LLC income distribution

November 19, 2007 5:19 PM

Help me make this LLC fair when it comes to income distribution...

First: I know no one here is an accountant. I have one. I have an attorney. But I also value the individual thoughts of the Community, as it were.

Scenario:
Person A and B jointly form an LLC that makes custom jewelry, and quickly start making decent money (i.e., a thousand or so in profit per month after expenses and improving).

Person B likes to make purchases of a personal nature on the LLC account. Said purchases are likely to pass the sniff test as far as being for business use (even though they are personal, i.e. clothes, occasional decorative items).

Person A is married to a doc and they make enough money and are cautious enough that pulling money out of the LLC for personal items that can be passed off as business expenses is not in her interest. She's rather not tempt an audit. She'd rather have cash. But it's also become the norm for Person B to buy Person A the same thing each time she gets herself something, for reasons I suspect have to do with trying to assuage a bit of a guilty conscience. Person A also doesn't necessarily find appealing what Person B thinks is. Etc.

So there's this elephant in the room. Person A can't get Person B to understand, using gentle, oblique language, that she doesn't want to spend money on these things, but isn't sure what scenario to propose. Since I'm married to Person A and Person B wants me to stay out of their affairs, but since my income tax statement is tied to the LLC, I feel I need to get involved.

Question:

How does one resolve this?
Let's assume that the purchases are legitimate, but that certain purchases are for joint use (metal supplies) and others are individual (a cell phone, a dress for a big jewelry show). How does one make it equitable?

My suggestion:
Let person B spend the money on "stuff" that is for personal use and not jointly needed by the LLC for operations.
Person A then takes an equal amount of money out as cash and declares it as income.

Does this make sense?

Thanks in advance.

posted by docpops to work & money (13 comments total)

Sadly, it looks as if the partnership is not working, and the LLC should be dissolved.
posted by Steven C. Den Beste at 5:22 PM on November 19, 2007

Sadly, it looks as if the partnership is not working, and the LLC should be dissolved.

Well, you may be right. But there's been more contentious stuff hammered out successfully between them. It's just that my wife (A) is not financially well-versed and B is slightly, only slightly, moreso. And I'm trying to handle this by proxy, and both of them, for similar and dissimilar reasons, want this to work.
posted by docpops at 5:35 PM on November 19, 2007

I am confused by this idea of "making it equitable."

Person B is either spending company funds inappropriately on these purchases, or she is not (ergo, using the money correctly for the benefit of the LLC).

If she is misspending, then the problem is with the misuse of company funds. There is no commensurate income issue for Person A. Person B just needs to cut it out.

If she is spending appropriately for the good of the business, then Person A isn't "entitled" to receive an equivalent amount in cash.

From what you say, it sounds like Person B is spending inappropriately. "Could pass the sniff test for an audit" is not the same as "an efficient and positive business practice that indicates long-term health of the partnership." Better to nip this in the bud now.

I would suggest that Person A tells Person B to knock off the questionable purchases, that those things which convey strictly to her personal benefit need to come out of her share of income. And then, both Persons agree to what percent of their net income is profit, and then that X% is paid to the Persons 50/50 as salary.
posted by pineapple at 5:44 PM on November 19, 2007

If they want it to work, they need to stop treating the business as a cash register or there will be an audit and it won't be pretty. The Small Business Administration has free workshops and so does the organization SCORE, which is made up of retired business people who volunteer to mentor small business owners and helps them make logical business decisions. You might have an accountant, but the two of them meeting with an accountant to set up the books and show them how entries are made would be useful. There are legitimate expenses that can be treated as business expenses that might look like personal expenses, but there are some grey areas, too. The accountant could really help them get on the right track and would get you out of the middle of it.
posted by 45moore45 at 5:48 PM on November 19, 2007

Pineapple - thanks. So along those lines, they've never declared a salary for themselves. Periodically they may take some cash out as a 'payday' and track it for their returns. But Person B steadfastly maintains the righteousness of what she's doing. Should they instead pay themselves, and then Person B can declare those purchases against her share of the LLC income? And if so, isn't it appropriate (and less inflammatory and confrontational) for Person A/my spouse, to essentially say, "Good for you, go buy your stuff, but I really don't need [cell phone/blouse/necklace/desk chair] and I'll just take the cash as a payday, and good luck with the IRS when you do your taxes"?

and 45moore - part of the problem is that her(PersonB) accountant is a CPA friend that seems to feel what's happening is permissable.
posted by docpops at 5:53 PM on November 19, 2007

Your suggestion is not bad. The key point is going to be the proportion of these expenses to overall income. An IRS auditor is not likely to make a big deal out of relatively small items.

