Another important part of an LLC Operating Agreement deals with the “capital” that comes into the LLC and with the corresponding percentage ownership rights of the individuals or entities providing such capital. Capital typically comes in upon formation of the LLC (initial capital contributions by the members) or over the course of the life of the LLC (additional capital contributions by the members). Finally, members can decide to provide loans to the LLC. Loans aren't considered capital, but I mention it here, because it is another way to transfer additional funds into the LLC.
Initial Capital Contributions
In the most common scenario, two owners (“members” in LLC lingo), at the time of formation of the LLC, each contribute the same amount of money and each receive 50% ownership interest in the LLC.
But capital contributions can also be in the form of property or services. For example, one member may contribute money and the other a business that was conducted as a sole proprietorship before formation of the LLC. Example: A, who has a retail store, wants to take in a partner. He finds B, who is willing to invest money into the business. They form an LLC. A contributes his retail store and B contributes money in an amount equal to one third of the value of the retail store. A would own 75% of the LLC and B 25% of the LLC.
As another example, one member may contribute money and the other services, which are to be provided over the course of a certain time period.
If a member’s contribution consists of property or services, it becomes necessary to put a value on these contributions. This is important with respect to ownership percentages and certain tax matters.
Service contributions by a member are tricky, because they may subject the contributing member to unexpected income tax obligations.
1. Example: A and B form an LLC. A contributes $50,000 and B contributes the promise of future services valued at $50,000. The Operating Agreement provides that A and B each have 50% ownership interest in the LLC. B would have to pay income tax on $25,000 at the time of formation of the LLC, even though he has yet to receive a penny in profit from this venture.
2. Example: A and B form an LLC. A contributes $50,000 and B contributes the promise of future services. The Operating Agreement provides that B will "earn" 50% of the ownership interests in the LLC once he has completed five years of service for the LLC, i.e. in year 5, he will have earned a total of 50% of the ownership interests. B will have to pay income tax upon year 5 when his ownership interest has "vested". Now, this could be pricey for B. Let's say the LLC increased its value from $50,000 in year one, to $500,000 in year five. In that case, B would have to pay income tax on $250,000 representing his 50% capital interest vested in year five. There is a solution. B could file a so called Sec. 83(b) election at the time of formation of the LLC. In that case, in year five, his income tax obligation would be calculated using the value of the LLC upon formation, i.e. when he received the capital interest (albeit restricted). Thus, he would have to pay income tax on $25,000.
3. Example: A and B form an LLC. As initial capital contributions, A and B promise to provide equal services to the Company; no money is contributed to the LLC. Since the LLC's initial value is zero, there are no adverse tax consequences to A and B based on their deferred service contributions.
Additional Capital Contributions
The operating agreement can provide that the members are required to contribute additional capital (cash, property or services) at certain times or as determined by a certain majority of members at any time. This would change percentage ownership interests of the members at the time of contribution. Since additional capital contributions can be a burden for small business owners and may require complicated readjustments of the owner’s capital accounts and ownership percentages, many small business LLCs provide that members shall not be required to make additional capital contributions to the LLC.
Loans by Members
Money can also come into the LLC via a loan by a member. In that regard the member would be deemed to be a regular creditor of the LLC. Loans do not affect the member’s percentage ownership interest in the LLC and will have to be repaid to the member.
Unfortunately, this stuff can get much more complicated and may require the help of your accountant and tax lawyer.
See earlier post: New York LLC Operating Agreements: Management Provisions