Getting Paid: How Your Operating Agreement Governs Payments to Owners
This is the fourth in a series of blog posts geared towards small business owners outlining the importance of Operating Agreements and explaining the components. To view other blogs in this series, click here.
If you’re an owner in a multi-member limited liability company (“LLC”), it’s important for you to understand what your Operating Agreement says about when and how much you as an owner get paid.
As explained in the prior blogs in this series, the Operating Agreement is the law of your LLC. It acts as a legally binding contract among the members (owners) of LLC, providing a clear framework for financial and operational decisions.
How Operating Agreements Dictate Profit and Loss Distribution
The Operating Agreement should outline the specific methods and formulas used to distribute the business’ profits and losses among its members. Without this agreement, many states' default rules apply, which typically require distributions to be made in proportion to each member's ownership percentage, regardless of their individual contributions or responsibilities. This can lead to fairness issues and disputes.
Key Provisions to Include
To avoid ambiguity, your Operating Agreement should address these key aspects of profit and loss distribution:
- Capital Contributions: This section details the initial and any subsequent investments made by each member. These contributions are the basis for calculating ownership percentages and, often, how profits and losses are allocated.
- Allocations: This is the core of the distribution section. It explains how the business's profits and losses are divided for tax purposes. These allocations don't necessarily mean cash is being distributed; they are a bookkeeping entry used to assign the company's taxable income or loss to each member's personal tax return.
- Distributions: This provision outlines when and how actual cash (or other assets) will be paid out to members. It's important to distinguish between allocations (for tax purposes) and distributions (for cash payouts). Distributions can be made regularly (e.g., quarterly) or based on a specific event, like reaching a certain profit target. The agreement can also specify if distributions are mandatory or if they require a majority vote.
- Draws vs. Distributions: A draw is an advance on a member's share of future profits. It's often taken to cover personal expenses or to give the owners some reliable income throughout the fiscal year. Distributions are formal payouts of profits. Your Operating Agreement can clarify the rules for taking draws to prevent disputes.
The Importance of a Custom Agreement
Creating a custom Operating Agreement tailored to your business is a proactive step that protects all parties. Here are some of the benefits:
- Tailored Allocation: You can design a distribution model that aligns with the members' contributions, not just their initial capital. For instance, a member who contributes more labor or expertise could receive a larger share of profits, even if their initial financial investment was smaller.
- Dispute Prevention: A well-drafted agreement reduces the likelihood of future conflicts. Everyone knows what to expect regarding their share of the business's financial performance.
- Clarity on Tax Implications: The agreement provides clear instructions for your accountant on how to allocate income and expenses, simplifying tax filings and reducing the risk of IRS scrutiny.
- Flexibility: It allows the business to retain profits for growth or reinvestment rather than being forced to distribute them, which is a common default rule in the absence of an Operating Agreement.
In conclusion, your Operating Agreement is more than just a legal formality; it's a strategic document that sets the financial and operational stage for your business. For small business owners, taking the time to draft a clear and comprehensive agreement is an investment in the long-term health and stability of the company and the relationships between its owners.
If need legal assistance regarding your LLC’s Operating Agreement, please contact Danielle Dietrich, Esq. at ddietrich@potomaclaw.com or 412-449-9141.
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