LLC Operating Agreement Tax Terms: Allocations and Distributions

Do you need an LLC operating agreement for taxes?

Federal tax law does not require a written operating agreement. For tax purposes the partnership agreement can be oral or written, and where it is silent, local law is treated as part of it (IRS: Publication 541). Whether you must sign one is a state-law question:

• New York requires the members of an LLC to adopt a written operating agreement before, at, or within 90 days after filing the articles of organization. It is kept internally, not filed with the Department of State, and the law is silent on what happens if members never adopt one (New York Department of State).
• Delaware accepts an LLC agreement that is written, oral or implied (Delaware Code, title 6, chapter 18).
• Other states set their own rules; check your state's LLC statute.

The tax clauses matter most when the LLC has two or more members and is taxed as a partnership, the default for a domestic LLC with at least two members (IRS: LLC). The agreement then decides each member's share on the Schedule K-1 (26 USC 704). These are the tax clauses to check:

A case is not simple when members put in unequal money or property, a member contributes property worth more or less than its tax basis, one member works while another funds, the LLC has made or plans an S election, a member lives outside the US, or the members want to change a year's split after the year has ended. Gather the articles of organization, the current agreement and every amendment, each member's contributions with dates and agreed values, distributions to date, any tax election and the IRS acceptance letter, and past Forms 1065 and K-1s. A lawyer drafts the agreement; a tax adviser reviews the tax clauses before members sign.

Single-member LLC operating agreement: which tax terms matter?

A single-member LLC needs few tax terms while it is a disregarded entity. By default the IRS treats it as part of its owner: its activity goes on the owner's return, with no K-1 and no allocations (IRS: single-member LLCs). State law may still require an agreement, as New York's does.

Three events bring tax terms into play:

• A corporate tax election. The LLC files Form 8832 to be taxed as a corporation (IRS: LLC), or Form 2553 for S status, which treats an eligible entity as a corporation without a separate Form 8832 (IRS: Form 2553 instructions). After an S election, the agreement's distribution and liquidation terms must fit the S corporation one-class-of-stock rule: every unit carries identical distribution and liquidation rights.
• A second member. With two members, the LLC is a partnership for tax unless it has elected corporate treatment (IRS: LLC). If it will be a partnership, rewrite the agreement with partnership tax clauses before the new member joins; see adding a member to your LLC.
• A spouse as co-owner. See spouse and family LLCs.

Multi-member LLC operating agreement: how does it decide each member's K-1 share?

The agreement's allocation sets each member's K-1 share if the allocation has substantial economic effect. If the agreement says nothing about an item, or the allocation lacks substantial economic effect, the share follows the member's interest in the partnership, judged on all facts and circumstances (26 USC 704; 26 CFR 1.704-1).

• Economic effect means the member who gets a tax allocation also receives the matching economic benefit or bears the matching burden. The regulation's test looks to the capital account terms in the next section.
• Substantial means a reasonable chance that the allocation substantially changes the dollars members actually receive, apart from tax. An allocation fails if, when adopted, it may leave at least one member better off after tax while it is strongly likely that no member ends up substantially worse off after tax.

The Form 1065 instructions allow special allocations, where members share specific items in a ratio different from their general profit split (IRS: Form 1065 instructions). An agreement where every item, cash distribution and liquidation payment follows one ratio leaves less to test than one where a single item, or cash, follows a different ratio.

Members can change the agreement for a tax year after the year ends, but only until the partnership return's due date, not counting extensions, and only with every member's agreement or by the method the agreement itself sets (26 USC 761; IRS: Publication 541). When a member joins or leaves mid-year, separate rules divide that year; see adding a member to your LLC.

What are capital accounts, and what should the agreement say about them?

A capital account is each member's running economic stake in the LLC. It rises with money contributed, the fair market value of property contributed (net of debt the LLC takes on) and income allocated; it falls with money and property distributed and losses allocated (26 CFR 1.704-1).

To meet the regulation's economic effect test, the agreement provides, for the LLC's whole life:

1. Capital accounts kept under the regulation's rules.
2. Liquidating distributions paid by positive capital account balances.
3. Either a deficit restoration obligation (a member must pay in a negative capital account balance on liquidation), or, under the regulation's alternate test, a qualified income offset (income is allocated to wipe out an unexpected negative balance). Which one fits is a drafting choice for the lawyer and tax adviser.

