KEY POINTS:
- Capital Contributions comprise the initial funding of an LLC. Typically completed at the outset, capital is how the LLC will grow and facilitate action.
- Know your numbers. Capital must be recorded well and accurately. Thorough bookkeeping may appear as an expense but will only save money in the long run.
- Managing Members control and maintain most aspects related to capital and funding.
- This process involves blending multiple facets to make one singular entity accomplish your goals. It is a collaborative effort of multiple different professionals and yourself as the business owner. You should guide the ship, and we provide the crew to run the ship.
Capital contributions are the essence of an LLC, either family or business. Without them, an LLC cannot and does not function as intended. It is like weaving a basket to carry things and carefully taking time and effort to ensure that the basket does not fall apart. Yet, nothing ends up in that basket; it just sits there unused. As for an FLLC, any potential benefits it could have are dependent on these contributions being made in the first place.
FLLC owners or business owners are referred to as “members” of that LLC. This status means that the individuals are not employees. While there are several classes of members, however, the non-managing and managing statuses are the most pertinent to the discussion surrounding capital distributions. As their names imply, managing members make all financial decisions, with non-managing members having ownership but minimal decision-making ability.
Members have access to two types of money: capital contributions and profit distributions. All capital must be recorded with proper bookkeeping. Business owners must know their numbers; it cannot be stressed enough. This includes any value that has been contributed to the business in capital. This article will cover the necessary facts about contributing both funding and additional capital.
LLC Contributions and Distributions
A family might form an LLC for several reasons: to make money, to provide asset protection, to utilize as a strong tax diversification tool that can assist in IRA planning, to provide a legacy for the next generation, or to shield assets from a Medicaid spend-down recovery attempt.
These goals often see a strong return on investment thanks to a combination of capital contribution, a strong plan, and a dedicated team. This return is due to the high tax efficiency inherent to the collaboration of a successful LLC Operating Agreement, dedicated goals, and keen professionals. This increase in wealth provided by enhanced tax efficiency can then be considered compensation for managing the family LLC (in other words, salary) or capital gains created from selling other assets. Profits generated by assets are how members of an LLC can receive “income” through distributions of any excess wealth generated by the capital now owned by the LLC.
A properly structured Operating Agreement will contain guidelines on the following: income, profit, and any capital distributions. Profit distributions can either be prorated by capital invested, by interest ownership, or distributed based on other family needs. Distributions are divided into one of two categories: (1) tax income/loss (distributions) or (2) money paid from the LLC to the member for services rendered.
Furthermore, a solid Operating Agreement acts as a sort of litmus test for the quality of a tax preparer. Suppose the tax preparer does not request to see or seek to understand an Operating Agreement. In that case, there is no possible way they can tailor strategies specific to the structure of that LLC. It is critical that your LLC is being looked at by multiple eyes, including attorneys, CPAs, and tax preparers. The collaborative result will be far more substantial than any solution one singular mind can form. WMA offers help and professional assistance in drafting strong, properly structured Operating Agreements that have been in the hands of multiple experienced minds.
What is a Capital Contribution?
A capital contribution is a cash or property asset founding members use to fund or “capitalize” their business. Members typically make capital contributions during the outset of the company’s creation, but an LLC may require additional assistance or capital funds in the future. This capital is what funds the LLC and allows for operations to begin.
Initial capital is frequently used as a potential factor to determine the ownership percentage of a business. In the case of an LLC, the distribution of “member units” can be directly proportional to the share of ownership interest. These units are used to determine respective ownership in a business that has no other tangible means of displaying said ownership. An Operating Agreement can allow for a more complicated ownership split in other situations. For example, one person or entity contributes most of the capital, and the other member(s) offer their expertise and labor in building the business.
Managing LLC Capital Contributions
Capital contributions are primarily controlled and dictated by the LLC’s Operating Agreement. This covers the initial capital required to fund the business and any capital contributions made in the future. Though most capital is typically contributed at the inception of an LLC, it is not always the last time capital is required. Moreover, contributions can come from sources other than members. Managing members may desire that future capital needs be satisfied by borrowing from third-party lenders. In that case, the Operating Agreement can outline such preferences, which may include provisions covering how much can be borrowed and which members have voting rights. Managing members may determine that additional capital is needed and adding new equity investors is one possible solution. The Operating Agreement can dictate limitations or opportunities for raising money and what terms will be offered to additional investors.
