LLC non-salary distributions mean huge tax savings, however they also come with a baggage train of “gotchas” that every LLC member should be aware of.
Federal LLC non-salary distribution tax rates range from as low as 0% (tax free) to as high as 23.8% for high income passive shareholders.
| Income | Status | Tax | Rate |
|---|---|---|---|
| Non-Passive | Below Stock Basis | Income | 10% - 37% |
| Passive | Below NIIT Threshold | LTCG | 0% - 20% |
| Non-Passive | In excess of Stock Basis | LTCG | 14.1% - 39% |
| Passive | In excess of NIIT threshold | LTCG & NIIT | 3.8% - 23.8% |
Here LTCG stands for Long-Term Capital Gains and NIIT referees to the Net Investment Income Tax
Soon you’ll be able to figure out exactly what type of income your distribution is and whether you can avoid those higher tax rates.
What’s a LLC Distribution?
Distribution (n) - A non-wage/salary allocations of capital and income made to members throughout the year.
A distribution is not a dividend, which is issued by C Corporations to its shareholders. None of the information in this guide pertains to LLCs taxed as C Corporations!
The appeal of non-salary distributions is that they are not taxed as ordinary or earned income, which has the highest tax expenses.
There’s two main groups that can get a distribution from an LLC: active members of an LLC taxed as an S Corp or passive members (i.e. passive shareholder or in legalese a “limited partner”). Each group has different tax treatment as well as advantages and disadvantages. Let’s walk through how each group classifies their income and what concerns they should have about triggering higher tax rates.
Single Member LLCs
For owners of single member LLCs, taxed as sole proprietors, who are actively in running their business: you cannot receive non-salary distributions! You may however consider becoming an S Corp for tax purposes.
If you’re actively involved in the day to day operations of an LLC taxed as an S Corp, then your distributions are taxed in a unique way from passive shareholders. Firstly, they have an obscure tax classification known as Non-Passive income. This has a few noteworthy features:
Advantage: Better tax treatment (when below member's stock basis)
Disadvantage: Must be materially involved in the business
Disadvantage: Your distribution can’t exceed your stock basis or it triggers LTCG taxes
Your non-salary S Corp distributions will appear on your Schedule K-1, however you’ll need to also determine your stock basis to see how much of this distribution income is taxable.
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 outside of the scope of this guide, however it’s likely something you’ll want to discuss with your CPA. For those brave souls that want to learn all about calculating your stock basis in a S Corp then use these IRS instructions.
To recap: if you exceed your stock basis as an S Corp member your tax rate could be as high as 40% on that income (your highest ordinary income tax rate). If you do not exceed your stock basis then your distributions only pay income taxes!
Passive Shareholder Distributions
Passive shareholders are legally referred to as “limited partners” and are defined in the U.S. Tax Code Section 1402 Subtitle A, Part 13 [Sec. 1402(a)(13)]. Their distributions are classified as passive income. Now it’s important to be careful that you qualify as a limited partner before claiming a distribution. These qualifications can be summarized as:
You are not personally liable for the LLC’s debts,
You do not have authority to contract for the LLC, or
You do not participate in the LLC’s more than 500 hours per year.
Thanks to Thompson Greenspon for providing these helpful qualifiers for a limited partner!
Because I wouldn’t say the IRS guidance is night and day clear (to me at least), I would want to talk to my CPA or Attorney to be sure I meet all the requirements of a passive shareholder before taking any distributions.
Here are some important features of this Passive Income:
Advantage: You’re not involved in day-to-day operations
Advantage: Your distributions can be tax free, as long as you’re below LTCG & NIIT thresholds.
Disadvantage: Passive shareholder status can be lost and contested, so you must be careful.
Disadvantage: your distributions are usually exposed to LTCG.
Disadvantage: If you've owned your shares less than a year you could pay short term capital gains tax rates which are higher.
Disadvantage: your distributions are exposed to Net Investment Income Tax if they exceed the threshold for your filing status.
Long Term Capital Gains Tax Rates (2020)
| Filing Status | Income | Rate |
|---|---|---|
| Single | $0 - $40,000 | 0% |
| Single | $40,001 - $441,450 | 15% |
| Single | > $441,450 | 20% |
| Married (filing jointly) | $0 - $80,000 | 0% |
| Married (filing jointly) | $80,001 - $496,600 | 15% |
| Married (filing jointly) | > $496,600 | 20% |
| Married (filing separately) | $0 - $40,000 | 0% |
| Married (filing separately) | $40,001 - $248,300 | 15% |
| Married (filing separately) | > $248,300 | 20% |
| Head of household | $0 - $53,600 | 0% |
| Head of household | $53,601 - $469,050 | 15% |
| Head of household | > $469,050 | 20% |
Net Investment Income Tax Thresholds (2020)
This 3.8% tax applies to all modified adjusted gross income above the following threshold amounts.
| Filing Status | Threshold |
|---|---|
| Single | $200,000 |
| Married (filing jointly) | $250,000 |
| Married (filing separately) | $125,000 |
| Head of household | $200,000 |
| Widow(er) | $250,000 |
State Level Concerns
The above taxes and rates pertain to federal taxes, not individual states that may have a less hands off approach towards your distributions. There’s also some states that don’t even recognize the S Corp election and may tax your distributions due to that. States that do not recognize the S Corp are:
Louisiana
New Hampshire
New Jersey
New York
Ohio
Tennessee
Wisconsin
While recognizing the S Corp tax classification is not the only concern for avoiding LLC distribution taxes, it's one worth looking into more with your CPA.
Conclusion
While non-salary LLC distributions can potentially be tax free, that’s often not the case so you need to be able to answer some key questions depending on your situation. However first and foremost you need to be able to know the tax classification of the LLC in question (S Corp, C Corp, or disregarded). Secondly, you’ll need to know if you’re an active manager or a passive shareholder.
For active managers of an S Corporation, you should know:
What's your stock basis?
Has your distribution exceeded your stock basis?
If so, then you should determine your filing status and what income tax bracket applies to you.
For passive shareholders, you should know:
You’re sure you’re not materially involved in the LLC.
What is your filing status?
How long have you owned your shares and should you pay short term capital gains?
What is your taxable income for the year and do you trigger a LTCG tax bracket?
What is your modified adjusted gross income for the year and do you trigger the NIIT?
If you’re able to answer all those questions you’ll easily be able to determine the exact tax rate of your LLC distribution from the tables above. Hope that helps and if all this talk about S Corporations has you curious, please check out our state by state calculators that could reveal some exciting tax savings for your LLC.
