Understanding allocations and distributions

To understand partnership taxation, you need to understand two concepts: allocations and distributions. At the end of the year, your company generates either a profit or a loss, which passes through to the owners on their personal tax returns. This number is referred to as the allocation, and each owner pays individual taxes on this amount. On the other hand, a distribution is the actual cash you get from your LLC (or, sometimes, hard assets). It’s usually what you can deposit into your personal bank account and spend as you please.

More often than not, the amount of profit you’re allocated at the end of the year and pay taxes on isn’t the amount of hard cash that drops into your pocket. Why not? Well, you’ll likely decide to retain some money in the company to pay for growth or keep it as a buffer. Or perhaps you or your partners will make a company expense or two that isn’t deductible. When this happens, you have to pay taxes on these profits, yet you don’t actually get to cash the check and hit Vegas for a nice little shopping spree.

Getting creative with flexible allocations and distributions

One of the coolest features of an LLC that has elected partnership taxation is that it has the ability to vary its allocations and distributions. This designation means the company’s profits and/or losses don’t have to be allocated or distributed according to the ownership percentage.

Following is an example of how you can use varied allocations and distributions to your advantage. Say you really need some last-minute capital to grow your business, and in exchange, you’re even willing to give up a 30 percent stake in your LLC. As an enticement for an investor to give you an infusion of capital, you offer to structure the deal so that they receive 100 percent of all company profits until they’re paid back. After that point, the profits will be distributed according to ownership percentage, with the investor receiving 30 percent and you receiving 70 percent. This scenario is just one of thousands of ways to use this flexibility to your advantage. Don’t underestimate how powerful this concept is!

Unfortunately, the concept of varied allocations and distributions opens up the system to abuse by shady folks, and the IRS is savvy. The IRS wants to know that you’re using flexible allocations for legitimate business purposes and not simply for tax evasion. This crackdown throws a wrench into things a bit because for you to vary the allocations among you and your partners, you need to prove to the IRS that varied allocations result in what’s referred to as substantial economic effect, described in IRS Section 704(b). Long story short: If you’re not trying to evade taxes, you’ll likely be okay; just make sure you run the scenario by your CPA before making any promises.

Deducting LLC losses from your other income

If you have sources of income other than your LLC, you may be able to deduct your LLC’s losses from that other income to pay less in taxes. The IRS recognizes three types of income:

• Portfolio income: Such as dividends from stocks held.
• Active income: Wages and 1099 compensation.
• Passive income: Income from a business or rental property in which you aren’t an active participant. In other words, you don’t make the day-to-day operational decisions for the business and don’t work many hours in the business.

Assuming your LLC has elected partnership taxation, you can use your share of the business’s losses to offset any additional passive income that you may have received from other sources.

If you aren’t an active participant in your LLC, you can’t deduct your LLC’s regular business losses from your personal portfolio or active income, such as the income from your day job. In other words, under the passive income rule, if you’re not active in the business and your LLC passes on $50,000 in losses to you, you can’t use it to offset the $50,000 you made when you made a good trade on Wall Street (portfolio income). So you can sound like a smarty-pants when talking to your accountant, this situation is called a passive loss limitation.

All forms of pass-through taxation — not just partnership taxation — are subject to the passive loss limitation. However, as a member of an LLC with elected partnership taxation, you get a wicked bonus that other guys with S corporations and sole proprietorships don’t get. Say you’ve shunned the slacker lifestyle and are regularly (and continuingly) engaged in the day-to-day operations of the LLC, making you an active participant in the eyes of the IRS. Never underestimate the value (literally!) of hard work because you now get to deduct your portion of the LLC’s losses from all other income, including wages and stock dividends, without limitation. Starting a small business and not yet ready to quit your day job? This incredible tax deduction is reason alone to form an LLC and elect partnership taxation.

To help clarify the ins and outs of what partnership taxation allows you to do, check out Table 7-1.

If your LLC holds rental property, to be considered an active participant, you must be so actively engaged in managing the property that you qualify as an active real estate professional. Otherwise, your involvement in the LLC holding is deemed passive, and any losses the LLC distributes to you are subject to the passive loss limitation rules. Personally, I can’t think of a better incentive to learn how to unclog sinks.

