General Practice, Solo & Small Firm DivisionMagazine
Allocations and Distributions in Partnerships and LLCs
BY ROBERT R. KEATINGE
© American Bar Association. All rights reserved. Robert Keatinge practices law in Denver, Colorado. Many of the ideas (although none of the mistakes) in this article are attributable to Steven G. Frost of Chapman & Cutler in Chicago.
New legislation and reforms in the tax rules have made unincorporated organizations such as partnerships and limited liability companies (LLCs) attractive forms in which to organize small businesses. It is now possible for a business to be organized as an unincorporated entity in which none of the owners is individually liable for the obligations of the organization, while not being subject to the disadvantages of corporate taxation.
A lawyer who organizes a partnership, LLC, or other unincorporated business organization needs to understand the economic concepts on which such an organization operates. (In this article, the term "organization" includes all forms of unincorporated business organization and "owner" includes owners in general and limited partnerships and members of limited liability companies.) The principal economic concept is the "capital account," which is determined by reference to "contributions," "distributions," and "allocations" of profits and losses.
Ignoring the economic concepts as incomprehensible tax boilerplate is a mistake because the economic structure of an organization controls not only taxes but also how the owners share in the economic results of the organization.
Subsequent Contributions, Surprising Consequences
Let’s say that A and B form an LLC, with each contributing $100 and each of them sharing equally in profits and losses. Immediately after the contribution, each has a capital account of $100. The LLC is very successful, and after a year the assets of the organization have appreciated and are worth $1,000. Because $800 has not yet been recognized (normally appreciation and depreciation are not recognized until there is a disposition of the property), no profits have been allocated, and A and B each continue to have a capital account of $100.
If A and B decide to admit C as a new member for a one-third membership interest in the LLC (i.e., one-third each of the profits, losses, and capital of the LLC immediately after the contribution), C should pay $500 for his interest (so that he has one-third of the total value of the capital of the LLC or $1,500, which consists of the $1,000 of value that A and B had before C’s admission and C’s contribution of $500). After C’s contribution, the capital accounts in the LLC are $100 for A, $100 for B, and $500 for C. If the property is sold for its fair market value, the $800 gain ($1,000 fair market value of the property of the LLC before C’s admission less the $200 reflected in the capital accounts of A and B) is allocated, with A, B, and C each getting a third. As a result, the capital accounts of A and B are $367 each ($100 original capital account increased by one-third of $1,000) and the capital account of C is 767 ($500 original capital account increased by one-third of $800).
But this may not be the result that the members anticipated. The members may have expected that each of the members would have an equal one-third interest in the organization, so that upon liquidation, each would receive a distribution of $500. In order to achieve this result, the owners may agree to "book up" their capital accounts at the time a new member is admitted by revaluing the property of the LLC to fair market value and allocating the amounts of profits and losses to their capital accounts immediately before a new member is admitted.
In this case, the property of the LLC would have been revalued to fair market value; as a result, the capital accounts of A and B would have been increased to $500, and A, B, and C would have had equal capital accounts after the contribution. If the members’ capital accounts are equal, the members will share equally in the proceeds on liquidation. The Economics of Partnerships and LLCs
To understand the economic structure of unincorporated organizations, it is helpful to consider them in comparison with corporations. In a simple corporation, each share of stock is economically indistinguishable from any other share, and regardless of the consideration paid for the share of stock, will entitle its shareholder to the same distributions; and on liquidation of the corporation, to a proportionate share of the distribution on liquidation based on the number shares outstanding at that time.
In contrast, in an unincorporated organization each owner has a unique capital account. An owner’s capital account is the amount of the owner’s contribution increased by the amount of money and the fair market value of property contributed by the owner to the organization and the owner’s share of income and decreased by interim distributions to the owner and the owner’s share of losses. Most partnership agreements and operating agreements provide that upon liquidation of the organization, each owner will receive an amount equal to the owner’s capital account (generally increased or decreased by the owner’s share of unrecognized appreciation or depreciation in the value of the organization’s assets at the time of dissolution). As a result of the capital structure, economic rights in an unincorporated organization are more complicated than those of a shareholder because the economic rights of each owner are determined by reference to that owner’s contributions, distributions, and allocations of profit and loss.
The economic value of an owner’s interest in an organization is based on the distributions of cash and property that an owner will receive from the organization. Distributions consist of liquidating distributions, which are transfers of money and property from the organization to the owner in liquidation of the owner’s interest in the organization, and interim distributions, which are all other transfers of money and property to an owner as owner.
The amount of distributions each owner will receive is determined under the partnership agreement (or, in the case of an LLC, the operating agreement or limited liability company agreement), which is the agreement of all the owners regarding the operation of the organization. In most cases, the partnership agreement will provide that each owner’s distributions, particularly liquidating distributions, will be made in accordance with the owner’s capital account.
