LLC Member and Limited Partners

Limited partners in a partnership, have their liability classified to included the amount of their investment. A general partner in a partnership on the other hand, hold unlimited liability to the debts and obligations of the partnership. General partners pay SE tax on their distributive share of income from the partnership, while limited partners do not.

The IRS regulations currently facilitate that logically, an LLC member who is personally involved with an LLC, likely should be subject the SE tax. The best way to handle this, is with guaranteed payments from the LLC to the members - subject the SE tax, with the distributive share not subject to the SE tax. This is similar to an S-Corporation, where reasonable wages are paid, and the distributive share is non-taxable.

Domestic Production Activities Deduction

For businesses that manufacture or produce new assets, the IRS permits a Section 199 deduction on a form 8903, also known as the Domestic Production Activities Deduction. The deduction percentage equals the lesser of qualified production activities income (DPAI) multipled by 9% for 2010 or 50% of W-2 wage expenses. Individuals deduct DPAD on line 35 of the 1040 to arrive at AGI, while corporations deduct it on line 25 of the 1120, and 1065 and 1120S filers pass the deduction through to shareholders on the K-1.

QPAI is defined as domestic production gross receipts minus other direct costs allocable to such gross receipts. Sales tax is not included as a gross revenue.

W-2 wages are those wages paid to employees relating to domestic production gross receipts (DPGR). For instance lets take an example where an construction company has DPAI of $10,000,000, COGS of $5,000,000 and 75% of gross receipts are DGPR, with W-2 income relating to DPGR of $2,000,000. The DPAD deduction would be the lesser of $10m - $5m = $5m * .75 = 3.75m * 9% = $337,500 or $1,000,000 (50% of W-2 Wages). So if the entity was a C-Corporation they would deduct $337,500 on line 25 of Form 1120 as an expense.

Corporations and Compensation

Although management in an S-Corporation and a C-Corporation may be very similar, wages may differ due to tax treatment of the entities. In an S-Corporation, shareholders are inclined to pay themselves a lower salary and take a larger distribution - taxed at ordinary rates on the flow through to the individual 1040. However, in a C-Corporation, income is taxed first at the entity level, and then again as a dividend. But C-Corporations have one major advantage over an S-Corporation, and that is the deduction of fringe benefits. A C-Corporation can deduct health insurance, and other fringe benefits paid to shareholders directly from income. In an S-Corporation, health insurance is added to the W-2 and taxed at the individual level. So in an S-Corporation reasonable compensation is essential as a lower wage may result in dividends being reclassified as wages. In a C-Corporation, high wages may be considered to be too substantial and reclassified as dividends, if wage and bonuses are to high. Therefore, before deciding on salary levels, it is best to check what is an equitable wage according to the IRS, and pay the dividend tax in C-Corporations.

Partnership Basis

A partners basis in a partnership upon creation is the combination of cash, property and services contributed. A partners basis increases with cash contributions or increases in liabilities assumed by the partnership, and the distributive share of income. Basis decreases occur when money is paid to partners, liabilities decrease or distributive losses are incurred. Basis is also decreased with non-deductible expenses and section 179 expenses that are disallowed on the personal return.

A partners capital is usually tracked on the K-1 on a tax basis, unless the partnership has a GAAP balance sheet which is required when a M-3 is used.

S Corporation Requirements

For a corporate shareholder in a C corporation, there are tax advantages to electing S-status. The main advantages is being taxed only once on the corporations net income, and with adequate basis, deducting losses on there 1040. However, not all C-Corporations can elect S-status with the filing of the 2553.

To elect to be taxed as an S-Corp, the following requirements are necessary:
1. All shareholders must consent to the S Corporation status, and sign the 2553
2. There can be no more than 100 shareholders
3. There can be only one class of stock (voting and non-voting stock is permitted)
4. The corporation must be a domestic corporation and shareholders must be U.S. citizens or residents
5. Only individuals, estates, and certain trusts and charties can be shareholders. Corporations, partnerships, LLC's, LLP's, IRA's are ineligible shareholders.

If S status is elected, the shareholder receives flow-through income from the corporation on a K-1 which is reported on the shareholders 1040. This avoids the taxation at the Corporate level, and then as a distribution at the individual level, thus avoiding double taxation.

S-Corporations vs. LLC's

S-corporations and multi-member LLC's are taxed both as flow through entities. As flow through entities, in essence, the taxable income is passed from entity to the individual shareholders 1040 via a K-1.

However, there are differences between LLC's and S-Corporations. While both provide limited liability to the owners, LLC's permit losses in excess of basis, while S-corporations losses if in excess of basis are not deductible. While S-corp's are exempt from local tax, LLC gains are not.

With a tax on Medicare of 1.45% for both the employee and employer for example is another difference. For a highly profitable S-corporation, if a salary is paid of $106,800, which is the SE limit, and income in excess of this is paid to the shareholders in the form of a distribution, the gain is non-taxable for Medicare purposes.

Partnership Capital Accounts and 754 Basis Changes

Partners in a partnership, have a capital account that track's the cumulative earnings or losses of the partnership interest. On the date the partnership beings, the book value should reflect the FMV of the partnership. One unique feature of partnerships is the fact that special allocations can be made for partnership income/loss. This however, usually increases audit risk of the partnership.

Capital accounts differ from basis. Capital accounts are calculated with the FMV contributions, plus percentage of earnings, minus distributions, minus losses. Basis changes as depreciation of partnership assets occur. A 754 step-up can occur when a partner sells his partnership interest, which is a transaction that increases inside basis in the partnership. This step-up in is depreciated on the partnerships books. A 754 election is made by attaching a written statement to the 1065 filed by the due date. The statement must include information on the partnership. Once the election is made, it cannot be revoked without IRS consent.