When should I include a Tax Distribution provision in my LLC Operating Agreement?
A tax distribution provision in a limited liability company (“LLC”) Operating Agreement assists the members in meeting their federal and state income tax obligations with respect to their allocated net profits.
A member pays tax on the amount of net profits allocated to him or her, not on the receipt of distributions of available cash. In certain circumstances, net profits are allocated to the members but the corresponding cash is withheld for operational reasons (i.e., establishing company reserves) resulting in “phantom income” to the members. In that case, the LLC may provide members with a tax distribution sufficient to cover their federal and state income tax liability. A tax distribution is generally helpful in cases where a member does not have alternative sources of income apart from income generated by the LLC. On the other hand, it has the disadvantage of withholding potential operating/investment capital from the LLC.
For example: Steve and Joe each contribute $1000 to the LLC in exchange for a 50% interest in the LLC respectively. In year 1, the LLC generates $400 of net profits. If management decided to reinvest the $400 in the business rather than distributing it to the members, Steve and Joe would still be forced to pay the income tax on their allocated share of net profits ($200 each). A tax distribution provision would allow the LLC to distribute enough money to Steve and Joe ($80 each – 40% (maximum combined federal and state income tax rate applicable to Steve and Joe) multiplied by the $200 of net profits allocated to each member) to cover their federal and state income tax liability resulting from an allocation of net profits without a corresponding distribution of cash.
