An entrepreneur who was trying to prepare a limited liability company (LLC) Operating Agreement on his own (apparently using someone else’s as a template) was puzzled by the concept of “sharing losses”. I could tell right away that he was not familiar with two fundamental concepts of LLC accounting: Allocations vs. distributions.
Before going further, I need to make two disclaimers:
- This post is not about taxes.
- The following discussion is extremely simple, addressing only the most basic considerations. One of the great things about LLCs is that the members can agree to make allocations and distributions in any way they desire to meet their business needs. As a result, LLC accounting can be far more complex than the following might suggest.
Each member has a capital account that represents his equity in the LLC. At the time he becomes a member, he makes a capital contribution (cash or property) to the LLC. The value of that contribution becomes the value of his capital account.
Over time, as the LLC operates, profits and losses are allocated to members. Profit allocations increase members’ capital accounts; loss allocations decrease capital accounts.
If the LLC has available cash (or other property), it may make a distribution to members. The value of the distribution reduces each member’s capital account.
Example: Assume that A is one of two members of an LLC. Assume, further, that the Operating Agreement specifies that the members will make equal capital contributions and will receive equal allocations and distributions. The following describes LLC accounting that could apply.
- If A’s initial capital contribution is $25,000, then his capital account will have a value of $25,000.
- If the LLC has a loss of $100,000 during the first year, then one-half of that amount ($50,000) will be allocated to each member at the end of that year, and A’s capital account will have a value of -$25,000.
- If the LLC has a profit of $200,000 during the second year, then one-half of that amount ($100,000) will be allocated to each member at the end of that year, and A’s capital account will have a value of $75,000.
- If the LLC has $50,000 available cash to distribute, then one-half of that distribution ($25,000) will go to A, and his capital account will have a value of $50,000.
Dana H. Shultz, Attorney at Law +1 510 547-0545 dana [at] danashultz [dot] com
This blog does not provide legal advice and does not create an attorney-client relationship. If you need legal advice, please contact a lawyer directly.