Capital Contributions and Equity Distributions in LLCs
Understanding how to invest and withdraw money into your business is an important aspect of managing an LLC or Corporation. By default, distributions from the LLC are allocated based on the percentage of equity ownership that the member holds as expressly noted in the Partnership Operating Agreement.
Although it's not typical, some Operating Agreements allow for "disproportionate" distribution among investors with a specific plan to remedy any imbalances at a later date, such as when the business dissolves or an ownership interest is sold.
However, if an S Corporation's leadership makes or has made excessive distributions, there can be problems beyond the fact that the shares' value will decrease. It is critical to “true-up” large distributions in accordance with investors' ownership percentages to minimize the risk of the company's S-Corp election being revoked.
In an Operating Agreement, it is not uncommon for members to receive a return on their contributions (known as a “preferred return”) before pro-rata distributions are made to other members. Furthermore, preferred shares may provide for certain shareholders to get excess capital back before any other distributions.
It is important to remember that, in an LLC, members are not guaranteed a return of their investment. Unlike corporate shareholders, who are protected by state and federal securities laws, LLC members only have the rights afforded to them in the Operating Agreement. As such, it is critical that investors understand the provisions of the Operating Agreement before contributing capital to the LLC.
If you are thinking about making a contribution to an LLC or are already a equity member of a business, it is important to consult with an experienced attorney to ensure that your rights and interests are adequately understood and protected.
What is a Capital Contribution?
A capital contribution is money or other property that a member contributes to an LLC in exchange for an equity ownership interest. The amount of the capital contribution is typically determined by the Operating Agreement, but it can also be set by state law.
In some cases, members may make in-kind contributions, which are contributions of property rather than cash. For example, a member may contribute a piece of equipment or real estate to the LLC. The value of in-kind contributions is typically determined an a neutral appraisal.
What is an Equity Distribution?
An equity distribution is a distribution of profits or losses to members based on their ownership interests in the LLC. In most cases, LLCs distribute profits and losses in proportion to members' ownership interests. However, the Operating Agreement may provide for different distribution methods.
For example, the Operating Agreement may give certain members a greater share of profits or losses based on their capital contributions. Moreover, the Agreement may provide for unequal distributions in order to achieve a particular business purpose.
How Are Capital Contributions and Equity Distributions taxed?
The tax treatment of capital contributions and equity distributions depends on the tax election of the respective entity. If the LLC is a partnership, then capital contributions are typically not taxed. However, equity distributions are generally taxable as income to the members.
If the LLC is an S corporation, then both capital contributions and equity distributions are taxable as income to the members. However, there may be some exceptions for certain types of property, such as stock in the corporation.
It is important to consult with a tax advisor to determine the tax consequences of capital contributions and equity distributions in your particular situation.
What Happens if There Are Not Enough Capital Contributions?
If the LLC does not have enough capital to fund its operations, then the members may be liable for the debts of the LLC. This is known as “vicarious liability.”
For example, if the LLC borrows money from a bank and fails to repay the loan, the members may be personally liable for the debt. Similarly, if the LLC leases a piece of equipment and doesn’t make the required payments, the members may be liable for the unpaid amount.
In some cases, members may be able to obtain limited liability protection by contributing capital to the LLC. This is typically done through a “capital call” provision in the Operating Agreement.
Under a capital call provision, the members agree to contribute additional capital to the LLC if it is needed to fund the LLC’s operations. The amount of the capital contribution is typically based on the member’s ownership interest in the LLC.
What Happens if There Are Too Many Capital Contributions?
If the LLC receives more capital than it needs to fund its operations, the excess capital may be returned to the members. This is known as a “distribution.”
Distributions are typically taxable as income to the members. However, there may be some exceptions for certain types of property, such as stock in the corporation.
Conclusion
Capital contributions and equity distributions are two important aspects of LLCs. They can have a significant impact on the tax consequences of the LLC and the members’ personal liability.
If you are thinking about contributing money to an LLC or receiving a distribution from an LLC, it is important to consult with an experienced business attorney to ensure that your rights and interests are adequately protected.