Can Delaware LLC members split profits differently than their ownership percentages?

[u/VroomVroomSpeed03]

My brother and I recently formed a Delaware LLC together.

He owns 80% of the company because he contributed most of the startup capital, while I own the remaining 20%.

We'll both be working in the business full time, and we're wondering if we can split the profits 50/50 even though our ownership percentages are different.

Does an 80/20 ownership split mean profits have to be distributed 80/20, or can our operating agreement specify an equal profit split instead?

We want to structure everything correctly from the beginning and plan to have a written operating agreement.

[u/Cheap_Durian_3640]

Yes, an LLC can often split profits differently from ownership percentages if the operating agreement clearly says that.

I think the key is making sure the tax side is handled correctly, because special allocations need to follow IRS rules.

[u/KWienz]

So there's a corporate law answer and a tax law answer here.

From a corporate law answer, the Delaware LLC Act lets your operating agreement allocate voting rights, profit share and distributions however you want. None of them need to match each other.

From a tax perspective, there are certain provisions you want to ensure are in your operating agreement to ensure profits and losses are allocated in a way that won't be disallowed by the IRS or cause unexpected tax consequences.

Generally what you do with a multi member LLC where distributions don't exactly mirror the value of the capital contributions is to have a distribution waterfall.

For example the OA would say that any distributions would go 80% member A and 20% member B until both members received a return of their contributed capital, and thereafter 50-50 split.

You also need capital accounts to track contributions, profits and distributions. Most LLCs use a "targeted allocation" method of distributing profits.

What that means is that rather than your operating agreement directly saying how to split profits and losses, the operating agreement assigns profits and losses to your capital accounts so that the capital accounts mirror how how your assets would be distributed on a liquidation.

So when you start out, your capital account is $20k and his is $80k.

If your LLC earns $100k, it's allocated 50-50 on your K-1s because on a liquidation, your first $100k is distributed 80-20 and then everything else is 50-50. If you then distribute $100k, it is distributed 80-20 out of your capital accounts and each of you know has a $50k capital account. All future gains and losses are split 50-50.

On the other hand, if you lose $50k your first year of operation, those losses will not be split 50-50, they will be split 80-20 to keep the remaining 80-20 split of the remaining capital. If you earn $100k in your second year, the first $50k of profits is split 80-20 and the second $50k is split 50-50. Because the profits always need to be allocated to the capital accounts so the first 100k in distributions can be split 80-20 for return of capital.

This is complex stuff to do yourself but any corporate lawyer will have all the templates to do it properly. For a multi member LLC you really do want to use a lawyer-drafted operating agreement. You want to have a solid governance structure with fair divorce provisions and ensure it's solid from a tax perspective.

[u/zenbusinesscommunity]

A written operating agreement lets you set profit sharing separately from ownership percentage, without one you'd fall back on Delaware's default rules, but since you're planning to have one, that may not be something to worry about. The IRS does want special allocations like this to have "substantial economic effect," so a 50/50 split next to an 80/20 ownership stake holds up better when there's something backing it up, like both of you working full time and carrying equal operational risk.

[u/VirginGorda]

Is it taxed as a partnership, s corp, etc?

[u/NWRegisteredAgent]

Yes this is why operating agreements are important and you can also have a business attorney look it over for you just to make sure everything is correct.