LLC Taxation – Distributive Share I
Distributive share is an important LLC tax concept. It generally determines the share of income earned by the LLC on which you must pay taxes. Distributive share also determines the share of the LLC’s loss that you get to use as an offset to income you earn from other sources.
Distributive Share Does Not Apply to Single Member LLCs
An LLC typically does not pay taxes. Instead, the income, gain, loss, deductions and credits earned by the LLC flows to the individual tax return of each member. The amount of your distributive share should be described in the “allocations” section of your operating agreement. Oddly enough, you probably won’t find the term distributive share mentioned in that, or any other part, of your operating agreement. Instead, it is typically referred to as an allocation.
A member that is the sole owner of the LLC doesn’t need to worry about distributive share. Single member LLCs are automatically taxed by the IRS as a “disregarded entity”, unless the LLC makes a different tax election with the IRS. This means that the income, gain, loss, deductions and credits earned by the LLC flow directly to the member’s individual income tax return (from Schedule C). Any net profit earned by operating the LLC is reported as income on the member’s individual tax return, and the member is personally liable for paying the tax on that amount at the member’s ordinary income tax rate. Likewise, any loss earned by the LLC passes through to the member’s individual income tax return, and the member may use the loss to offset income from other sources, to the extent of the member’s basis in the LLC. (Determining the basis of a member will be discussed in a future article.)
Distributive Share Taxed Even if Not Received
Multi-member LLCs are automatically taxed by the IRS as a partnership, unless the LLC elects to be taxed as an S corporation or as a C corporation. Each member of a multi-member LLC taxed as a partnership is generally liable for paying the income tax on the member’s distributive share of income earned by the LLC, regardless of whether the member actually received the distributive share.
For example, in United States v. Bayse, a group of physicians formed a partnership through which they provided healthcare services in California. The partnership, called Permanente, entered into an agreement with a California health foundation, called Kaiser, in which Permanente agreed to provide certain medical services to Kaiser. Kaiser agreed, as part of its compensation to Permanente, to make payments to a Permanente retirement fund. The U.S. Supreme Court held that each partner physician of Permanente was liable for the income tax due on their respective distributive share of the retirement payments made by Kaiser, even though the physicians had not yet received the retirement benefits. In reaching this decision, the U.S. Supreme Court said that “it is axiomatic that each partner must pay taxes on his distributive share of the partnership’s income without regard to whether that amount is actually distributed to him.”
Substantial Economic Effect
The Treasury regulations don’t tell you how to determine the distributive share of each member. Rather, the regulations state, in a complex manner, the circumstances under which the IRS will not “respect” a distributive share, i.e., watch out. Let’s take a quick look at the regulation, and then we’ll look at some examples of how the regulation is applied.
According to the regulation, if the operating agreement does not provide for the distributive share of a member, or if it does but the distributive share does not have “substantial economic effect”, then the member’s distributive share shall be determined by the facts and circumstances of the situation. Distributive shares provided for in an operating agreement will be respected by the IRS if (i) the distributive share has substantial economic effect, (ii) the distributive share reflects the member’s interest in the LLC, or (iii) special rules apply to the distributive share.
A distributive share will have substantial economic effect if the distributive share has (i) economic effect and if the economic effect of the distributive share is (ii) substantial. A distributive share has economic effect if the operating agreement: (i) provides for the maintenance of capital accounts for the members, (ii) requires that liquidating distributions be made in accordance with the positive balances of each member’s capital account, and (iii) requires each member with a negative capital account balance following a liquidation to restore the amount of such deficit by the end of the taxable year of the liquidation. (A liquidation generally occurs when a member leaves the LLC or when the LLC goes out of business.)
What does all of that mean? Well, first, your operating agreement must require the LLC to establish and maintain a capital account for each member. A capital account is simply a ledger, which can be maintained in an excel spreadsheet for each member. A member’s capital account generally must be increased by the amount of money contributed to the LLC by the member, the fair market value of property contributed to the LLC by the member, and by the amount of income or gain earned by the LLC that is allocated to the member. The capital account must be decreased by the amount of money actually distributed to the member by the LLC, the fair market value of the property distributed to the member by the LLC, and by the amount of the loss and deduction of the LLC allocated to the member. If your operating agreement requires such maintenance of its members’ capital accounts, which any good operating agreement does, then you should be good as to the first element of economic effect.
Under the second element, the operating agreement must require liquidating distributions to be made according to the positive balance of each member’s capital account. For example, if Member A has a positive capital account balance of $50,000 at the time of liquidation and Member B has a positive capital account balance of $20,000, then the operating agreement must require that Member A receive $50,000 upon the liquidation and Member B $20,000. However, if the capital account of a member has a negative balance following a liquidation, the operating agreement must require that the member with the negative capital account balance pay to the LLC an amount equal to the negative balance.
A negative balance can typically occur when deductions are allocated disproportionately to the capital contributions of the members. For example, Member A and Member B both contribute $50,000 to the LLC, but the operating agreement provides that Member A shall be allocated all of the depreciation deductions of the LLC. The LLC purchases equipment worth $100,000, which is depreciated at the rate of $20,000 per year. Member A decides to withdraw from the LLC at the end of year 3. Assuming no additional contributions or gains, Member A’s capital account balance at the end of year 3 will equal negative $10,000 ($50,000 contribution minus $60,000 in deductions). The distributive share of Member A will not have “economic effect” unless the operating agreement requires Member A to pay the deficit amount, in this case $10,000, to the LLC upon the liquidation of his membership interest. If the operating agreement does not include this requirement, then the IRS will find that the distributive share lacks economic effect and disregard it.
As mentioned above, the concept of “substantial economic effect” as related to distributive share has two components: (i) economic effect, which is discussed above, and (ii) substantiality, which will be discussed in Part II.
The information provided in this article is general in nature, and it is not intended as legal advice. Your circumstances may be unique, and you should therefore consult knowledgeable legal counsel about how the information or concepts discussed in this article might apply to you or your business.
Michael Sewell has a MBA and JD, numerous years of high level business experience with multi-billion dollar corporations, and he has practiced law in Missouri since 2005. Michael Sewell is the owner of Sewell Law, LC, which provides litigation and other legal services to businesses.
Feel free to contact Michael at 314.261.7528 for a free consultation. michael@stlouisllcattorney.com; www.stlouisllcattorney.com.
This article was published on March 14, 2015.
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