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Start Ups and Emerging Companies – 101: Allocations and Distributions

January 14, 2013

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The income and losses of a company must be allocated to a person or entity for tax purposes.  Taxes must be paid on profit (income in excess of losses), and tax deductions may be had on losses (where losses exceed income).  In a C-Corporation, the income and losses are allocated to itself. 

LLCs and S-Corporations are treated differently for tax allocation purposes.  LLCs and S-Corporations are pass-through entities, which means that the members (in the case of an LLC) or shareholders (in the case of an S-Corporation) pay the tax on profits or take the deduction for losses.

Allocations are not distributions.  A distribution results in the actual release of funds/assets to a member or shareholder from the company.  A distribution may be mandatory (e.g. a tax distribution or preferred return), or may be declared by the management of the company as a distribution or dividend.  Profits from a company may be allocated without actually being distributed to the members or shareholders.

Also, while allocations are based on the company's income and losses (i.e. earnings), distributions are made from capital.  A company's capital account is funded not only by earnings, but also includes any capital contributed to by the members/shareholders.  Accordingly, the allocations in a given year may not be the same as the amount distributed to the members/shareholders. Accordingly, a member/shareholder of a company could end up paying tax for money that he or she never received.  The founders should discuss how allocations and distributions will be made for the company, and document the founders' intent as part of the Operating Agreement or Shareholder Agreement.

 

For more information, please contact:

Derek Ridgway

925-746-8484 Direct Phone
925-746-8493 Fax

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