When a member contributes property whose value differs from its tax basis, section 704(c) requires the tax items from that property to account for the difference (26 USC 704). Record the agreed value of every contribution in the agreement or the LLC's records.

The K-1 reports capital on a tax basis, so it can differ from the agreement's capital accounts (IRS: Form 1065 instructions); for the entries, see partner capital accounts.

What is a tax distribution clause, and why add one?

A tax distribution clause makes the LLC pay members cash toward the tax on income allocated to them. Partners owe tax on their share of partnership income whether or not it is distributed (IRS: Form 1065 instructions), so without the clause a member can owe tax on profit the LLC keeps. No tax rule requires the clause; it is a contract term.

The clause should state:

• the assumed tax rate, and whether one rate applies to every member;
• whether earlier allocated losses reduce the income the formula uses;
• when payments are made, for example ahead of the quarterly estimated tax dates;
• whether a tax distribution is an advance against the member's later distributions;
• whether a state pass-through entity tax the LLC pays counts toward each member's tax distribution;
• what happens when cash is short or a lender limits payouts.

Like any distribution, a tax distribution lowers the receiving member's capital account (26 CFR 1.704-1). For investor terms, see raising money as an LLC. In an LLC taxed as an S corporation, a tax distribution formula that differs by member can be treated as a second class of stock and put the election at risk.

How should the agreement pay a working member?

The agreement can pay a working member a guaranteed payment, an amount set without regard to the LLC's income, or a larger share of profit. The LLC generally deducts a guaranteed payment and the member reports it as ordinary income, even in a year when the LLC shows a loss; a larger profit share pays only if there is profit (26 USC 707; 26 CFR 1.707-1). State the amount, the timing and whether it is paid in a loss year. To choose the split, see splitting ownership between LLC partners; for the books, see guaranteed payments vs partner draws.

Who is the partnership representative, and can the agreement limit that power?

The partnership representative is the one person with sole authority to act for the LLC in an IRS partnership audit; the LLC and every member are bound by that person's actions and by a final decision (26 USC 6223). Unless the LLC elects out of the audit regime, it names a representative on each year's Form 1065. The representative, or the individual who acts for an entity representative, needs a substantial presence in the US: a US taxpayer identification number, a US street address, a US phone number, and availability to meet the IRS in person in the US (IRS: Form 1065 instructions). A member living abroad may not qualify.

An LLC that must issue 100 or fewer Schedule K-1s for the year (an S corporation member's shareholders count too), with every member of a permitted type, may elect out each year on a timely filed Form 1065 with Schedule B-2, and must notify each member within 30 days of electing. A partnership, trust or disregarded single-member LLC as a member rules it out (26 USC 6221; IRS: Form 1065 instructions). The agreement can direct whether the LLC elects out when it qualifies, and who sends the notice; for the audit itself, see how partnerships are taxed.

The agreement cannot narrow the representative's authority as the IRS sees it: a representative's failure to follow state law or the partnership agreement has no effect on it (26 CFR 301.6223-2). It can set duties among members:

• who serves each year and how members replace that person; the LLC may revoke a designation and name a successor on Form 8979, but generally only after the IRS opens an examination or with an administrative adjustment request (26 CFR 301.6223-1; IRS: Form 1065 instructions);
• prompt notice to members of IRS contact, and member consent before the representative settles, extends the audit period or makes an election;
• who bears an audit bill. The partnership pays an imputed underpayment in a later year (the adjustment year), not the year audited (26 USC 6225), so current members can bear tax on a past year's income unless the LLC elects, within 45 days after the notice of final partnership adjustment, to push the adjustments out to that year's members (26 USC 6226; IRS: BBA audit regime). If the LLC does not pay within 10 days of the IRS's notice and demand, the IRS may assess each member as of the end of the adjustment year (or the former members, if the LLC has ended) for that member's share, with higher interest (26 USC 6232);
• whether former members must cooperate and pay their share.

LLC operating agreement taxed as an S corporation: which terms cause trouble?

An S corporation may have only one class of stock: every share must carry identical rights to distribution and liquidation proceeds, though voting rights may differ (26 CFR 1.1361-1). Those rights are read from the governing provisions, which include binding agreements on distribution and liquidation proceeds, so an LLC that elects S status needs its operating agreement checked against the rule. A company that stops meeting the S corporation requirements loses its election from that date, though relief may be available when the IRS finds the termination inadvertent (26 USC 1362).

