ESSENTIAL LLC ACCOUNTING CONCEPTS
Allocation vs. Distribution
The conventional terminology used in partnership entities includes two basic terms: “allocation” refers to division of net profits/losses and capital gains/losses for tax and accounting purposes. “Distribution” refers to the payout of cash (or other assets) to the Members. Thus, allocation occurs only on the LLC's books, while distributions involve actual transfers to the Members. Depending on the specific structures in place, distributions also frequently occur on a very different schedule from the allocation of profits and losses (e.g. profits are allocated annually, but distributions are made bi-monthly to cover Members' living expenses).
Capital Accounts
Each Member is assigned a Capital Account within the LLC. This account is a record of all contributions made to the LLC, profits and losses allocated to the Member, and distributions to the Member. Stated as a simple formula, a Member’s Capital Account = (money and property contributed) + (share of profits allocated to the Member) – (losses allocated to the Member) – (money or property distributed to the Member).
For example, assume that an LLC is formed by two members. Member A contributes $50,000 and Member B contributes $25,000. On formation, the Capital Accounts of Members A and B are $50,000 and $25,000, respectively.
Allocation of Profit and Loss
In general, profits and losses are allocated to the Members in the ratio of their LLC interests. In the above example, the ratio of the Members’ interests is 50,000:25,000, or 2:1.
Assume, then, that the LLC loses $100,000 in its first year of operations. $66,666.66 of this loss is allocated to Member A, and $33,333.33 is allocated to Member B. The Capital Accounts now stand at -$16,666.67 and -$8,333.33, respectively.
If a profit of $50,000 is made in year two, that profit is allocated in the same way. $33,333.33 is allocated to Member A and $16,666.67 to Member B to bring the Capital Accounts to $16,666.66 and $8,333.33, respectively.
In some LLCs with significant early year losses (e.g. a real estate holding entity), the Members may wish to allocate losses to those Members who have substantial capital accounts (i.e. those how have contributed the business's early capital), and not to “service members” whose contributions are in the form of services provided. Passive members may be able to offset losses from the LLC against profits earned in other areas. In these cases, once profits are earned, the capital accounts of Members who were allocated early losses are brought up to $0 before profits are allocated to the service members.
Capital Transaction vs. non-Capital Transaction
A Capital Transaction is a transaction not in the ordinary course of business in which the LLC receives cash or other consideration (excluding contributions from Members). Sale by a manufacturing business of its factory is an example of a Capital Transaction.
A non-Capital Transaction, on the other hand, is any transaction resulting in the receipt of cash or other consideration through the ordinary course of business, e.g. revenue from sale of the LLC’s manufactured goods.
These types of transactions are often treated differently because passive Members of an LLC may be able to utilize losses from Capital Transactions to offset gains in other areas, while they would not be able to obtain the same treatment for losses from non-Capital Transactions.
Treatment of profit or loss arising from Capital and non-Capital Transactions causes allocations to vary from the structure described above under certain circumstances, particularly where one Member has received distributions not made to others.
For example, assume that Member B is an active participant in the LLC, while Member A is a passive investor. Member B may have received distributions from the LLC as a “salary” (really an advance against future profits, as described on the next page). Member A, with an outside source of income, has not required such distributions.
If a transaction is a non-capital one, Member B’s "salary" payments are essentially ignored in allocating profit and losses. For Capital Transactions, however, Member A is allocated a larger share of any profits or losses until Member A has “caught up” to the amount previously distributed to Member B.
The foregoing is a highly simplified overview of the accounting concepts at work in allocating profit and loss within an LLC. Moreover, the foregoing are merely examples of possible LLC arrangements. The LLC form is inherently flexible and many variations on the above concepts are possible. Please do not hesitate to contact one of our attorneys for further clarification, or with any related questions.