The relationship among these terms may be reflected in the following simple formulas:
1. Capital account = Contributions + Owner’s Share of Profits - Owner’s Share of Losses - Interim Distributions
Each owner has a unique capital account. When all profits and losses of the organization are taken into consideration, the capital accounts of all the owners equal the capital of the organization. While the owners’ respective capital accounts may be used to determine the owners’ voting rights or rights to share profits and losses of the organization, in many organizations both voting and profit and loss sharing is determined in other ways, such as by a separate voting percentage or "units" held by the owners that are not necessarily based on capital accounts. In most organizations, however, the capital accounts do determine the manner in which liquidating distributions are shared. Thus, at the time of distribution, the appropriate formula is:
2. Liquidating Distributions = Capital Account + Owner’s Share of Unrealized Profits - Owner’s Share of Unrealized Losses
In other words, on liquidation of the organization, the final amount is divided among the owners in proportion to the owners’ respective capital accounts. Thus, although capital accounts may be simply a matter of book entry while the organization is operating, at the conclusion of the organization they have economic consequences on liquidation.
Each of the components of the definition of a capital account has its own definition. An owner’s contribution to the organization includes transfers of money and property made by the organization in the owner’s capacity as an owner. It does not include money or property lent or leased to the organization by an owner as a creditor or landlord of the organization . Ordinarily, capital accounts will not include the value of services or reflect promised future contributions until the contributions are actually made.
A distribution, whether an interim or liquidating distribution, is a transfer of money or property to an owner on account of the owner’s interest in the organization. Distributions reflect the actual money or property being transferred from the organization to the owner. Money paid by the organization to the owner as a landlord or creditor are not distributions.
The times at which interim distributions are made will depend on the organization agreement, subject to the limitation in many statutes that a distribution cannot be made when the distribution would render the organization insolvent. The agreement governing the organization may name any interim distribution scheme the owners desire. There are several common arrangements:
1. Tax distributions. Because the income of an organization is taxed to the owners, many agreements require the organization to make distributions sufficient to pay the taxes on the income that the owners are required to report. This provision can be as simple as requiring that there be an annual distribution to each owner equal to a specified percentage of the taxable income allocated to that owner or as complicated as to require consideration of the marginal tax bracket of each owner, whether the owner has been allocated losses in the past, and whether the owner’s distributive share is ordinary income or capital gain.
2. Guaranteed payments and "draws." At times, an organization, particularly one in which the owners provide services to the organization, will provide for regular distributions of cash similar to the wages that would be paid to an employee. Such regular distributions may be characterized as "draws" or advances against the owner’s share of the profits of the organization or may be absolute distributions. If they are draws or advances, they will be subject to adjustment at the end of the year when the owner’s share of profits is determined. It should be noted that owners are not considered employees of the organization for federal tax purposes.
3. Preferred distributions. An owner may put money or property into an organization either as a contribution to capital or as a loan. If an owner has lent money to the organization in a bona fide loan, the owner will be treated as a creditor and repayments will not be considered distributions to the owner as an owner. Often an owner will contribute capital to the organization as an equity contribution, but will want to be assured that the owner will have a preference with respect to distributions until the owner has gotten her equity back, sometimes with a percentage return on the equity.
4. Other interim distributions. Most organization agreements provide rules for determining when interim distributions will be made and how the distributions will be shared. Interim distribution may be made in proportion to capital accounts, in the same manner as the profits and losses are allocated, or in any other regime the owners can imagine. Most statutes do not set forth rules with respect to when interim distributions should be made, leaving the determination of when, or if, distributions will be made before the liquidation of the organization. Many statutes provide rules for how the distributions will be shared if the organization agreement does not provide an alternative rule, often decreeing that distributions will be shared in the same manner as the profits of the organization.
5. Liquidating distributions. Organization agreements and most statutes provide for the assets of the organization to be distributed on liquidation in proportion to the owners’ capital accounts or the owners’ positive capital accounts. Generally, on liquidation the unrealized profits and losses in the assets of the organization are realized (either by agreement or through sale of the assets). Those profits and losses are allocated among the owners, increasing and decreasing capital accounts before the liquidating distribution.
Allocations of profits and losses. Unlike distributions, which are actual transfers of money or property to the owner, the allocation of the profits and losses are bookkeeping entries that alter the capital account. As noted above, the changes in the capital account will be reflected in liquidating distributions, and, sometimes, in interim distributions. The agreement among the owners may allocate the profits and losses among the members in any manner that they desire, but the allocations will not be respected for tax purposes unless the allocation actually determines the amount of money that the owners will get on liquidation.
Special Circumstances and Operations
One of the benefits of the contractual flexibility is that the owners may agree to financial relationships that fit their objectives. Often, the relationships take advantage of the fact that interests in capital accounts are not necessarily the same as the manner in which profits and losses are allocated.