The Operating Agreement should cover how additional capital needs will be satisfied if third-party sources are not available or desirable on acceptable terms. It may provide alternatives to the company’s members that require additional funds. Below are possible options to navigate critical issues when additional funds are necessary:
- Why would the LLC need additional capital contributions from its members?
- Who has the authority to determine that additional funds are needed? Which members can make a “capital call” for additional funds?
Why Would a Mandatory Additional Contribution Happen?
An Operating Agreement can stipulate that members must contribute additional capital to meet non-discretionary cash needs for future company growth. Some examples of non-discretionary cash needs include cash to pay tax liability or funds required to service debt on loans, make necessary repairs, make equipment purchases, or pay any bills from contractors or suppliers. An Operating Agreement can also provide a budget that members must follow, granting strict control of expenses. This budget can contain provisions regarding additional capital contributions in the future.
Which Members Can Decide that Additional Funds are Necessary?
Managing members always have the authority to make this decision. This power, in addition to what is known as a “capital call,” comprise the primary means to ensure the continued prosperity of the LLC. Without this ability, the resulting stagnation from too little capital can cut the growth of an LLC short. Suppose there are multiple managing members or managers. In that case, the Operating Agreement should contain provisions to settle a disagreement of opinion.
How Distributions Are Received
Operating Agreements can stipulate that members’ capital contributions are not proportional to their percentage ownership interests. For example, some members may contribute more capital than others. They may get a “preferred return” on their additional contributions paid to them before payments are distributed to other members. These payments can also be paid out on a pro-rata basis. Along with receiving a preferred return on their additional capital, they may also receive a return on their excess capital before other distributions are paid out.
Operating Agreements have provisions regarding distributions of operating cash flow and distributions of proceeds from “capital transactions” created in a sale or financing event. An LLC’s distribution priorities can also be different in various categories that the Operating Agreement establishes. Without provisions dictating contributions, there is no consistent manner to control and manage that capital. It also means that there is very little dictating what happens with those assets or what should happen if additional capital is needed. Simultaneously, having a proper Operating Agreement enables many tax strategies for the tax preparer. It is crucial that your tax preparer understands an LLC’s goals and Operating Agreement. Without doing so, they cannot adequately create solutions that will fit your goals. This is a collaborative process, not the result of a single mind.
The managing member of a particular project can receive generous distributions if that project exceeds income expectations. This member may add “sweat equity” or value by introducing parties to each other. This incentive encourages sales performance and is a bonus for a job done well. To accommodate varying incentives, the Operating Agreement can provide for distributions to members for various contributions that do not necessarily follow percentages of ownership.
How distributions are managed is intrinsically tied to the design of an Operating Agreement. These issues cannot be resolved routinely without outlining the proper processes beforehand. Suppose you do not define how a problem should be approached ahead of time. In that case, it can be challenging to settle a matter adequately and consistently. This is a necessity to increase prosperity within an LLC.
The Operating Agreement and the Bottom Line
Much of what was discussed previously is contingent upon the Operating Agreement. It will stipulate and control much of the LLC functions and (for lack of a better term) operations. It distinctly outlines and manages all potentials before they occur. This is why it is critical you seek professional assistance in establishing your LLC. Without doing so, drafting a time-tested and adequately prepared agreement will be incredibly difficult.
It is critical to clearly define what you want to accomplish here at WMA. We are glad to help you, but it cannot be stressed enough that you know best what you want. We are readily equipped with an array of tools to make available, but not every tool will work for you to accomplish what you want. Though we have the experience of countless cases, we are not mind-readers and cannot create the best plan for you if you do not communicate your goals to us. Capital is a fundamental component in founding an LLC. Without managing it, all your hard work to set up the LLC will likely not have the desired results.
