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LLC Operating Agreement Glossary of Terms

TERM
DEFINITION
Annual Cumulative Preferred Return With Compounding An “annual cumulative preferred return with compounding” is a non-guaranteed cumulative return on investment that compounds annually.
Annual Cumulative Preferred Return Without Compounding An “annual cumulative preferred return without compounding” is a non-guaranteed cumulative return on investment that does not compound. An annual cumulative preferred return without compounding means that if cash is not available to pay the preferred return in one year the amount of the arrearage is added to the preferred return due for payment when such cash is available. For example: In year 1, Steve contributes $100 to the LLC which in turn purchases a building. Steve is to receive a 10% annual cumulative preferred return without compounding on the capital he contributed ($100) before distributions are made to the members based on their respective percentage interests in the LLC. At the end of year 1, Steve would be entitled to a preferred return of $10 if the LLC made a preferred return distribution. At the end of year 2, assuming the LLC did not make any preferred return distributions, Steve would be entitled to the same $10 preferred return in year 2 (10% on the initial investment of $100), raising his preferred return balance to $20.
Allocation of Net Profits/Net Losses The amount of net profits and net losses allocated to the member for tax purposes. A member is liable for tax on her allocable share of the LLC’s net profits, whether or not distributed.
Basic Distribution of Available Cash Option This distribution of available cash formula is the most common distribution option for LLCs. It provides that available cash of the LLC will be distributed to the members according to their percentage interests in the LLC.
For example: Steve and Joe each contribute $10 to the LLC for a 50% interest in the LLC respectively. If in year 1, the LLC earns $10 of net profits and decides to distribute the $10 to the members, Steve and Joe will each receive a distribution of $5.
Basis A member’s basis in his or her LLC interest is equal to the amount of cash the member contributes to the LLC, the basis the member had in any property contributed, and the member’s share of the LLC’s debt. A member’s basis is increased by the member’s share of LLC income or gains and any additional contributions the member makes to the LLC. A member’s basis is decreased by any cash distributions the member receives, by the basis of property distributed to the member, and by net losses the member deducts.
Blue Sky Laws State regulations designed to protect investors against securities fraud by requiring sellers of new issues to register their offerings and provide financial details.
Book Value The values used for the assets on the LLC’s balance sheet, generally historical costs adjusted for depreciation.
Capital Account Each member has a separate capital account, the balance of which represents the member’s equity in the LLC. A member’s capital account is increased by (a) the amount of money the member contributes to the LLC and (b) the fair market value of property (net of liabilities) the member contributes to the LLC. A member’s capital account is further increased by that member’s share of the LLC’s net profits for the year. A member’s capital account is decreased by (a) the amount of money and fair market value of any property distributed to that member, and (b) the member’s share of the LLC’s net losses for the year.
Capital Asset In general, all assets are capital assets except those specifically excluded by the tax code. Major categories of non-capital assets include property held for resale in the normal course of business (inventory), trade accounts and notes receivable.
Capital Contribution The amount of money or capital contributed by the member to the LLC.
“C” Corporation A standard business corporation, so named because it is taxed under subsection C of the Internal Revenue Code (two levels of tax). A "C" corporation has two levels of tax (entity level and shareholder level), whereas, an LLC only has one level of tax (no entity level tax).
Check-the-Box Regulations The “check-the-box” regulations allow most unincorporated businesses to elect whether they will be taxed as a corporation or a pass-through entity (e.g., a LLC or sole proprietorship) for federal income tax purposes.
Company Minimum Gain "Company minimum gain" is created when the company borrows money on a nonrecourse basis and the LLC claims deductions (typically depreciation) that decreases the company’s basis in the property below the balance of the nonrecourse debt securing the property.
Company Minimum Gain Chargeback Upon a net decrease in “company minimum gain”, each members shall be allocated such member's share of the “company minimum gain. "Company minimum gain" is created when the company borrows money on a nonrecourse basis and the LLC claims deductions (typically depreciation) that decreases the company’s basis in the property below the balance of the nonrecourse debt securing the property.
Curative Allocations Allocations of company income, gain, loss, or deduction that offset any regulatory allocations.
Depreciation An income tax deduction which allows a taxpayer to recover the cost of property or assets placed in service.
Dilution A reduction in a member’s percentage interest in the LLC as a result of one or more of the other members making up a member’s failed required capital contribution or additional capital contribution, as the case may be.
Disguised Sales A transfer of property by a member to an LLC and a related transfer of property by the LLC to the member may be reclassified as a sale of property between the member and the LLC (sale instead of a tax-free distribution).
Distribution The amount of available cash or property that is distributed to the members.
Distributions in Kind Distributions of property other than cash.
Drag-Along Rights

Drag-along rights enable the members holding at least a majority of the interests in the LLC the right to force the minority members to join in (be “dragged along” in) the sale of the LLC if the buyer is seeking to purchase all of the interests of the LLC. The minority members being dragged along will be required to sell their interests in the LLC for the same price, terms, and conditions received by the majority.

