Generally, there are three ways that you can take money out of a business if you are one of the owners. Either the company pays you compensation for your labor; if you have loaned money to the company, the company repays your loan; or the company makes a distribution of profit to you (this is called a “dividend” for a corporation, or a “distribution” for a partnership or L.L.C.).
Let’s say you and I are fifty-fifty owners of an L.L.C. You are the “worker bee” who runs the business, while I am a passive investor who loaned you $20,000 to get the business started. During our first month in business, we had $10,000 in gross sales and we had $2,000 in operating expenses, leaving $8,000 in the L.L.C. checking account. Let’s say we meet and agree to leave $2,000 in the L.L.C. checking account as a “reserve” to pay next month’s expenses, as we don’t know what our sales will be next month. That leaves us with $6,000 in the account. We want to pay this to ourselves, but how?
Because you are the “worker bee” who runs the business, you should receive some compensation for your hard work. Let’s say we agree that the first $2,000 of “net profit” (the $6,000 in the checking account) belongs to you and that you can take out this amount each month as compensation (called a “draw” in L.L.C. language). That leaves us with $4,000 in the account.
Because I’ve loaned $20,000 to the L.L.C., I intend to see that money back someday, with interest. Let’s say we agree that the next $2,000 of “net profit” will be used to pay down my loan —if the loan bears 6 percent simple annual interest and it’s been exactly one year since I made the loan, the first $1,200 of the $2,000 would be interest on the loan ($20,000 x .06), which is taxable to me, and the $800 balance would be considered a return of my principal, which is not taxable to me. The outstanding balance of the loan has now been reduced from $20,000 to $19,200.
The remaining $2,000 of “net profit” we decide to take out as a “distribution.” Unlike compensation and loan repayments, distributions of an L.L.C.’s profits must be made “pro rata” — in accordance with our percentage ownership of the L.L.C. Since we own the L.L.C. fifty-fifty, you must take $1,000 and I must take the other $1,000.
If we do not divide the distribution evenly, then there’s a risk that the person receiving the larger distribution will find their percentage ownership of the L.L.C. reduced significantly (a process called “dilution”). If you take a distribution of $1,500 and I take one of $500, your extra $1,000 will be treated as a return on your capital investment in the L.L.C., which will reduce your percentage ownership of the L.L.C. by the amount of $1,000 divided by the fair market value of the entire L.L.C. on the date the distribution was made. If the L.L.C. is worth $100,000, your additional distribution would reduce your ownership by 1 percent ($1,000 divided by $100,000).
When it comes time to pay our taxes at the end of the year, here’s how each of us will report the money we took out of the L.L.C. checking account during the first month of operation: You will report $3,000 as income (your $2,000 compensation plus your $1,000 distribution); and I will report $2,200 as income (my $1,000 distribution plus the $1,200 portion of the loan repayment that is treated as “interest” for tax purposes).
Even though we remain fifty-fifty owners of the business — you can’t make any decisions without my approval and vice versa — the amount of income each of us reports to the IRS will vary depending on how we characterize our withdrawals from the L.L.C. checking account, as compensation, loan repayments or distributions.
Be sure to retain a good accountant when setting up your L.L.C. so that any withdrawals you and your partner make don’t cause unexpected headaches come tax time.