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What's Fair? -- Options for Distributing Profits of Your LLC Partnership

One of the most difficult conversations between new business partners is often how to split the profits fairly. With partnerships where each member contributes an equal amount of startup capital and work, the decision is easy. But in cases where one partner puts up the capital and the other runs the day-to-day, or similar such situations, the definition of "fair" is less clear. Obviously, the goal is to ensure that each partner gets a return commensurate with their input and that neither feels resentful (or litigious) down the road.

Before you can make a reasonable decision on the money split, it is important to understand the features of the LLC entity that provide the foundation for creative payment options. Organizing as an LLC does offer more flexible distribution options than a corporation -- yet another reason that an LLC is the best choice for any business partnership that will not be going public any time soon.

Allocation of Profits is Separate from Ownership Percentages

LLCs allow for special allocations of profits. This means that the distribution of cash (and losses) does not have to be proportionate to the percentage of ownership. Therefore, the Articles of Organization can show a 50% ownership for each partner, but the profits and losses can be distributed 80/20, 60/40, 50/50, or in any other proportion the partners deem fair. This can be particularly important if the balance of responsibility is likely to change over time -- whoever is contributing the most effort can reap higher rewards, while each partner ultimately retains the same ownership interest.

Distributions

There are two types of payments that can be made to LLC members -- distributions of profit or guaranteed payments. Distributions can be taken at any time (when profit is available) simply by writing yourself a check. Distributions taken by active owners (managing members) are considered earned income, meaning self-employment taxes are due on that amount but they are also eligible for fringe benefits. Distributions taken by members who are not active members (not involved in the day-to-day) are not considered earned income, thus are not subject to the self-employment tax.

Guaranteed Payments

Guaranteed payments are akin to a salary as they are usually paid on a regular basis. Guaranteed payments are considered earned income and allow that individual to enjoy the benefits of fringe benefits. Technically, as a member of an LLC, you are not allowed to pay yourself wages, so guaranteed payments are basically the best alternative for those who work regularly in the business.

Active vs. Inactive LLC Members

Basically, any payments received by an active, working member of an LLC are subject to self-employment tax but also eligible for fringe benefits (such as writing off health insurance premiums), where regular distributions to inactive partners are not considered earned income. A managing member is considered active by default -- obviously if you are managing the business you are active in it. Other members may or may not be active in the business, but it is this distinction that determines whether the income is considered "earned income" or not. Silent partners or capital investors, then, would be considered inactive members, while managing members and those working consistently in the business are active members.

Agree Before You Launch

Using these basics, there is likely a fair and reasonable way to pay all partners for their share of work and contribution to the LLC. Because regular distributions can be taken at any time (as long as profits are available), for any member, in any proportion, there are plenty of options for ensuring that everyone involved gets paid what they earn. The key to making it all work out is to hash it out with your partner before you launch -- what each person will contribute, how important those tasks and roles are to the success of the business, and how each will be compensated for their part.

About the Author

LaunchX.com is dedicated to training entrepreneurs to turn their good ideas into great companies. The LaunchX System provides step-by-step education in the mindset and skill set entrepreneurs need to succeed. Our program includes intensive seminar training, key business software, and specialized workbooks that teach you the fundamental skills you need to achieve your financial and worklife goals through entrepreneurship. Register today for our introductory course and see what LaunchX can do for you!