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Situation

I am in the process of deciding which type of taxation to choose for my LLC. Up until this point I was leaning towards Partnership taxation because that is what LLC For Dummies was recommending, but my brain is still having issues connecting the dots. I have found the following answer Simple Overview of LLC Pass Through Taxation useful but let's see if I manage to articulate my question(s).

Facts

  1. One of the advantages of an LLC is no double taxation - via pass-through taxation profits are not taxed at the company level, only at the individual level.
  2. With partnership taxation, the business's profits and losses get passed on to the owners, who report their share on personal tax returns. These profits and losses are called allocations
  3. When the company does not distribute profits to the members, the profit is called phantom income, and the members still have to pay taxes on it out their own pockets.

Questions

For the questions below, let's pretend that

  • The LLC has partnership structure with my 2 daughters and myself as members.

  • Each one of my daughters has 1% ownership, myself 98% ownership.

  • I am the manager of the company.

  • I make a profit of $10,000 say for example in my first 3 months

Questions as follows:

  1. Would the $10,000 be considered an allocation, and hence I would only have to pay taxes once during my personal income tax returns?
  2. Would my daughters being underage (way underage like 2 & 3) have to submit personal income tax return at the end of the year since they had a 1% allocation?
  3. Where do allocations go? to my personal bank account? or to the business bank account? If they go directly to my personal bank account then its mine and I can take the $ out and spend it whatever i want, but if it goes to my business bank account, can I take it out and spend it for my personal use?

  4. If I was to pay myself a salary (because I am a manager) that is a distribution, then I would have to pay taxes on that salary is that right? That means I get taxed double. Is this a correct statement? If so I do not see the no double taxation advantage

  5. What happens if I have an employee? Do I have to pay taxes 3 times? Once for ownership (profits-losses) included in my personal tax returns, twice for my own distribution (salary), and third for payroll?

I hope you are able to internalize my confusion. If the assumptions in my questions are correct then I am not sure what my billable rate will have to be in order to make the same money (or more) that I make out of my full-time job. Seems like in order to be able to provide benefits for yourself and pay and employee with benefits you need to be rolling in a pretty good chunk of money. Just to throw a number out there it feels that I have to charge $150 per hour...not exactly sure if that is pretty feasible.

I guess my final question will be:

  1. Is there a way to be taxed once and only once?

Thanks.

share|improve this question
Please be careful when determining salary for yourself, see my post below. – Henry the Hengineer May 17 '12 at 22:57
@Henry What post are you referring to? the only post below that I see is the one by littleadv – Viriato May 18 '12 at 0:12
Can you see my post below his? If not, I'll repost. He was able to comment on it. – Henry the Hengineer May 18 '12 at 1:52

2 Answers

up vote 2 down vote accepted

First and foremost, you need to talk to a (real) tax advisor.

Having said that, and putting a disclaimer that this answer was not intended or written to be used, and it cannot be used by any taxpayer, for the purpose of avoiding penalties that may be imposed on the taxpayer (circ. 230, as I am a tax practicioner), lets go over your questions:

Would the $10,000 be considered an allocation, and hence I would only have to pay taxes once during my personal income tax returns?

Yes.

Would my daughters being underage (way underage like 2 & 3) have to submit personal income tax return at the end of the year since they had a 1% allocation?

Percentage doesn't matter, amounts matter. Depending on the amounts of the allocated earnings, they might be required to submit personal tax returns.

Where do allocations go? to my personal bank account? or to the business bank account? If they go directly to my personal bank account then its mine and I can take the $ out and spend it whatever i want, but if it goes to my business bank account, can I take it out and spend it for my personal use?

For better accountability and records-keeping, all your business income and expenses should go through your business account. You can take distributions from the business account, make sure to record them in your books accordingly. Mangling business and personal expenses in the same account may lead to piercing the limited liability.

If I was to pay myself a salary (because I am a manager) that is a distribution, then I would have to pay taxes on that salary is that right? That means I get taxed double. Is this a correct statement? If so I do not see the no double taxation advantage

No, it is not a correct statement. Whether you pay yourself a salary, or get a business income, the taxes are the same (if its earned income), just paid differently (SE taxes instead of salary withholding and payroll taxes). You can extend your portion of income in excess to the allocated income by paying yourself a salary.

What happens if I have an employee? Do I have to pay taxes 3 times? Once for ownership (profits-losses) included in my personal tax returns, twice for my own distribution (salary), and third for payroll?

You have to pay payroll taxes, for each employee. It is your business expense. You don't pay the tax on the money you paid someone else on your tax returns, they should be paying on theirs. Why would you pay someone else's taxes?

Is there a way to be taxed once and only once?

Not sure I understand why would you think that you're taxed more than once. Unless you're treating your LLC as a C-Corporation, you will always be taxed only once.

