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LLC Allocation vs Distribution
What is the difference between “LLC allocation” and “LLC distribution”?
It’s important to properly differentiate the meaning of allocation and distribution as it relates to limited liability companies as it can have an important consequence on your taxes.
The main reason why you have to differentiate “allocation” and “distribution” for an LLC is primarily caused by the manner LLCs are taxed.
By default, a multi-member LLC is taxed like a partnership where the LLC does not pay taxes as a separate entity.
The LLC income is passed down to the LLC members (the owners) who will report their business income or losses on their personal income taxes.
Since the LLC income passes to the members, it’s important to understand the distinction between LLC allocation and LLC distribution.
Let’s start by defining what is an LLC allocation.
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What Is An LLC Allocation
An LLC allocation provides a way for the LLC members to keep track of their tax liability.
When an LLC is formed, the members will determine how profits and losses will be “allocated” to each member in their operating agreement.
In other words, whether or not the LLC pays any money to its members, the LLC members will be allocated a certain portion of the LLCs profits or losses for tax purposes.
In the end, the LLC member will have to pay taxes on the LLC income that is allocated to him or her (regardless of the fact that the LLC made any distributions to the members).
LLCs must determine the income and loss allocation for each member to avoid running into problems with the IRS.
What Is An LLC Distribution
An LLC distribution refers to cash or property that was actually paid to the LLC members.
When an LLC member gets a distribution, he or she is actually getting something tangible (like cash or an asset).
A member receiving a distribution will not necessarily have to pay taxes on the distribution.
Keep in mind that an LLC has to pass through income and losses to its members no matter if it has made any distributions.
As a result, the members will have paid their taxes on the income generated by the LLC in a given year even if the LLC chooses to keep the funds in the business.
However, if the following year the LLC pays out the profits from prior years, the member will not be taxed on the distribution as he or she had already paid taxes on this amount.
The exception is if the distribution to the member exceeds the member’s tax basis in the LLC.
An LLC does not have the obligation to make distributions unless the members decide to do so as per their operating agreement.
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LLC Allocation vs Distribution Example
Let’s look at an example of how a limited liability company may allocate and distribute profits.
An LLC is required to flow through its income to the members.
Imagine that John, Jack, and Mary own an LLC where they each have ⅓ of the LLC ownership interest.
This year, the LLC generates $300,000 in profits.
The members choose to reinvest the $300,000 back into the business so they can continue scaling their operations.
As a result, the members do not get any profits distributed to them.
However, in the operating agreement, each member is “allocated” ⅓ of the business profits which means that they each have to report $100,000 of profits on their personal income tax even though they did not get any money from the LLC.
Even if the LLC chose to pay each member $10,000 out of their $300,000 profits and reinvest $270,000 back into the business, the members will still pay taxes on $100,000 representing their allocated share of the LLC.
In this case, the $10,000 represents an LLC distribution (a cash payment) and the $100,000 earnings passed to the member represents the allocation of LLC profits.
Takeaways
So there you have it folks!
What is the difference between an LLC allocation and distribution?
An LLC allocation refers to the proportion of the LLC income and losses that will be allocated to each LLC member.
This is the case since LLCs are not recognized as separate legal entities for tax purposes and must flow through their income and losses to the members.
The LLC distribution, just like a partnership distribution, refers to the actual payment made to LLC members in the form of cash or property.
It’s important to properly distinguish between an allocation and distribution in LLCs so each member has a better understanding of his or her tax responsibility.
Now that you know the difference between LLC allocations and distributions, good luck with your research!
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