LLCs and Partnerships Tax Perks and Traps

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LLC & Partnership Tax

Perks

  • Income Pass Through- Income earned by the partnership-taxed entity (LLCs are taxed as partnerships) is passed through and taxed to its partners or LLC members. The entity records the earnings but does not pay taxes because the earnings are passed through. The advantage here is that it avoids the double taxation issues discussed in the C corporation section. The redemption trap and disguised dividend trap have no bearing on partnerships because there is no double taxation to be concerned with.
  • Loss Pass Through- Unlike the C corporation the losses of a partnership-taxed entity are not trapped inside the entity. The losses can be passed through to its owners. These means that partners or members of an LLC can use these losses to reduce their taxes on other income. There are four requirements that you must meet to utilize this strategy, come in today and we can discuss how an LLC or partnership may be beneficial to your taxes.
  • Passive Income Potential- There are three types of taxable income; portfolio income (dividends, interests, gains form stocks and bonds, assets that produce income and royalties), active income (income from activities in which the taxpayer materially participates), and passive income (income from passive business ventures). Passive income is the only type of income that can be sheltered by both an active loss or a passive loss. C Corporations have no ability to create passive income because they pay out dividends and interest (both portfolio income) or compensation income (active income).
  • Outside Basis Adjustment- A partner's basis is adjusted upwards based on capital contributions and income allocations and is adjusted downwards by distributions and loss allocations. C Corporations have a locked in basis. This can make partnerships and LLCs attractive to businesses that a retaining income to finance expansion and growth.
  • Special Allocation- Entities taxed as partnerships have the ability to allow owners to be allocated differing income and losses amongst themselves. A partnership allocation will be respected by the IRS if it has "substantial economic effect." The partnership-taxed entity special allocation function allows for a flexibility not found in C Corporations.
  • Easy Bailouts- It is generally very easy to move money or property in and out of an entity that is taxed was a partnership. With a few exceptions, partners or LLC members will find moving money around these entities is far simpler than the onerous situations that arise with C Corps including the dividend, redemption and liquidation provisions can be nightmare for C Corp situations.
  • Inside Basis Adjustments- A partnership's basis in its assets is capable of being adjusted when an interest in the the partnership changes hands due to a sale or exchange of the partnership interest or the death of a partner. The basis is of that portion of the partnership interest is adjusted to reflect the current value of the assets. This can allow for higher depreciation deductions and less taxable gains in the future. A section 754 election is required to make this adjustment. 
  • Tax-Free Profits Interests- Frequently a business entity want to transfer an equity interest in future profits of the business to a current employee. A partnership-taxed entity can do this without triggering any current tax obligation for the employee recipient. Generally, a corporation can not do this without creating a taxable event. 
  • Transfer-for-Value Exception- Generally insurance planning is easier in a partnership-taxed entity than in a C corporation. This is because transfers of inters in life insurance policies among LLC members or partners are exempt from he IRS's "transfer-for-value" rule. That rule is harsh provisions hat transfer life insurance proceeds into taxable income.
  • Potential 20% Deduction- This is a NEW deduction under the TCJA. It permits an individual to deduct 20% of his qualified business income that he or she earned directly or through a partnership, LLC or S Corporation. There are potential limitations based upon an individual's taxable income, but this deduction could have a dramatic reduction on a person's taxable income.

Traps

  • Ordinary Income Asset Traps- Section 751 of the code requires that a partner must recognize ordinary income whenever a change occurs in the partner's interest in ordinary-income assets owned by the partnership or LLC. Section 751 is complex provision and can end up classifying income as ordinary income rather than the preferable capital gain.
  • Family Partnership Trap- Family businesses that attempt to shift income from family members in a high tax bracket to family members in a lower tax bracket will have to deal with section 704(e). These partnership interests created by gifts can have detrimental tax consequences.

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