Get a tax advisor to help you, that's what professionals are there for.

share|improve this answer
thanks a lot, yeah definitely need a tax advisor, I am not trying to avoid one I just want to understand how things work so that I can have "intelligent" conversations rather than saying: "yeah yea wathever you handle that and do not tell me anything about it :) " Up to a certain point i want to keep a conversation with my accountant to discuss strategies, after a certain level it's all him/her. – Viriato May 17 '12 at 22:42
up vote 1 down vote

Would the $10,000 be considered an allocation, and hence I would only have to pay taxes once during my personal income tax returns?

Yes, it is considered an allocation, since it is derived from company profits. The amount from that which goes to you and your daughters individually is considered a distribution or distributive share, and the distributive share is what is taxed.

Would my daughters being underage (way underage like 2 & 3) have to submit personal income tax return at the end of the year since they had a 1% allocation?

Not if they are only receiving $100 each (1%). They have to file if:

-The child has unearned income (from investment interest, gains, and so on) above $950.

-The child has earned income above $5,800.

-Gross income is greater than the larger of $950 or earned income (up to $5,800) plus $300.

-Net earnings from self-employment are $400 or more.

(These amounts might change over time, so please check the IRS for updated rules. Also, if a child earns more than $1900 in interest income, they may be taxed partially at the parents' tax rate: http://www.irs.gov/publications/p929/index.html).

Where do allocations go? to my personal bank account? or to the business bank account? If they go directly to my personal bank account then its mine and I can take the $ out and spend it whatever i want, but if it goes to my business bank account, can I take it out and spend it for my personal use?

They should go to the business bank account to establish a clean paper trail for the IRS and protect your personal assets from liability. Since your business is family-owned and you are the 98% interest-holder, you have authority over company expenses... However, the actual purpose of the expense affects whether you can write off the expense when calculating your company's net profit.

If I was to pay myself a salary (because I am a manager) that is a distribution, then I would have to pay taxes on that salary is that right? That means I get taxed double. Is this a correct statement? If so I do not see the no double taxation advantage

If you pay yourself salary for management duty, it is considered a guaranteed payment. There is no double tax. You treat the guaranteed payment it as income on your personal income tax statement. Be VERY careful, however, about predicating that salary on the LLC's income. See below: http://www.entrepreneur.com/article/30062

Generally, regular payments for services rendered by a member should be treated as "guaranteed payments" by an LLC. Guaranteed payment is a specific term in the Internal Revenue Code, which is defined as payments to a partner in his or her partner capacity for services or the use of capital if determined without regard to the income of the partnership. The courts have determined that a partner is acting in his or her capacity as a partner when he performs services that are ongoing and integral to the business of the partnership.

What all that gobble-de-goop means is that any regularly scheduled payment to a member of an LLC for services rendered that is not predicated on the LLC's income, such as in the case of salary, should be treated as a guaranteed payment.

The good news for the LLC is that guaranteed payments are deductible by the LLC as business expenses and the net profit of the LLC is reduced by that amount. The bad news for the member receiving the guaranteed payment is that the payment is treated as ordinary income.

As ordinary income, guaranteed payments aren't subject to income tax and FICA tax withholding as a salary would be; instead, guaranteed payments are subject to estimated income taxes and self-employment taxes. What this means is that the LLC saves on FICA taxes but the member has to carry the burden of self-employment taxes.

Another important consideration is if premiums for health insurance are paid by the LLC on behalf of a member for services rendered, then those premiums are also treated as guaranteed payments. Guaranteed payments have other ramifications relative to the member's capital account in the LLC (especially if the LLC is losing money) that are beyond the scope of this column. Seek help from your tax advisor to sort out all the intricacies in your situation.

Some folks have tried to get around the guaranteed payment rules by using distributions from an LLC instead. Distributions are generally made relative to prior or current year's earnings, or in liquidation of a member's interest or the LLC, whereas guaranteed payments are made irrespective of earning considerations. Cash distributions are generally treated as a return of the member's capital or previously taxed income. It gets complicated at this point. Using cash distributions to pay salary exposes you to the risk that the IRS may reclassify the distribution as a guaranteed payment and subject the payments to self-employment taxes, penalties and interest.

LLCs allow significant flexibility and benefits for small businesses. Be careful, however, to avoid misclassifying salary payments to members as cash distributions, because reclassification by the IRS could prove to be quite a headache.

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1  
That is why paying yourself a salary from LLC might not be such a good idea. Its a wash, tax-wise, either way, but it just makes too much complications. Unless you really need a payslip for whatever reason, I wouldn't advise for paying salary to members. But it does have its advantages (not relevant to the OP, IMHO) when the managing member should be compensated in addition to his/her allocated portion of income, for the work done. I mentioned it in my answer. – littleadv May 17 '12 at 23:15

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