Taxing the Division of Profits

April 13, 2006

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How taxable allocations of income and interests are figured depends on a number of factors when strategically funding the business.

Limited liability company (LLC) owners typically divide profits based on the relative capital accounts of the owners. Subchapter S corporation owners divide profits based on relative number of shares owned. However, the number of shares owned is determined by the relative capital contributed by the owners. Hence, in both cases, the relative amounts credited to each owner for his or her contribution will control the division of profits.

Note that, even in the LLC, the relative amounts credited will translate into the issuance of ownership interests. These ownership interests may be termed shares. Division of profits can then be made according to the relative number of shares owned in the LLC, which will be the same as the relative balance of the capital accounts.

Voting rights in the LLC also are usually dictated by the relative capital accounts of the owners, or the relative number of shares owned, which is based on the relative capital accounts. Voting in the corporation is usually on a per share basis and is unaffected by the ratio. However, relative capital account contributions will, again, dictate how many shares each owner will be issued.

Unfortunately, the issue left open by many small business owners is which capital accounts are to be used in making these assessments: the capital accounts based on the tax basis of the owner's equity interest or the capital accounts based on the fair market value of the owner's equity interest. The differences can be significant.

Usually it makes more sense to use the fair market value of the owner's equity interest for each owner, as this is the true representation of what each owner contributed.

However, since for tax purposes, records must be maintained based on the tax basis of the owner's equity interest, it is generally easier to simply base assessments on these figures. In short, using the fair market value of the owner's equity interest usually provides a fairer result, but this requires that a separate record for the capital accounts be created and maintained. For this reason, some businesses make all assessments based on the tax basis figures.

For income allocation purposes, the best approach is usually to record interests within the accounting system based on the fair market value of the owner's equity interest. The agreement among the owners then must clearly specify that profit-sharing and voting (in the LLC) are to be based on this measure. As discussed above, determinations based on fair market value provide a much more equitable result.

For tax purposes, a separate record of the capital accounts based on the tax basis of the owner's equity interest is then maintained outside the accounting system.

Alternatively, the owners could record the tax basis in the accounting records. This is not desirable because the accounting system does not reflect the true economic effect of the contribution.

Clearly, the tax implications of funding decisions can be complicated, and extend beyond the immediate tax consequences, at least in certain cases.

A Sample Operating Agreement for a Delaware LLC appears in the Business Tools section. You should not attempt to use this form without first understanding all of the implications and alternatives available, and having it reviewed by an attorney. In other words, the small business owner should use the sample agreement as a guide and have it adapted to suit his particular needs.