COVID Funding Tips for Small Businesses
Knowing how your distributions from an LLC are taxed is critical to your LLC formation strategy. After your LLC is formed, your business is up and running, and revenue is flowing, will you come to that important point where you distribute money to the partners. That may be just you, your spouse, or other outside partners.
Some people just write checks from the LLC to themselves, as the owner, and really don’t consider the tax ramifications of their actions. This is especially important anytime you have a partner, whether that is a spouse, outside partner, or a separate legal entity.
Let’s address some basic fundamentals first, then get into more details:
The first step is to be aware of how your LLC is taxed. Are you a single member LLC taxed as an S corporation, or disregarded for tax purposes? If you have earned income and a single member LLC that will flow through to schedule C, you are basically operating as a sole proprietorship, but have the liability protection of an LLC).
Test question: Is there any payroll for a single member LLC? The answer: depends. If the LLC is disregarded for tax purposes, there is NO payroll to the owner. Is it possible for a single member LLC to have employees? Yes. If the single member LLC is taxed as an S corporation, the active member (owner) would have payroll and distributions. If you have a single member LLC taxed as an S corporation, of course, the only member is active. If you have a two-member LLC taxed as an S corporation, it is possible that the second member could be passive (this could be a spouse or silent partner). Would the passive member be the manager of an LLC? No. By definition, if passive, they would not be running day-to-day operations. Keep that in mind.
A single member LLC taxed as a C Corporation; there would be, at some point, some type of payroll to the owner of the C Corporation. Is it possible that there was only enough revenue in the LLC taxed as a Corporation to only pay business expenses and not enough profits left over for any type of payroll? That is possible. You may take dividends out of the LLC taxed as a C Corporation, but keep in mind dividends are NOT deductible to the LLC taxed as a C Corporation’s profits.
An LLC taxed as a partnership is a very common structure. The big mistake you want to avoid is doing payroll for partners. There is NO payroll to partners in an LLC taxed as a partnership. There is something called “guaranteed payments” to the manager of the LLC for their role in the day-to-day operations of the LLC, which is subject to employment taxes, but it is not payroll. The members (or partners) of the LLC will receive distributions in profits. If the member or partner is actively involved in operating the business, those distributions will be subject to employment taxes.
Let’s get into more detail about when an LLC can make distributions to members. Absent any agreements with third parties restricting distributions, LLCs generally can distribute cash or property. Here is an important point (a reason to have great accounting records from the beginning); most LLCs prohibit distributions to members if the LLC’s liabilities (other than liabilities to members) would exceed the value of the LLC’s assets. Most LLC statutes hold members liable to creditors for wrongful distributions under their fraudulent conveyance statute.
Is compensation considered a distribution to a member? In some states, the answer is yes. Compensation to a member when the LLC is insolvent may be considered a wrongful distribution that is subject to recovery. Some states see that differently. Most state LLC statutes provide that distributions are shared in proportion to each member’s contribution to the LLC. If you and a partner own an LLC 50/50, typically, that is the percentage of profits that are distributed. If you have $5K to distribute, the LLC would distribute $2,500 to each member. Some (very few) LLCs have a situation where there is a disproportionate distribution of ownership percentage and profits percentage. It is possible to have a situation where two partners own the LLC 50/50 and the profits are split 80/20.
It is very important to note that the LLC is not obligated to distribute profits at all, unless otherwise written into the operating agreement to distribute enough profits to cover the tax bill of each member. That seems to make sense on the surface, but there are other issues with having that written into the operating agreement. You may be a member of an LLC, with no profits distributed, and you receive a K-1 for $40,000 of profits from the LLC. If you did not receive any distributions, you will have to pay the taxes due on that $40K out of your own pocket. Be careful in that situation.
As you can tell, having a great CPA firm onboard with the foundation of your entity is critical to avoid issues that may come up with distributions of profits to the members in your LLC.
Need support forming an LLC correctly? Learn more at NCP.