If you’re reading this, you probably encountered the terms “allocation” and “distribution” in your LLC operating agreement and spent longer than you care to admit trying to parse the difference between them. Here’s a quick and easy primer to help.
The reason why this allocation/distribution issue exists is because of how most LLCs are taxed. The default tax treatment of a multi-member LLC is as a partnership. Income for an LLC taxed as a partnership is not subject to a tax at the LLC level. Instead, this income “passes through” the LLC and is taxed to the owners.
This creates a need for the owners of the LLC to decide how to split up these tax responsibilities. The mechanism for doing this is the allocation process.
Allocations are a tool to help the owners of the LLC track their tax obligations. When your LLC operating agreement says that a certain percentage of the profits and losses of the LLC will be allocated to you as a member, that doesn’t mean you’re entitled to be paid that amount by the LLC—instead, it means that’s the amount you’ll be responsible for paying taxes on to the IRS.
Wait a minute, you might be thinking. Don’t I just pay taxes on what I’m paid from the LLC? Well, no.
As an LLC owner, have to pay taxes on the share of LLC income that’s allocated to you—regardless of whether you actually receive this money in the form of a…wait for it…distribution.
Distributions are the cash or property earned by the LLC that’s actually paid out to the owners of the LLC. A distribution gives you something tangible, something satisfying. It’s money that’s going into your bank account as an owner. And just to be clear, you are not taxed on distributions (unless the distributions exceed your tax basis in the LLC). Remember, you’ve already had an amount allocated to you as an owner on which you must pay taxes; whether or not you receive a distribution has no impact on that.
Note: “Tax basis” refers to the amount of money a person has invested in an asset.
Unlike allocations, which must be done to keep the IRS happy, distributions are not mandatory, unless the owners of the LLC agree to make them mandatory. This can lead to problems if the owners have sizable tax burdens from LLC income that’s been allocated to them but no money in the form of distributions to help pay these taxes. This problem even has its own name: The Phantom Income Problem.
Related: The Phantom Income Problem
You should be getting help from an attorney in structuring LLC allocation and distribution provisions, so don’t feel overly emboldened by your new knowledge here. The key for most business owners is simply to understand the basic difference between allocations and distributions. Your attorney can help you get the details right.