I would suggest that your wife find similiarly borderline items that she would like to purchase.
posted by yclipse at 6:17 PM on November 19, 2007

yclipse - thanks. The amount spent isn't becoming a concern as far as harming business cashflow. It's just very clear that Person B is a bit drunk on the idea of getting something as a business expense and it's irritating as hell to my wife. I feel like it would be better if they both take cash, then each spend it how they want. If Person B wants to list it as a deduction/expense against income at the end of the year/tax time, she could still get the tax break on her purchase, and I think [correctly/incorrectly?] that there would be less risk to the LLC.
posted by docpops at 6:30 PM on November 19, 2007

(Assuming, for the sake of argument, that this is an equal partnership and there's not some sort of majority/minority issue)

Ideally 'B' would buy these things with her own money and then deduct. The problem with this suggestion is that the deduction saves her whatever her marginal tax rate is... so if the item is $100 and she's in the 35% bracket, the deduction saves her $35, while just buying it out of the LLC coffers saves her (obviously) $100.

I would suggest that 'A' and 'B' have a sit-down. 'A' would explain that she doesn't think the purchases are the best use of the LLC's money, and ask that they set a policy going forward for spending LLC money on personal items. Everything in the past is forgiven/forgotten. (Ideally the lawyer would draft some sort of addendum to the LLC's partnership agreement making this policy official)

One option is to just require mutual agreement on all spending of LLC monies. Another is to establish a reasonable expense allowance for each partner (on a monthly/yearly basis), and let them spend as they and their accountant/lawyer see fit.

Really, though, the bottom line is that A needs to stand up and express her feeling that B's "business" expenses aren't in the best interest of the LLC.
posted by toomuchpete at 7:10 PM on November 19, 2007

I feel like it would be better if they both take cash, then each spend it how they want. If Person B wants to list it as a deduction/expense against income at the end of the year/tax time, she could still get the tax break on her purchase, and I think [correctly/incorrectly?] that there would be less risk to the LLC.

Yes, you are spot on. If Person B wants Tchotchke X bad enough, and is convinced enough that it's a legitimate business expense, and her own accountant is backing her, that's fine... for her. She can buy it with her very own free-and-clear, personal cash and then deduct it in April if she feels justified -- and then Person A is out of that picture, as is the LLC.

Should they instead pay themselves, and then Person B can declare those purchases against her share of the LLC income? And if so, isn't it appropriate (and less inflammatory and confrontational) for Person A/my spouse, to essentially say, "Good for you, go buy your stuff, but I really don't need [cell phone/blouse/necklace/desk chair] and I'll just take the cash as a payday, and good luck with the IRS when you do your taxes"?

Not really. Let's use your other idea: the LLC pays out $500 per month to both Persons as salary, and then after that transaction, Person B buys a phone or necklace or whatever -- at that point, it's A-OK fine because Person B is clearly spending her own personal funds. What she and her accountant work out with the IRS is between those three parties, but you and Person A are in the clear.

But in your scenario (if I'm understanding it properly), you're saying, "...so then, what's the big diff if Person B spend 500 LLC dollars on things for herself, but Person A takes $500 cash? Same original pile of dollars, same destination." Yes, it would definitely be less confrontational to let that happen.

Where it becomes legally/financially/ethically hinky for you and Person A is the commingling of funds. Regardless of the original pile, and the original destination of the assets, in the middle is Person B using the LLC's account as her own personal shopping spree.

And if Person A knows this, and it ever becomes a problem, she is complicit. As is Mr. Person A.