Gross Asset Value The Gross Asset Value (value of the asset upon contribution or purchase) of all company assets shall be adjusted to equal their respective gross fair market values upon the occurrence of either: (i) the issuance of an interest in the LLC to a new member, (ii) the distribution by the LLC of money or property to a member for the sale of an interest in the LLC, or (iii) the liquidation of the company.
The step-up in the LLC’s assets to their respective gross fair market values will ensure that a member receiving a profits interest will not be taxed upon the grant of the interest.
Guaranteed Payments Payments by an LLC to a member for services rendered are taxed as ordinary income.
Indemnification A contractual provision whereby the LLC will assume the liability of all claims brought against the protected party within the scope of the agreement.
Inside Basis The LLC’s basis in the contributed property.
Member Minimum Gain "Member minimum gain" is created when a member loans money to the LLC or guarantees an LLC loan, thus, bearing the economic risk of loss with respect to the amount of the loan, and the LLC claims deductions (typically depreciation) that decreases the company’s basis in the property below the balance of the member nonrecourse debt securing the property.
Member Minimum Gain Chargeback The member who enjoys the benefit of nonrecourse deductions in connection with a member loan of money to the LLC or guarantee an LLC loan (member nonrecourse debt) should be required to report a corresponding share of the member minimum gain. The minimum gain chargeback provision dictates that if there is a net decrease in the “member minimum gain”, each member must be allocated an amount of income or gain equal to the member’s share of the decrease.
Multi-Member LLC An LLC with multiple members. For tax purposes, a multi-member LLC is treated as a partnership and provides the flow-through of tax attributes to the members.
Nonrecourse Debt Debt for which the borrower is not liable.
Nonrecourse Deductions Deductions with respect to nonrecourse debt.
Operating Agreement An agreement among the LLC members which governs the company’s operations and the rights of its members.
Outside Basis The member’s basis in her interest in the LLC.
Preferred Return A preferred return is typically provided to the member or members who have contributed money or property to the LLC. The preferred return will be based on a percentage of a member’s unreturned capital contributions. A preferred return is a way of providing a member or members with a return on the capital contributed to the LLC, much like receiving interest payments on a loan. The preferred return may be annually cumulative with compounding or annually cumulative without compounding.
Preferred Return Distribution of Available Cash Option

This distribution of available cash formula is commonly used to provide the member or members who contributed capital to the LLC with a special bonus distribution, or “preferred return”. Note, only members that contributed money or property to the LLC may be granted a preferred return. In addition, each member that has contributed capital to the LLC is typically provided a “preferred return”. The “preferred return” may be annually cumulative with compounding or annually cumulative without compounding and is based on a percentage of the recipient’s unreturned capital contribution. The preferred return percentage typically ranges between 5%-15%, but members are free to select any percentage they wish.

Under the “Preferred Return Distribution Option”, once the “preferred return” has been distributed, the members who contributed money or property to the LLC will receive distributions of available cash equal to the amount of their capital contributions so that each member that contributed capital to the LLC has received the full amount of capital contributed back (“return of capital”). Then, any remaining available cash will be distributed to the members based on their percentage interests in the LLC.

