What happens when a member of a Limited Liability Company (LLC) wants an interim distribution, but the other members don’t? An issue that may arise in a closely held-business formed as an LLC. LLCs, unlike corporations, are treated as pass-through entities for federal tax purposes, members are taxed based on their interest in the LLC and their proportionate income, whether or not a distribution is made (while it is possible to treat the LLC as a corporation for tax purposes, this is the subject for your CPA or tax adviser to discuss). A member may be allocated income from the company, but may never receive a distribution related to that money. Some members may not be able to pay taxes on money never received and may demand a distribution. This is one of many issues that may arise in a closely held LLC that can be mitigated in advance with a well drafted operating agreement.
When forming an LLC with multiple members, a well drafted operating agreement is important for documenting ownership interest and governance of the LLC. The operating agreement, like many contracts, is used to define the rights and obligations of the parties (members). Illinois does not require specification as to the ownership interest of each member when filing the Articles of Organization. Further, Illinois does not require that all members be listed, only members with management authority.
While there are numerous rights and obligations that may be outlined in an operating agreement, this article focuses on rights of distribution, when the company makes a transfer of money, property or other benefit to a member or a party with the member’s ‘distributional interest.’
Default Rule (no Operating Agreement):
The default rule, based on the Limited Liability Company Act (805 ILCS 180), is for distributions to be made in equal shares to the members. The Act does not provide for mandatory or compelled distributions to members, except when the company is winding up its business. Many operating agreements may mirror the statutory restrictions on distributions, but may include additional provisions and criteria for distributions.
Time and Consent for Distribution (in Operating Agreement):
Members may wish to outline the timing and consent for distributions. The Act does not specify a timing mechanism or voting requirement to make a distribution to members. An operating agreement can dictate when a distribution is made to the members of the company and may outline the authorization needed for a distribution, including unanimous or majority consent by all members, or only certain members. The operating agreement can also include requirements for distributions to members when tax liability is incurred.
Restrictions on ‘Distributional Interest’:
Section 15-5 of the Act restricts what may be altered by an operating agreement, including the restriction of the rights of a person, other than a manager, member, and transferee of a member’s ‘distributional interest.’ Since a ‘distributional interest’ is treated as personal property and may be transferred in whole or in part, a member’s ‘distributional interest’ may be used to satisfy a third-party’s (often a creditor’s) claim against the member, without transferring the other rights held by the member. Restricting that third-party’s right to a ‘distributional interest’ in the operating agreement violates the Act.
Additionally, members should be mindful of circumstances when distributions may not be made, regardless of what the operating agreement may state. A Distribution should not be made, when the LLC would not be able to pay its debts as they become due in the ordinary course of business; or when the assets of the LLC would be less than Liabilities and the amount needed to dissolve. Individual members may be liable to the LLC for any amount of distribution that exceeds the amount that could have been distributed without violating the prohibitions on distributions. So even if a distribution is made, but the company is indebted to third-party creditors, the creditors may seek the turnover of those funds from the member.
When forming an LLC with multiple members, it is important to have a well drafted operating agreement, which may be worth the time and costs of a lawyer to draft and review.
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