Avoiding self-employment taxes

If you elect partnership taxation, you’re assessed a 15.3 percent self-employment tax in addition to the personal income taxes you must pay on the profit allocated to you. In addition, even if you’re an active member of your LLC, you aren’t allowed to hire yourself and use payroll taxes as a way to get around the hefty self-employment tax bill each year. This taxation is one of the only drawbacks of LLCs compared to S corporations, which only assess self-employment taxes on the salary you choose to pay yourself, assuming it’s within the norm for your industry.

One caveat, however, lands this guideline in the LLC’s favor. Although you may not be able to officially hire yourself (and thereby avoid self-employment tax), you can slack off a bit to the point where you’re no longer considered an active participant but rather a passive participant. In the case of an LLC electing partnership taxation, only active participants are required to pay self-employment tax, whereas inactive participants aren’t. The income itself is considered passive, which, as far as income goes, is about as favorable as the IRS gets. However, the rules can be murky depending on your industry and specific situation. I strongly suggest letting your CPA help guide you in this area.

If “slacking off” isn’t a viable business plan (I mean, if it was, I would have made a fortune in my teenage years), there is also another way to get around paying out the nose in self-employment taxes. You can have your LLC managed by a corporation (even if you and the others technically in charge are just owners of that corporation) or a trust. The management fees paid to the corporation are not subject to self-employment tax. Also, the corporation can offer high-quality medical insurance and reimbursement plans to its officers and directors (and their families). While owners of an entity with pass-through taxation have a rough time deducting those uber-expensive medical costs on their personal tax returns, it’s not so with a corporation. They are all fully deductible. So, by having a corporation as the manager of your LLC, you can get the best of all worlds.

Knowing when to choose corporation taxation

To explain why corporation taxation can result in less tax than any of the forms of pass-through taxation (such as sole-proprietorship, partnership, and S corporation taxation), I’ll use an example from my life. As an entrepreneur, I often use loans from my established businesses to help cover the cost of establishing new businesses (instead of paying double taxation by taking the money as personal income before investing it into the new business). I own all of my companies, so approval for this practice doesn’t present much of a problem.

After the company is established, I may pay myself a salary (which is taxable to me but deductible by the corporation); however, I rarely issue dividends. Instead of taking a lot of money from the business, I reinvest it and use it to help propel growth, which is the only way a business can achieve exponential growth. If you reinvest those profits into further building your company — a tax-free endeavor — instead of just buying yourself a fancy car, you’re compounding your resources, and the results you can achieve are much greater.

By following this plan, you manage to grow your company while maintaining a nominal — almost nonexistent — tax burden. And when the company reaches its peak, you can sell it. I keep my stock for over one year, so any income from the sale of my company ownership is considered long-term capital gains, which are only subject to a long-term capital gains tax rate of less than 20 percent. The government is happy because creating new companies creates new jobs and helps stimulate the economy, and you’re happy because now you can get the fancy car you’ve been wanting!

With an LLC, you don’t have to make this tax election right away. If you’re putting a lot of money into the company and want to deduct the losses of your initial formative years, you can maintain default partnership taxation for a few years and then make the tax election to switch to corporation tax status. However, this change may have other tax implications that aren’t obvious at first glance, so run any strategies like this one by a qualified accountant before committing.

Seeing how corporation taxation can be a terrible idea

In some circumstances, you should never elect corporation taxation for your LLC — namely, if your LLC holds passive real estate investments. In today’s litigious America, the idea of putting your personal assets in another name to protect them is a generally accepted practice; using an LLC to hold real estate is a good move, but you’re going to find yourself in a world of hurt at tax time if you elect corporate taxation in this scenario.

If you hold a piece of investment property in a corporation or an LLC electing corporation taxation, you’re subject to double taxation on all the income that property receives, such as the rent it collects. Also, you will face a problem when you want to offload the property because removing the property from the entity is a taxable event. Switching back to partnership tax status before selling the property won’t do you much good, either. You may be forced to calculate the appreciation during the corporation tax election and pay a BIG tax on that amount. Literally! BIG is an acronym for built-in gain, and it’s one well suited to the tax term, considering it’s currently hovering around 35 percent! When you make the corporation tax election, you’re stuck with it for five years, so this appreciation period can represent a pretty hefty chunk of change.