Preferred Return Percentage The preferred return percentage determines the percentage of a member’s unreturned capital contribution such member will receive as a preferred return. The preferred return percentage is similar to an interest rate paid on a loan. The preferred return percentage typically ranges between 5-15%, but members are free to select any percentage they wish. For example, if Steve contributes $10 to the LLC and is provided an 8% preferred return on the $10 contributed, the preferred return percentage would be 8%.
Priority Return Distribution of Available Cash Option This distribution of available cash formula is commonly used when one or more members have not contributed money or property to the LLC. The members that have contributed money or property to the LLC may wish to receive distributions of available cash equal to the amount of their capital contributions so that each member that contributed capital to the LLC has received the full amount of their capital contributed back (“return of capital”) before any distributions are made to the other members. This distribution option provides the members that have contributed capital to the LLC with what is called a “priority return”. Once the contributing members have received distributions equal to the amount of their capital contributions (priority return), the remaining available cash would then be distributed to the members based on their percentage interests in the LLC.
Profits Interest A profits interest is typically given as a reward for the performance of services, or as a way for the LLC to secure the future services of an individual. A profits interest is often referred to as a “carried interest”. A profits interest is similar to a stock option in the corporate context A profits interest recipient (Class B member) will typically receive an interest in the LLC for the performance of services without contributing capital to the LLC (or by contributing less than the percentage interest received in return). A grant of a profits interest means that the grantee receives an interest in the future appreciation of the LLC.
Qualified Income Offset A “qualified income offset” provision provides that a member who unexpectedly receives an adjustment, allocation, or distribution will have allocated to him as quickly as possible LLC income and gain items sufficient to erase any capital account deficit that was created by the unexpected adjustment, allocation or distribution. Those income and gain items must consist of a pro rata amount of each item of the LLC’s income for the year, including gross income and gain. A “qualified income offset” provision is significant because if the LLC agreement contains a “qualified income offset provision” a member may be allocated losses without being required to restore a capital account deficit.
Recourse Debt Debt for which the borrower is liable.
Registered Agent A Registered Agent acts as the representative for receiving Service of Process served upon the company within the jurisdiction of any state where the company conducts business. Service of Process is broadly construed to include any legal proceeding, legal notice, or official government communication presented to the company while it is within the jurisdiction of a state. A registered agent also provides services for helping companies stay in compliance.
Who is National Registered Agents, Inc. Founded in 1995, National Registered Agents, Inc. is a professional service company providing Registered Agent services in all 50 states, the District of Columbia and many foreign jurisdictions. Managed by a well-known and experienced team of veterans, NRAI has been serving businesses for over a decade and has proven itself as a trusted expert. NRAI's primary business is to act as Registered Agent for a variety of business entities such as Business Corporations, Not-for-Profit Corporations, General Partnerships, Limited Partnerships, Limited Liability Companies, Tax Haven Corporations, Insurance Companies, and Banking Companies. NRAI represents thousands of companies large and small throughout the world and has handled over one million service of process deliveries.
NRAI
Regulatory Allocations Special allocations that are intended to comply with the “substantial economic effect” provisions of Treasury Regulation Section 1.704.
Right of First Offer The “right of first offer” means that a member doesn't need a third-party offer in order to notify the LLC and the other members of the terms under which such member would be willing to sell its interest. If the LLC and its members elect not to purchase the selling member’s interest in the LLC, the selling member can either sell his, her, or its interest to a third-party based on the terms of an un-affiliated third-party offer or, if no third party offer has been made, the selling member can shop around the offer (for a period of 180 days) on the same terms that were extended to the LLC and the other members.
Right of First A “right of first refusal” provides the LLC and the other members with an opportunity to match the terms of a third-party offer to purchase a member’s interest in the LLC. The “right of first refusal” option provides the LLC and the members with some control over the persons who can join the LLC. If the LLC and the members fail to exercise their “right of first refusal”, the selling member may sell his, her, or its interest to a third-party buyer.
"S" Corporation A corporation granted a special tax status as specified under the Internal Revenue Code. Individual shareholders enjoy the benefits under state law of limited corporate liability but avoid corporate federal tax (one level of tax).
Schedule K-1 The LLC uses Schedule K-1 to report a member’s share of the company's income, deductions, credits, etc.
Section 83(b) Election

A tax filing with the Internal Revenue Service within 30 days of the grant of a profits interest subject to vesting restrictions which allows a profits interest recipient (Class B member) to pay taxes on the grant date instead of on the date restrictions lapse so that any future appreciation of the profits interest will be subject to capital gain treatment when realized through a sale and the gain would be long-term capital gain (15% tax rate) if the interest was held more than one year after making the Section 83(b) election.

The Internal Revenue Code Section 83(b) election only applies to a grant of a profits interest subject to vesting restrictions. A member that receives the entire profits interest upon the execution of the LLC operating agreement (no vesting restrictions) should not make an Internal Revenue Code Section 83(b) election.

The filing of the Section 83(b) election form will only be a precautionary measure because the LLC operating agreement generated by myLLCagreement.com is drafted to comply with Internal Revenue Service Revenue Procedures 93-27 and 2001-43 so that a profits interest recipient will not be required to recognize income on receipt of a profits interest subject to vesting restrictions (the profits interest granted will be treated has having a value of zero on the date of grant).

