Two posts ago I started telling you how to setup a limited liability company. Last post I talked about the control issues in an LLC operating agreement. This week I’m talking about the economic and tax aspects of the LLC operating agreement, plus some of the other housekeeping you’ll need to round-out your new LLC.
As I’ve mentioned in the past, this isn’t legal advice. It’s general information. Your situation is probably unique in subtle but important ways. It’s important that you run your plans by a lawyer, particularly when it comes to the tax-related provisions, which can be quite tricky.
When you start a new company, there are thousands of questions on your mind. There are operational questions, market questions, control questions. But the biggest questions usually revolve around economics: if this thing works, who gets what? What are the likely profits? How will they be distributed? What do I stand to make? (Or lose?!)
These questions—the economic and control ones, anyway—are all answered in the operating agreement.
The operating agreement is the cornerstone of every limited liability company. It sets out the rights and obligations of all LLC members and managers. It is the first place you should look if you have a question about how to manage your company, distribute its income, or divvy up the tax burden. With the control issues handled in the last post, we’re now moving on to the economics: Who gets what? Who pays what? Who owns what?
Capital accounts are a reflection of each member’s economic interest in the LLC. Capital account provisions in the operating agreement determine how the LLC will allocate income, gain, loss, deductions, and credits. Your capital-account balance is your ownership interest in the LLC.
Each member’s capital account begins with the amount initially contributed to the company. From there, the default is to allocate future income and loss among the members according to the size of their initial capital contribution. This keeps the capital accounts steady, since all allocations are pro rated according to existing account balances. Allocations may also be made based on a pre-determined percentage of ownership. This is a popular alternative where some members are contributing capital and others are contributing services, reputation, or expertise. Any other imaginable allocation is allowed, so long as it doesn’t run afoul of the IRS’ tax-shelter rules, discussed below.
When the LLC winds up operations and cashes out—after a collapse or a successful acquisition—the members will receive a distribution of assets based on their capital accounts. Preferred returns of invested capital are possible in an LLC—nearly anything is possible in an LLC—but as with all deviations from the norm, it is vitally important that all economic provisions are matched by tax allocations. Otherwise the IRS could deem your special arrangement a tax shelter.
Since the 1980s, the IRS has issued a series of highly complex regulations that govern partnerships and LLCs. These regulations are designed to prevent tax shelters. In general, they prevent tax burdens and benefits from being split apart and allocated to different people. In other words, it was once popular to write an operating agreement that would allocate all profits to the lowest-tax-bracket members, and allocate all the losses to the highest-tax-bracket members (so they could offset other sources of income). Regulations now prohibit that sort of tax shelter. Benefits must be linked to burdens.
If your LLCs capital-account provisions are the default—allocations based on initial contribution—compliances isn’t too difficult. If you go with a pre-determined percentage of ownership, things get more complex. Treasury Regulation 1.704-1 (go, read; enjoy) requires the operating agreement to include a number of anti-abuse provisions. The effect of these provisions is to prevent the income/loss split I mentioned, and to prevent any member from maintaining a negative capital-account balance. (If it happens that a member has a negative capital account balance, other members must re-allocate tax attributes to make up for the shortfall. The operating agreement must include language from the Regulations that spells this out.)
Regardless of allocation structure, it’s usually a good idea to provide that no member will be required to supplement his or her capital account when the company is liquidated (that is, if the company fails and creditors are left unpaid), and to include the mandatory related provisions from Treasury Reg. 1.704-1. The default is to require liquidating contributions, but that undermines the very reason you setup the LLC: owner protection.
As you may have discerned, the tax-allocation section tends to take up a lot of space in the operating agreement, and most people never read it. Nevertheless, it’s important stuff. If the tax-allocation provisions in your operating account don’t match up with the capital-account provisions, the IRS may choose to step in and re-allocate things as it sees fit. I can assure you, you don’t want the IRS to step in and re-allocate things. Use great caution.
We have now covered all of the operating-agreement basics. Your LLC is organized and operational. There are just a few last housekeeping steps to take care of, stating with minutes.
Member minutes are meeting notes following an actual member meeting or, if authorized by the operating agreement, written minutes in lieu of an actual meeting. (I recommend including this provision. It will save you lots of time.) The minutes should begin with the members ratifying all actions taken to date. Next, the members should adopt the operating agreement you’ve prepared as the operating agreement of the company. Finally, the members should appoint any managers and take any other necessary, situation-specific actions, like buying assets, approving loans, and granting authority for specific actions.
If you appoint managers, it is good practice for the managers to prepare their own meeting minutes. The managers should specifically accept their appointment as managers, in order to comply with the recent changes to Ohio law. (It’s a good idea in any state.) The managers should also take the opportunity to get moving on any of the specific actions authorized by the members.
Last but not least, you will want to file Form SS-4 with the IRS in order to get your company’s Employer Identification Number. (See the instructions for how to select the appropriate entity on the form.) You can also apply for an EIN online through the IRS website. (Don’t pay anyone for an EIN! This is a dead simple process and completely free through the IRS website. Third parties add nothing.)
Finally, file Form 8832 if you want to be taxed as a corporation, and file Form 2553 if you want to be taxed as an S-corporation. But don’t do either unless you have a really good idea of what you’re doing any why. Electing out of standard LLC tax, within the LLC structure, makes sense in very few cases.
You now have an operation ready LLC!
Remember to tell the IRS (and the state) if you will have employees. Pay all withholding taxes. Get all appropriate licenses and clearances. And try to have fun. This stuff is exciting!
Good luck. And feel free to give me a call if you have any questions or want a bit of help.