Subsequent contributions. When the owners make initial contributions at the formation of the organization, the initial capital accounts reflect the fair market value of the property contributed. Thus, if the organization were liquidated before it had any profits or losses, each owner would get back an amount equal to the value of that owner’s initial capital contribution. As profits and losses increase or decrease capital accounts, the profits and losses are allocated in accordance with the agreement so that when the organization is liquidated, the amounts distributed to each owner would continue to reflect the owners’ agreement.
A surprising result can occur if the property of the organization has appreciated or depreciated and the organization has other unrealized gains or losses at the time a new owner is admitted that have not been reflected in the existing owners’ capital accounts. Because the new owner will share in profits and losses realized after the new owner’s admission, her capital account may not reflect her expectations (see "Subsequent Contributions, Surprising Consequences").
"Profits interest." At times the organization will want to grant a new owner an interest in future profits without giving that owner a current capital account. Such an interest is sometimes referred to as a "profits interest."
As a general rule, when a person receives property of any kind, including stock or interests in an organization, for services, the recipient is required to include the fair market value of that property in income unless the property is subject to a risk of forfeiture (such as an obligation to sell the property back to the person from whom it was received for less than fair market value). It is possible to avoid the current recognition of income by giving a service provider a profits interest.
A person who receives a profits interest in an organization in exchange for services rendered to the organization should be able to avoid being taxed on the receipt of the interest. Of course, like other owners, the owner will be required to include her share of income and deduction from the organization in determining taxable income.
On the day an owner is admitted with a profits interest, the owner has a capital account of zero. In other words, the value of the other owners’ capital accounts should equal the value of all of the organization assets. After admission, the owner with a profits interest will share in profits and losses; that share will increase or decrease the owner’s capital account like the other owners, so that after a period of time an owner with a profits interest will have a capital account that reflects the profits and losses incurred after his admission.
Preferred distributions. It is not uncommon to provide in an agreement that an owner who has made a large contribution will be entitled to a return of that contribution (sometimes with an interest-like return) before the owners otherwise share in distributions. To accomplish that result, the agreement should provide for preferred distributions to the contributing owner until that owner has received distributions equal to the amount contributed, and if agreed, the appropriate return (see "Preferred Distributions, Payback for Owner").
The bottom line: In analyzing the allocation provisions, it may be useful to crunch the numbers and determine what would happen to capital accounts under a variety of scenarios.
The tax rules applicable to organizations can be bewilderingly complex, but are generally designed to accomplish a single objective: to cause the taxation to follow the actual economics of the arrangement. One hundred percent of the taxable income and deductions will be allocated among the owners. Because an organization does not pay tax in its own right, all of the income, deductions, gain, loss, and credits of the organization must be allocated to the owners. The tax allocation rules do not create or reduce income or deductions; they simply determine how those items will be allocated among the owners.
Preferred Distributions, Payback for Owner
Partner D contributes $1,000 to a partnership while partner E contributes nothing, and the partners agree that until D has received distributions of $1,000 and 10 percent per annum on the $1,000, E will not receive any distributions, and thereafter the partners will share distributions equally. The provision of the partnership agreement dealing with distributions will be fairly straightforward.
The provision dealing with allocation of profits and losses will be a bit more complicated. A common error in drafting the profit allocation provisions is to allocate the first $1,000 (plus an amount equal to the 10 percent return) of profits to D. If the partnership agreement has such a provision and the partnership has profits of $1,000 in the first year, all profits would be allocated to D, and D would have a capital account of $2,000 (the $1,000 initial contribution plus the $1,000 of profits allocated to D) and E would have a capital account of zero. If the partnership were to liquidate, all $2,000 would be distributed to D and nothing would be distributed to E.
E would be surprised at this result because E expects to receive $450 (one-half of the profits less one-half of the 10 percent return on contribution). In order to ensure the right result, the partnership agreement should provide that, although D will receive the first $1,100 of distributions, only $100 of profits (the 10 percent return) should be allocated to D and that all other profits (in this case, $900) should be allocated equally between D and E. If this arrangement is adopted, the capital accounts at the end of the first year will be correct. D will have a capital account of $1,550—$1,000 initial contribution, $100 (the 10 percent return), and $450 (one-half of the net profits [$1,000 profits less the 10 percent return]). E will have a capital account of $450. In planning this arrangement, the parties should realize that profits (and thus taxable income) will be allocated to E before E actually starts to receive distributions. That problem can be solved by providing for tax distributions before the preferred distributions.
However, if the losses are allocated to E, those losses will reduce E’s capital account below $1,000 even though E has not received the full distribution. For example, assume the agreement provides that losses will be allocated equally between D and E, the organization sustains $1,000 of loss in the first year, and that the loss is allocated entirely to E. This allocation would reduce E’s capital account to zero.