Also, myriad other tax problems can pop up if you subject your rental property to corporation taxation. You can spend time and money getting a second opinion from a CPA, but I think you’ll find it’s a universally accepted rule: Never elect corporation tax status for an LLC that’s being used to hold passive investments such as real estate. Now, if you have a corporation as a management company that engages in the active business of flipping or renting out your properties, that could definitely work with corporate taxation. But for passive income investments like real estate, an LLC with partnership taxation is a better option.

One big tax benefit that entities with corporate taxation are unfortunately not entitled to is the 20 percent automatic tax deduction on qualified business income (QBI). This awesome tax break for pass-through entities will expire in 2025, so let’s hope they renew it! If you want to get the best of both worlds — that QBI deduction as well as some of the perks that corporations get, you may want to consider having your operating company be an LLC managed by a corporation.

Reducing your taxes

S corporations get a pretty big advantage when it comes to taxation, though at first glance, the situation looks comparable to partnership taxation status. If you’re a member of an LLC electing partnership taxation, you must pay personal income tax on all company profits allocated to you. In addition to personal income tax, you must also pay a 15.3 percent self-employment tax, which is simply both the employer’s and employee’s shares of Social Security and Medicare taxes. But with an S corporation, you can pay yourself a salary, which is a deductible expense for the company, and any amount over that isn’t subject to self-employment tax. You simply pay personal income tax on those profits and nothing more after they’re allocated to you. This setup differs substantially from LLCs (which have elected partnership taxation) because all profits you derive from the company in that scenario are subject to the 15.3 percent self-employment tax.

In other words, if you’re taxed as an S corporation, the amount of Medicare and Social Security you pay is limited to the amount you take as a salary. As long as your salary is comparable with others in your position and your industry, any profits the company takes above that amount aren’t subject to extra taxes.

In a nutshell, this designation means you save 15.3 percent in taxes on all profits above an appropriate salary. So, if you have a business from which you intend to remove a substantial amount of profits — more than the reasonable salary you’re taking — you’ll probably see some pretty hefty tax savings by electing S corporation taxation.

Dealing with the restrictions

Unfortunately, even if S corporation status is your best choice, you may not be able to elect it. When the IRS created the S corporation election, it wanted to make sure that the status was employed by genuinely small businesses and not exploited by large enterprises strictly as a tax-saving strategy. Therefore, you must meet quite a few restrictions in order to take advantage of S corporation taxation:

• Your corporation must not have more than 100 shareholders.
• Shareholders can only consist of natural persons, individual trusts (for estate-planning purposes), and tax-exempt nonprofit organizations. This list specifically excludes any other entity or business structure, such as limited liability companies or corporations.
• Shareholders must be citizens or alien residents of the United States.
• The corporation may only issue one class of stock, and all owners are treated equally. You’ll have to save the preferred shares for your IPO.
• Banks and insurance companies are barred from being shareholders.
• All shareholders must unanimously consent to the S corporation tax designation. In other words, a majority vote just won’t do the trick.

In addition to these ownership restrictions, you may want to take into consideration a few other downsides before committing:

• There’s no step-up in basis on assets after you die. When your heirs inherit your assets in an S corporation, they’ll have to pay capital gains tax on the appreciation from the date you first purchased the asset rather than just from the date you passed it on to your heirs.
• You can’t add debt to your tax basis. Earlier in this chapter, I discussed that LLCs allow tax-free distributions to the extent of your tax basis, including the amount of debt the company has that you can be held personally responsible for. With S corporation tax status, you receive no tax benefits for being personally responsible for the company’s debt unless it’s a loan you’ve made personally.

These rules (plus many more) make S corporations a bad choice for holding real estate. Even though S corporation status lets you get around the double-taxation nightmare that comes with a regular corporation, you’re still limiting yourself by being unable to deduct the mortgage personally.