While there may be reasons for choosing to give members distributions instead of compensation, there are potential risks to the LLC’s members from a creditor standpoint. A.R.S. § 29-706 provides that a limited liability company “shall not make a distribution to its members to the extent that at the time of the distribution, after giving effect to the distribution, all liabilities of the limited liability company would exceed the fair value of the assets of the limited liability company….” Liability is imposed on each member who receives such distributions for the amount of such distributions.
Take, for example, a medical practice that conducts its business as a professional limited liability company and for which there has been a large malpractice claim. If the medical practice thereafter continues to pay its doctor members in the form of distributions instead of compensation, each member potentially can be personally liable for distributions received at any point after the company’s liabilities exceed its assets.
Other legal doctrines can lead to the same result; and similar rules can apply in the context of corporations and limited partnerships. Thus, while there may be good reasons for classifying payments to members as distributions instead of compensation, beware the unintended consequences of doing so: it may adversely affect the limited liability protection otherwise afforded an LLC’s members.