If this happens, it is important to make sure that sufficient income is allocated to E to restore his capital account to $1,000 before any income is allocated to D. If the partnership agreement does not have such a provision, and if the partnership has income of $1,000 in the second year that is allocated equally between D and E, D would have a $500 capital account, as would E. In order to avoid this result, it is probably appropriate to allocate profits to E of the lesser of an amount sufficient to bring E’s capital account back to $1,000 or the amount of losses allocated to E so that if the partnership were to be liquidated, all of the liquidating distribution would go to E until E had received his $1,000 and 10 percent return back. Taxes
Tax rules attempt to tax economic income. Federal income tax rules often vary from economic rules in both the timing and the amount of income and deductions. The organization allocation rules attempt to cause the income and deductions attributable to the organization to be taxed to the owner who will have the economic benefit of the income or deduction. In an organization without a significant amount of debt, allocations of taxable income and deduction will generally follow the allocation of economic profits and losses.
Take the simplest of cases, where each owner makes an equal contribution but the profits and losses are shared in some other ratio. Profits and losses will be credited to or debited from capital accounts, and liquidating distributions will be made in accordance with the capital accounts. Taxable income and deductions will be allocated in the same manner as profits and losses, because the allocation of profits and losses to an owner will have an impact on the money ultimately received by that owner.
The impact of debt on tax allocations. When an organization borrows money, particularly if no owner has individual liability on the debt, the tax rules become more complicated. When the organization borrows money, the amount borrowed increases the owners’ tax basis in their organization interests but does not increase the owners’ capital accounts because there is no net increase in the assets of the organization. If the organization uses the money borrowed to pay an expense that is deductible for tax purposes, the deduction will reduce the capital accounts of the owners. Thus, when money is borrowed, it is possible to have negative capital accounts.
Normally, an owner may not be allocated a tax deduction that would cause the owner’s capital account to become negative unless the owner has an obligation to restore any deficit in the capital account. If the owner does not have such an obligation, the tax rules would allocate the tax deductions to owners with positive capital accounts. If no owner has a positive capital account, the tax rules attempt to cause the owner who gets the deduction to be required to pick up income sufficient to bring the capital account back to zero.
These rules provide the most complex of the tax provisions that appear in complex organization agreements. If the organization either does not have deductions or is not debt financed, much of the complexity in the tax allocation rules may be avoided.
Unrecognized gain or loss applicable to contributed property or revaluation will be allocated. Generally, an owner will not recognize gain or loss on the contribution of property to an organization and the organization will succeed to the owner’s basis in the property. Under that rule, an owner’s capital account is credited with the fair market value of the property contributed, but the organization only takes a basis in the property equal to the owner’s basis in the property.
For example, if an owner contributes a piece of property worth $200 but in which the owner only has a $100 basis to an organization, the owner’s capital account would be credited with the $200 fair market value of the property, but the property’s basis to the organization is $100. If the organization were to sell the property for its fair market value, it would have a gain for tax purposes of $100 but the value of the capital in the organization would remain the same (i.e., instead of having property worth $200, it now has $200 in cash). Thus, while there are no economic consequences to the sale of the property, there is taxable gain.
The partnership tax regime generally requires that this tax gain be allocated back to the owner who contributed the property. In spite of the fact that the contributing owner has taxable gain or loss on the sale of the property, that gain or loss will not affect the owner’s capital account. Because the fair market value of the property, rather than its tax basis, was credited to the owner’s capital account, the sale of the property does not result in an economic change, and thus does not change the amount of the owner’s capital account.
The rule about differences between value for capital account purposes and tax basis will also apply when owners’ capital accounts are revalued or "booked up" when a new owner makes a contribution. For example (see "Subsequent Contributions, Surprising Consequences"), where the capital accounts of A and B are each increased from $100 (which would also be the tax basis in the LLC’s property) to $500, each member will have a difference of $400 between the book value of the member’s interest in the property of the LLC as reflected in the capital accounts and the tax basis in that property.
Under rules similar to those that apply to the contribution of appreciated property, tax allocations of profits and losses should be made in a way that minimizes the difference between the tax basis and the book value of the property. This may entail allocating losses to C or gain to A and B. As in the case of allocations with respect to contributions of appreciated or depreciated property, the allocations to deal with revaluations will not change the capital accounts of the owners.
This article has only considered the most simple of arrangements. Lawyers organizing unincorporated businesses should understand the basic operation of these rules and should be alert for the following items that may indicate the need to discuss the economic structure with a specialist:
1. Contribution of property
2. Assumption of debt by the organization
3. Contributions made after formation, either by existing owners or new owners
4. Distribution of property to owners
5. Special allocations of profits or losses
6. Special rules with respect to distributions to owners. CL