Section 83(b) Election Form A Section 83(b) election must be filed no later than 30 days following the transfer of property (the receipt of the profits interest subject to vesting restrictions). The Section 83(b) Election Form should only be filed if the profits interest was granted subject to vesting restrictions. Currently there is no Internal Revenue Service form available for this purpose. Any future appreciation of the member’s interest will be capital gain income when realized through a sale.
Section 704(c) Section 704(c) dictates that income, gain, loss, or deduction attributable to property contributed to an LLC must be allocated to the contributing member. The purpose of Internal Revenue Service Section 704(c) is to prevent the shifting of tax consequences among LLC members with respect to pre-contribution gain or loss. An LLC must allocate income, gain, loss and deduction for contributed property so as to take into account any variation between the adjusted tax basis of the property and its fair market value at the time of contribution.
Section 751(a) Property Under Internal Revenue Code Section 751, ordinary income treatment applies to the sale or exchange of an LLC interest for amounts attributable to the company’s unrealized receivables and inventory (sometimes called “Section 751 property” or “hot assets”).
Section 754 Election The purpose of an Internal Revenue Code Section 754 election is to provide a way to alleviate differences between inside and outside bases caused by (i) transfer of an LLC interest (Internal Revenue Code Section 743(b)) or (ii) distribution to a member (Internal Revenue Code Section 734(b)). All members must agree to the Internal Revenue Code Section 754 election.
Single Member LLC An LLC with only one member.
Subchapter K The taxation of partners/members and partnerships/LLCs is governed by Subchapter K of the Internal Revenue Code.
Tag-Along Rights If a member or group of members receives a bona fide offer from an un-affiliated third-party to sell their stake in the LLC, a “tag-along” provision allows the other members to elect to join the transaction and sell their interests in the LLC on the same terms and conditions (effectively, tag-along rights oblige the selling members to include the interests of the other members in the sale).
Tax Distribution A tax distribution provision in an LLC agreement helps members meet their federal and state income tax obligations with respect to the net profits that have been allocated to them.
Tax Matters Partner A tax matters partner (TMP) is a member of the LLC who acts as (i) a liaison between the company and the Internal Revenue Service during an administrative proceeding, and (ii) a representative to handle judicial proceedings in connection with the company.
Unreturned Capital Contributions A member’s unreturned capital contribution amount is the amount of capital (money or property) owed to a member before he/she receives distributions equal to the amount of capital such member contributed to the LLC (return of capital). For example, if a member contributes $10 to the LLC and receives $5 of distributions as a return of capital, the member’s unreturned capital contribution amount is $5. Whereas, if a member contributes $10 to the LLC and has not yet received any distributions, the member’s unreturned capital contribution amount would be $10.
Vest/Vested

Vesting occurs when a profits interest recipient acquires actual ownership of the profits interest granted pursuant to the terms of such profits interest recipient’s Restricted Class B Interest Grant Agreement. If you provide a profits interest recipient with a fully vested profits interest in the LLC, that individual will acquire the entire profits interest granted upon the signing of the LLC operating agreement. In contrast, if a profits interest is granted subject to vesting restrictions, only the percentage of the profits interest that the recipient has acquired based on the vesting restrictions set forth in such member’s Restricted Class B Interest Grant Agreement shall be treated as vested.

Note, in order for the grant of a profits interest to be tax-free, Revenue Procedure 2001-43 provides that, for allocation of net profits (tax) purposes only, a profits interest recipient granted a profits interest subject to vesting restrictions will be treated as owning the entire profits interest granted on the date of grant, irrespective of whether the profits interest is still subject to vesting restrictions. For all other purposes (i.e. distributions of available cash, voting, etc.), the profits interest recipient will be treated as owning only the percentage of the profits interest that has vested.

Vesting Restrictions

Vesting restrictions means that a profits interest recipient (Class B member) is not entitled to the entire profits interest upon grant, but must continue to be employed by the LLC for a specified period of time before acquiring the entire profits interest granted. For example, Joe is granted a 20% profits interest subject to Joe remaining employed by the LLC over the next 2 years (vesting restrictions). After Year 1, if Joe is still employed by the LLC, Joe will have acquired a 10% interest in the LLC (half of the 20% profits interest granted will have vested). After year 2, assuming Joe remains employed by the LLC, Joe will have a 20% vested interest in the LLC. In other words, after year 2, Joe would have acquired the entire 20% profits interest granted and the profits interest will no longer be subject to vesting restrictions.

Note, in order for the grant of a profits interest to be tax-free, Revenue Procedure 2001-43 provides that, for allocation of net profits (tax) purposes only, a profits interest recipient granted a profits interest subject to vesting restrictions will be treated as owning the entire profits interest granted on the date of grant, irrespective of whether the profits interest is still subject to vesting restrictions. For all other purposes (i.e. distributions of available cash, voting, etc.), the profits interest recipient will be treated as owning only the percentage of the profits interest that has vested.

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