LLC distributions are a frustrating subject for business owners hoping for straightforward answers about taxes. This article is meant to simplify what business owners need to know about their distributions.
LLC distributions can be taxed as ordinary, passive, or other kinds of income. Typically limited partners (shareholders) receive passive income, while active managers get ordinary income. Knowing the full context of the distribution is necessary to determining its income category.
By answering some key questions you’ll be able to discover how much your distributions will likely pay in taxes. Once we consider who it’s going to, what it’s for, how your LLC is taxed, as well as some other context you’ll have all the tools you need. If that’s too much, please just review the cliff notes.
Cliff Notes
LLC distributions mean many things in the world of taxes. However if we are over generalizing based on membership then:
Distributions to active managers are usually ordinary income.
Distributions to passive shareholders (limited partners) are usually passive income.
S Corps enable active managers to receive some tax advantaged non-ordinary income.
Next we go into the key questions you need to be able to answer to accurately tell what type of income your distribution is.
LLC Distribution
An LLC’s payment of cash, stock, or physical product to its members. This is a broad term that encompasses many different ways LLC members get compensated and taxed.
Key Question: Who’s It For?
The first step to determining the income category of a distribution is who’s receiving it. Are they an active manager that has material participation in the business operations? Or does the member have a more passive role, unable to make decisions or create contracts? Knowing this information can help you understand what options are available to you.
Active managers in regular LLCs don’t typically get anything other than ordinary income. Whether your LLC has multiple members, taxed as a partnership, or just a single member, your options for distributions are usually limited to ordinary income. By changing your LLC tax classification you’re able to explore other options we’ll discuss soon.
Limited partners, commonly called shareholders or “silent partners” are also members of LLCs. In exchange for the many disqualifiers passive shareholders need to look out for, they have far better tax treatment than active managers. They generally pay capital gains taxes on their distributions. Speak with a tax attorney to be sure you meet the qualifications for a limited partner.
Key Question: How’s Your LLC Taxed?
As mentioned, S Corporations open up new income options for active managers running their LLC. While regular LLCs can only pay their active members ordinary income, S Corps allow them to add on “non passive” income. While non passive is unusual in the tax world, it has very advantageous tax treatment. We discuss this in more detail below.
Next Question: Salary or Other?
Active members of an S Corp will always need to take a salary, however can shift some of their compensation into non passive income. Their salary will need to be “reasonable” as defined by the IRS, so expect to pay in line with what your industry would offer someone for the same role. Compensation outside of your salary will enjoy better tax treatment as "non-passive income".
Non-passive income can be thought of as halfway between earned and passive income. This income avoids self employment taxes, only paying income taxes. This leads us to our next question.
Next Question: What’s Your Stock Basis?
For active managers you'll want your non-salary S Corp distributions to be below your stock basis or will owe full taxes on that amount.
Stock Basis
Generally defined as the amount of one's investment in a property for tax purposes. This amount should be recalculated each year.
Stock basis is a complicated topic and completely outside the scope of this article. To calculate your stock basis you’ll need to complete a Schedule K-1. Please meet with your CPA in order to get your exact stock basis.
Income Categories
We’ve talked about income types and how some have better tax treatment than others. Here we’ll go over each one. You’ll discover who typically receives each type of income, what taxes it pays, and any caveats you need to know about as an LLC owner.
Ordinary Income
This type of income is frequently called earned and active income. It’s often received by sole proprietors, general partners, and active managers. This is the type of income you want to avoid as it has the worst tax treatment.
I urge business owners to think of ordinary income as double taxed similar to a corporation. That's because it's subject to 2 major rounds of taxes: Self Employment/FICA and income. While your accountant may not like us misappropriating "double taxation" this way, it is helpful when thinking about your tax strategy.
Because ordinary income pays 2 large rounds of taxes it is more expensive than passive and non passive income types. Tax rates on this income are discussed in detail here. Let’s look at why you want to shift your compensation out of this category.
Passive Income
Distributions to limited partners are usually taxed as capital gains. There are 2 different tax groups for capital gains: short and long term. If you’ve owned the LLC stock for more than a year you’ll be taxed at the more preferable long term capital gains tax rates. Note that to be a limited partner you must have no management role in the company and ensure you meet the many qualifications in order to stay this way!
For tax reasons you want to be a passive shareholder because you only pay one round of capital gains taxes. While high earners may have to pay an added net investment income tax, you’re still going to get given better treatment than ordinary income.
Non Passive Income
Very uncommon, yet very important for LLC owners, is non passive income. This is what active managers of LLCs receive that is not part of their reasonable salary. When below a members’ stock basis this income only pays income taxes, otherwise it pays both self employment and income taxes.
Similar theme with this preferable income is that there is only one round of taxes! Again this makes it far less expensive than ordinary income. This non passive vehicle for your income is why S Corps are a popular tax saving strategy for LLC owners. Check out our S Corp tax calculator to see if your LLC could be saving thousands in taxes.
Portfolio
Not that common when dealing with LLCs. Portfolio income is generated from selling an assets. We will not be covering this income group here.
Be Passive
As a business owner myself I have tremendous respect for those of you with the drive and passion to build and operate great businesses. However as a business person you must be aware of the tax implications of this income. Ordinary income can be thought of as double taxed just as much as corporate profits are.
Improving your tax strategy with tools like S Corps can help you start to shift some of your income into better tax treatment. Using our S Corp tax savings calculator can help you determine if this is a strategy you should talk about with your CPA. While S Corps have powerful tax advantages, please research the more restrictive ownership rules and additional upkeep they require.
Next Steps
We’ve covered a lot of ground in this article! You’ve learned that distributions can mean many things, but mostly are just cash payments to its members. These payments can result in different types of income including ordinary and passive. You and your accountant need to be able to ask key questions about who the members are and the full context of the distribution being made.
By asking the questions we’ve listed above you should now be able to diagnose the tax treatment of the vast majority of your LLC distributions.
For you passive members and S Corp owners curious about your distribution LLC tax rates, please read our post. Now that you’ve categorized your income, calculating its tax rate is your next step!
