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I am the majority member of a 2-member LLC.  Ownership is currently split 67/33.  Over the past 3 years, we have not distributed any earnings or paid ourselves anything (except amounts to cover taxes) but have left all earnings in the company's capital account.  I've allowed the other member to earn equity each year he has worked.  At this point, we are putting in the same amount of hours each month, but the difference is that I have a full-time job and he does not.  The LLC takes up time for him and prevents him from earning income from other jobs.

We are discussing ways to potentially distribute earnings to him beginning next year.  Since we both put in the same amount of work, it doesn't seem fair to pay earnings to him but not myself.  However, I'm not in need of the money and would rather leave the money in the company so it can continue to grow.  What would be the most common way(s) to handle this?

Some possibilities we have discussed:

1. Distribute earnings to him and not myself.  To balance things out, his equity in the company would be decreased proportionally to the amount that is paid to him, depending on the company's valuation.
2. Distribute equal earnings to both of us, but keep my portion within the company.  I would be paid interest on this money by the LLC since I'm essentially "loaning" the money back to the company that would have been paid to me.
3. Distribute earnings to him and not myself.  These earnings would decrease his capital contribution amount and could potentially put it into the negative.  From what I understand, if we ever sold the company, this difference between our capital contribution amounts (mine would be much more) would be deducted from his portion of the sale proceeds and given to me.  Or, we could "settle up" at a future time when the company is generating more revenue by paying myself the amount he was paid up to that point.
4. Distribute equal earnings to both of us in cash (not very ideal because it could hurt the company's capital and ability to continue doing business).

Dear Coolguy982

Your desire to meet a business objective in the LLC is apparent. However, LLC'sare governed by the IRC partnership provisions and the operating agreement.  You have indicated that the sharing ratios are 67/33 but you want to distribute either 100/0 or 50/50. This is inconsisent with the partnership provisions unless you have provided for a "special Allocation". This is a unique concept for partnerships which provides for flexibility in this form of entity.  You also, surmised that if you allocate all of the profit to the minority partner he would create a negative capital account. This may or may not be the case. In calculating the partner capital account, the earning are a plus and the cash distribution are a negative so they generally washout.  The risk you run is that if the IRS reallocates the profit you would have phanton income and your partner would then have a negative capital account to the extent of the reallocated income.

The partnership provision are one of the most complex in the Code.  To achieve your objective, you may have to modify your operating agreement to reflect a special allocation or interest on capital.

I have a website that you can sign up for a 20-30 minute free consultation since this is a topic that requires a dialogue beyiond an email. tHe site is www.businessconsultingnow.com

Mike Janicki

The jan Consulting group