Partnership Taxation and Limited Liability Companies
All LLCs are created with a default tax status. If your LLC has at least two partners and the LLC doesn’t make any tax classification election with the IRS, then your LLC is automatically assigned the default, which is partnership taxation — a favorable form of pass-through taxation.
The various forms of pass-through taxation have some differences, but the premise remains the same: The business itself doesn’t pay federal income taxes; instead, the profits of the business pass through to the owners to be reported on their individual income tax returns.
The individual owners then pay regular personal income tax. Similarly, any loss the LLC takes for the year flows through to the owners, and they can use these losses to offset other income they may have.
Unfortunately, if you’re a single-member LLC, you can’t elect partnership taxation. Your default status is disregarded entity unless you elect corporation or S corporation taxation.
Partnership and S corporation taxation differ dramatically from one another, and the regulations on structuring are different (for example, S corporations have more restrictions on who can and can’t be an owner). Don’t make the mistake of forming a corporation and electing pass-through S corporation tax status, thinking it’s the same as the partnership taxation of an LLC.
Corporations can elect to have a form of pass-through taxation (creating what is called an S corporation), but it’s not the same as the default partnership taxation of an LLC.
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. A distribution, on the other hand, is the actual cash you get from your LLC (or, sometimes, hard assets). It’s usually what you’re able to 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 most likely decide at some point that you want to retain some money in the company to pay for growth or to keep as a buffer.
Or perhaps you or your partners will make a company expense or two that isn’t deductible. When this situation happens, you have to pay taxes on these profits, yet you don’t actually get to cash the check and go hit up Vegas for a nice little shopping spree.
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 that the company profits and/or losses don’t have to be allocated or distributed according to the percentage of ownership.
Unfortunately, this concept of varied allocations and distributions opens up the system to abuse by shady folks, and the IRS has gotten 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 in order 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.
Deduct 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 you don’t work very 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 that has elected partnership taxation, you get a wicked bonus those other guys with S corporations and sole proprietorships don’t get.
Say you’ve shunned the slacker lifestyle and are regularly (and on a continuing basis) 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.
|Can Offset Portfolio Income with LLC Losses||Can Offset Active Income with LLC Losses||Can Offset Passive Income with LLC Losses|
|Active in LLC||Yes||Yes||Yes|
|Passive in LLC||No||No||Yes|