State tax the company pays or withholds for some owners, and payouts that differ in timing or amount, follow their own rules (26 CFR 1.1361-1), covered with unequal payouts already made in S corporation disproportionate distributions. A tax distribution clause that pays the same amount per unit does not by itself make rights differ; the rest of the agreement still has to give every unit identical rights.

If the agreement has any of these terms, change them before the election takes effect. For an LLC taxed as a partnership, the election is treated as the partnership putting all its assets into a corporation for stock and then liquidating, which ends the partnership on the effective date, so a final Form 1065 can be due (26 CFR 301.7701-3; IRS: Form 1065 instructions). From then on, shares follow units held per day, not the agreement's allocation and capital account clauses. Form 2553 is due no more than 2 months and 15 days after the start of the tax year it is to take effect, or during the year before (IRS: Form 2553 instructions). For the election itself, see should you elect S corporation status.

What happens with no signed operating agreement, or one that is silent?

State default rules fill the gap. For tax purposes the partnership agreement includes oral agreements and the state law that governs the LLC (26 CFR 1.704-1; IRS: Publication 541). Delaware, for example, divides profits, losses and distributions by the agreed value of each member's contributions, as stated in the LLC's records, when the agreement is silent (Delaware Code, title 6, chapter 18). Other states use their own defaults.

Where nothing settles an item, or the result lacks substantial economic effect, each member's share follows their interest in the partnership, weighed on factors that include (26 CFR 1.704-1):

• relative contributions;
• interests in economic profit and loss;
• interests in cash flow and other non-liquidating distributions;
• rights to capital on liquidation.

The hard part is proof. Bank records, messages and past K-1s become the evidence, and members may remember the deal differently. A written agreement signed now sets terms going forward; a change counts for a past year's allocations only if made by that year's original return due date (26 USC 761). For how the shares reach each member's return, see how partnerships are taxed.

Example

These examples are illustrative; figures are in US dollars.

A 60/40 LLC keeps its profit

Two members own an LLC 60/40. It earns $100,000 and keeps the cash. The K-1s show $60,000 and $40,000 of income, and each member owes tax on that share with no cash received. A tax distribution clause at an assumed 40% rate pays $24,000 and $16,000, the same 60/40 ratio as the income.

One member works full time

The agreement gives the working member a $50,000 guaranteed payment, then splits the remaining profit or loss 50/50. The LLC earns $100,000 before that payment. It deducts the $50,000 and splits the other $50,000: the working member reports the $50,000 guaranteed payment plus a $25,000 share, $75,000 in all; the other member reports $25,000. Had the LLC earned $40,000, the working member would still report the $50,000 guaranteed payment, and the $10,000 loss would be split $5,000 each, deductible only within each member's basis in the LLC and the at-risk, passive activity and excess business loss limits (IRS: Schedule K-1 instructions).

An S corporation LLC with a tax gross-up clause

Two equal members' LLC elected S status but kept a clause paying one member an extra $3,000 a year because her state income tax is higher. That clause adjusts distributions for state tax burdens, the case the regulation treats as a second class of stock, which puts the election at risk. Replacing it with a clause paying the same amount per unit fixes the terms going forward but does not by itself repair the years already affected: the election may have ended or never taken effect (26 USC 1362), and S corporation disproportionate distributions covers the relief.

Different for you?

• Members put in unequal money, property or work: see splitting ownership between LLC partners and have the allocation and capital account clauses reviewed with corporate tax help.
• The LLC has elected, or plans to elect, S status: see should you elect S corporation status and S corporation disproportionate distributions, and get corporate tax help before the next distribution.
• You are adding a member or buying one out: see adding a member to your LLC and buying out a partner, and have the amended tax clauses reviewed with corporate tax help.
• Investors want units or a SAFE: see raising money as an LLC.
• The members are spouses or family: see spouse and family LLCs.
• A member lives outside the US: see an LLC owned by two non-residents and foreign partners' withholding, and get cross-border tax help; the partnership representative needs a substantial US presence.
• Past K-1s do not match the deal, or an IRS audit letter arrived: see how partnerships are taxed and get corporate tax help.
• The books need to match the agreement: see partner capital accounts and guaranteed payments vs partner draws, or have bookkeeping keep capital accounts and payments the way the agreement reads.