Again, would the IRS really care? Probably not. But what happens when Custom Jewelry LLC really takes off? What happens when BigMegaGemsCorp wants to buy the venture... but the books are funny? What happens when Person A has become so accustomed to financing her lifestyle via the LLC bank account that she makes the easy leap from "Well, I need this dress for a jewelry show" to "This dress really only looks good with a new haircut. And, if I can't make my car payment I can't get to the workshop, right? Voila, business expense."

I wish these what-ifs were hyperbole; I have known and worked with people who did this. Your exact words hit the mark: they were drunk with the idea that as long as the purchase passes a sniff test, no matter at what arm's length, it is therefore acceptable. Those people are both no longer with my company, because their profligate misuse of company funds became not only reckless but eventually illegal, in one case.

Your wife's LLC is not that big yet... but the notion that a bad behavior is okay because the stakes are small will always lead to trouble.

How Person A deals with Person B is the rub. Can she use you as an excuse? "Look, I hate to be a stick in the mud but docpops talked to our accountant on this, just to find out what we need to document for reporting, and the guy flipped out about your phone and dress and stuff. Let's just start paying ourselves, and then you can buy what you want with your own money."

But Person B steadfastly maintains the righteousness of what she's doing.

Person A might suggest using the IRS rules for what a person can and cannot deduct as a business expense (basically anything that someone is also going to use for any personal purpose is suspect). It seems a pretty reasonable comparison to me. If Person A is buying a phone... and only using it for LLC-related calls, nothing else ever... then the IRS would call it a fair expense, and so might the LLC. Your wife could appeal to the IRS standard as the authority, and then avoid being the bad guy.

Or it might be worth spending LLC funds to hire an accountant that isn't conflicted by prior engagement with either person, to give them a call on this. Guarantee you that accountant tells Person B to knock it off.

If Person B is absolutely firm that her "business expenses" are all justified, and won't budge, then you've got another fairly serious problem on your hands (see SCDB's comment, above). But either way, this one is far better to resolve now, when the stakes are very low.
posted by pineapple at 7:13 PM on November 19, 2007 [1 favorite has favorites]

Why not set up budgets for expense spending for each individual? This amount would be set for each month for the fiscal year. These amounts would be equal. If they go over their budget then it would carry over and be deducted from the next month. If the company hits a short fall then the necessary funds to cover payables come from the owners' expense spending budget.

Have the two of them submit a figure they think is fair then take the average. Let them know that the business is doing well and it is common business practice to do this to avoid problems as the business grows- problem being the audit they both want to avoid.

You can also add that at the end of the fiscal year both owners can sit down and adjust the budget based on profit going forward to the next year.
posted by bkeene12 at 7:17 PM on November 19, 2007

...a more snarky answer is this:

If the LLC bought it, the LLC owns it. Dresses and jewelry should be stored at the offices, not in individual partners' closets or jewelry boxes. For business events, partners can use the stuff, and then must return it to the offices. Using it for non-business related events is disallowed.

Good luck enforcing that, though.
posted by toomuchpete at 7:20 PM on November 19, 2007

Wow - thanks everyone. This is why I come here. Pineapple, your lengthy and articulate answer will be a template for me going forward, and my spouse will also glean much from the words here. Thanks again, all.
posted by docpops at 5:45 AM on November 20, 2007

Hopefully this will be extraneous and it's all already taken care of. In case it's not, though...

I'm not sure what smell test this is passing, but the point of an LLC is to protect the personal assets of the owners. Making personal purchases from business accounts could possibly compromise that protection.

I would add to pineapple's eminently reasonable recommendations that another tact is for them to talk to an attorney who represents the LLC (not you or either of the owners, but the distinct legal entity of the LLC) for a quick rundown on maintaining the corporate veil. They probably already have one, it shouldn't take that long, and it may be more persuasive than another accountant who says, "Your accountant is wrong." Person B needs to hear the corporate-misfeasance-is-not-as-fun-as-you-think-it-is speech from someone they'll believe.

To my mind, the possibility of making it easier for creditors to grab your own personal stuff would be more concerning than an audit. Unless they love paperwork, why go through the hassle of maintaining an LLC just to undercut it?
posted by averyoldworld at 2:57 PM on November 20, 2007