Your Guide to Allocations of Distributions
By: Barry E. Haimo, Esq.
February 24, 2025
Did you know that different types of business structures have different rules for how profits can be distributed?
Corporations (C and S) do not have the ability to allocate distributions of available cash to the partners in any way that is contrary to their percentage interests (pro rata). It’s really simple for them, which can be good or bad depending on your goals.
Partnerships are the opposite. They provide super flexibility when it comes to allocations of profits and losses to the partners – as long as the agreement has substantial economic effect (i.e. actually following the agreement).
By way of example, a partnership agreement can state that the money partner (the investor) receives 100% (or any greater percentage, really) of all available cash or profits until it receives its investment amount. The provision can further build in a preferred return for the investor as well.
Ultimately, in practice you’ll find that the partners will share distributions in accordance with how they agree. Sometimes that’s by percentage interest (pro rata) and sometimes it’s not.
This issue is an important one when raising capital and also in choosing which entity to form. Sophisticated investors know this, and you’re at a disadvantage if you do not.
There are legal and tax implications for forming each type of entity. Getting it right is important from the outset or you’ll pay for it later – literally.
The video below breaks it down in a bit more detail.
Read Transcript
Hi. This is Barry Haimo. Thanks for tuning in for another dose of Bite-sized Bits of Knowledge, where we give you meaningful information in a short amount of time. Today we’re talking about allocations of profits, allocations of cash.
Your business is going well, accumulating cash in the bank. What are we going to do with it? Are we going to invest it in the business, employees, contractors, product innovation, marketing, whatever, or are we going to give some back to the shareholders?
In a corporation, you do it as a dividend and it’s pro rata. There’s nothing to talk about in terms of reallocations. You have no flexibility. That’s C or S. Doesn’t matter. In a partnership, you have flexibility. It’s pretty cool. You can actually say, “I want the investor who’s 25% to get 75% of the distributions of cash for a certain amount of time, forever, until their investment is paid back plus a preferred return.” It’s all negotiable.
And what happens is that this 25% investor partner can actually get 75% of the profit distributions as long as on paper and in reality they are the same thing. It’s called substantial economic effect. The IRS will honor that as long as both of those things are in harmony. You can’t just say it and not do it. That’s not going to work. So investors sometimes like that flexibility.
Sometimes investors want a C Corp because there’s no pass-through taxes. The difference is that in a C Corp, they put their investment in and they wait. They get dividends, maybe, but they’ll wait. There’s no tax issues every year.
In a pass-through, the investor and the partners are going to get, again, the 1065 reporting the profits and losses, all the shareholders, all their interests, and each shareholder gets a K-1. That K-1 is attached to the 1040 of the partner, and that partner has gains or losses to report to the IRS. And the IRS expects taxes to be paid on the income share of the partnership whether or not the partner actually gets the money. You’re taxed on the income, your share of the income, whether you get the money or not. Whether it’s in the company’s bank account still or it’s in your pocket, you’re still going to pay taxes on it.
That’s why partnership tax is the worst, most difficult, complex class I ever took. And so, that being the case, distributions of cash is– usually you’ll find a minimum requirement to pay the taxes that will derive from the income to each partner. It’s called a minimum tax distribution provision. You might not find it in the tax in the statute, it could be another big hole, but you’ll find it in good operating agreements, because obviously you don’t want to have to start paying taxes on income you’re never seeing.
So there’s a difference between the pass-through, non pass-through. Investors get that flexibility of reallocating. We can reallocate a 25% shareholder to be a 75% distribution receiver until a certain amount of time, forever, until their preferred return is paid in full, whatever. It doesn’t matter as long as it’s mirroring the deal.
I think it’s worth mentioning that the partnership distributions– there are rules. The statute has rules. The partnership agreement will have rules. You can’t just pay out distributions if it’s going to make you insolvent or you’re going to not be able to have a certain amount of assets over liabilities. You need to be careful.
So what we’re talking about now is on the assumption that there’s enough cash to pay the partners and how it’s going to be done. You can reallocate or you can leave it as pro rata and have the flexibility. It enables you as a partner looking to raise capital to make deals. You can give investors attractive terms.
You just can’t do that kind of stuff in a C Corp or an S Corp. So it’s worth mentioning. LLCs, partnerships, limited partnerships, and all the variations of limited partnerships this would apply to.
It’s really important to know this kind of stuff. I hope you found it helpful. And don’t forget to download the our free business planning stress test. The link is below in the description.
Next video, we’re going to talk about transferring interests and all the things that go into that. So thanks for tuning in, and stay tuned for more.
One of the reasons that so many people like LLCs is because they enable you to protect your assets like a corporation while providing flexibility that is closer to partnerships – including how profits are allocated.
Splitting Profits As the Owner of an LLC
As we touched on above, LLCs offer flexibility in profit allocation closer to partnerships than corporations. Members (owners) can distribute profits based on ownership percentage or through a special allocation, where certain members receive a larger share due to factors like higher initial investments.
How profit division works is typically outlined in the LLC operating agreement. Without one, state default rules apply, often requiring equal distribution regardless of contributions.
Special Allocations & IRS Rules
For a special allocation to hold, the IRS requires it to have substantial economic effect – meaning it must reflect a real economic arrangement, not just a tax strategy. If denied, profits and losses revert to ownership percentages.
Profit Allocation vs. Profit Distribution
Profit Allocation. Determines how profits and losses are divided among members for tax purposes.
Profit Distribution. The actual disbursement of LLC earnings to members.
Something important to remember is that members can be taxed on allocated profits even if they receive no distributions – this is known as phantom income. To offset this, LLCs often provide tax distributions to cover liabilities.
Regardless of how you and your other member-owners want profit allocation and distribution to work for your business, the terms should always be clearly outlined in the LLC operating agreement. Let us help you set your LLC up the right way – get in touch today to get started!
Download our FREE:
Business planning stress test
https://legacy.haimolaw.com/Business-Planning-Stress-Test
Florida business entity comparison chart
https://legacy.haimolaw.com/business-entity-comparison-chart
Additional Resources:
Video Ads Mastermind business accelerator from the highly credentialed Tall Oak Consulting; helps businesses level up in a straight line, minimizing the painful process of learning and adjusting, to achieve founders’ particular goals.
https://haimolaw.krtra.com/t/1wUjsqaKxza4
99 Designs – economical design for your initial IP
https://99designs.qvig.net/n1o0E7
Originally published 01/20/2022. Updated 02/24/2025.
Author:
Barry E. Haimo, Esq.
Haimo Law
Strategic Planning With Purpose®
Email: barry@haimolaw.com
YouTube: http://www.youtube.com/user/haimolawtv
YOU ARE NOT OUR CLIENT UNLESS WE EXECUTE A WRITTEN AGREEMENT TO THAT EFFECT. MOREOVER, THE INFORMATION CONTAINED HEREIN IS INTENDED FOR INFORMATIONAL PURPOSES ONLY. EACH SITUATION IS HIGHLY FACT SPECIFIC AND EXCEPTIONS OFTEN EXIST TO GENERAL RULES. DO NOT RELY ON THIS INFORMATION, AS A CONSULTATION TO UNDERSTAND THE FACTS AND THE CLIENT’S NEEDS AND GOALS IS NECESSARY. ULTIMATELY WE MUST BE RETAINED TO PROVIDE LEGAL ADVICE AND REPRESENTATION. THIS INFORMATION IS PROVIDED AS A COURTESY AND, ACCORDINGLY, DOES NOT CONSTITUTE LEGAL ADVICE.
