distributions in the operating agreement if such distributions are desired. The operating agreement can provide that distributions are permitted only when certain events occur, such as upon the sale of assets or at the retirement of a member. Alternatively, distributions can be permitted at the discretion of the members or managers or on a more regular basis, such as annually or quarterly.

Giving the members no right of distribution or providing a manager with unfettered discretion to withhold distributions can prevent a transfer of the interest from being a present interest and thus make it ineligible for the gift tax annual exclusion (IRS Technical Advice Memorandum 9751003). One way to limit this problem is to provide the managers with broad authority to retain funds for operating needs, reserves for capital additions, and reserves for future contingencies before making distributions, but not allow the managers unfettered discretion to withhold distributions.

The organizers must decide whether they want required or discretionary distribution provisions. While logic says requiring distributions may be dangerous to the LLC's continued health, it is also arguably unfair to pass income through to the members without providing them with cash to pay the taxes on that income. If this is a problem, the organizers might consider including a tax distribution clause that requires the LLC to make a distribution prior to April 15 each year to fund the members' tax liabilities resulting from allocations of LLC income.

Given the disparity between the tax status of members and the possibility that some members may themselves be passthrough entities, corporations, or not-for-profits, many LLCs compute the tax distribution at the highest combined federal and state tax rates. Normally, the state tax rate used is that of the state of formation. However, tax distributions may run afoul of bank loan requirements, which frequently limit allowable distributions. Accordingly, this issue should be thoroughly discussed with the lender prior to executing any loan documents.

Amount of distribution

The operating agreement may provide for distributions of a specific amount or distributions based on a formula or a percentage of income. For example, the agreement may provide for a $10,000 distribution to the members each year or for a distribution upon the sale of LLC assets equal to 75% of the net sales proceeds (after payment of appropriate liabilities). Distributions that are expected to provide a return on capital may be drafted as distributions equal to a specific percentage of unreturned member capital.

Whatever the method for computing the distribution, the practitioner should ensure all of the terms used in the allocation formula are clearly defined in the agreement. For example, how are net sales proceeds or unreturned capital defined? If distributions are made based on members' unreturned capital, not only should the term "unreturned capital" be defined, but the agreement should provide a date on which the computation of unreturned capital will be made. The organizers may also want to limit members' ability to make capital contributions immediately before the computation date.

Noncash distributions

Under many state LLC statutes, members have no right to demand or receive distributions in kind (noncash distributions). Members may be required, however, to accept an in-kind distribution of their pro rata share of each LLC asset. If the LLC's organizers want the power to make noncash distributions to members (which might be the case when distributions of a specific dollar amount are required each year), a provision permitting such distributions should be included in the articles of organization or operating agreement (if allowed under the statute). If noncash distributions are allowed, the method for determining the value of the distributed property should be included in the operating agreement.

Distributions resulting in the LLC's insolvency

Many states prohibit distributions if the LLC would be insolvent after the distribution. When such a prohibition exists, the statutory remedy for making a prohibited distribution is usually either to require the members to return the excess distribution, or to hold the members or managers who authorized the distribution liable for the excess. When this is a concern, the organizers should consider some similar limitation in the operating agreement.

Since some state statutes allow alternative remedies for prohibited distributions, the operating agreement should specify which ones the LLC elects to use. Furthermore, the agreement should include some limited indemnification for managers or members who make such distributions in good faith but unintentionally or unknowingly violate the statutory limits on distributions. Since creditors are likely to argue any distribution or payment, even one that compensates a member for services, should be repaid, the agreement should clearly specify that payments for compensation are not distribution equivalents.

Members' rights to distributions

Many state LLC statutes grant creditor status to members once a distribution has been declared. The member can sue the LLC for payment or take other legal steps to collect the distribution, including levying on the LLC's assets. This type of provision can have some significant advantages for members, as well as some disadvantages. The primary advantage is that it gives the members some priority for payment, assuming the distribution does not render the LLC insolvent.

On the other hand, granting creditor status to members for declared distributions can create problems for the LLC when assignments of interests are permitted. Since assignees would also be entitled to creditor status, the LLC could be forced to make a distribution as declared, even if the other members were willing to wait or even forgo the declared distribution for valid business purposes.

Furthermore, if the LLC refused to make the distribution, all of the creditor remedies available under state law would be available to the assignee. These remedies include liens, levies, and garnishments. Similar problems arise when the statute permits a creditor to obtain a charging order or similar lien on a member's right to distributions. Whether the creditor status of a member can be changed by agreement is questionable, particularly when a creditor of a member or an assignee holds the right to distributions.

This case study has been adapted from PPC's Guide to Limited Liability Companies, 25th edition (October 2019), by Michael E. Mares, Sara S. McMurrian, Stephen E. Pascarella II, and Gregory A. Porcaro. Published by Thomson Reuters/Tax & Accounting, Carrollton, Texas, 2019 (800-431-9025; tax.thomsonreuters.com).

 

Contributor

Sheila Owen, CPA, is a senior technical editor with Thomson Reuters Checkpoint. For more information about this column, contact thetaxadviser@aicpa.org.

 

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