L.L.C. (Partnership Format) and Capital Gains Tax

[Wealthinvestigator]

Hello to everyone, I have a question about the L.L.C. and Capital Gains Tax. I was talking to an individual about L.L.C.'s and their benefits. The person mentioned that one essential benefit of the L.L.C. (structure in the partnership format) is the members paying less in capital gains taxes. Futhermore, he explained that the members of the L.L.C. usually pay less capital gains taxes upon the sale of property than a sole proprietor. Are the previously mentioned statements accurate?

[mcwagner]

no.  

LLC's do not have their own tax rules. Your LLC will be taxed however you choose:  C-Corp, S-Corp, partnership or sole proprietor.  

Since you state that you have elected partnership classification, the real question here is whether partnerships pay different capital gains than individuals.

Generally, the answer is no, they do not.  Income and losses from partnerships will pass through to the partners in the same form. ie:  a partnership's capital gain will be a capital gain to the partners, and therefore taxed at the partner's rates.

There are some special rules for sales to related parties, sales of collectibles, etc, so your results may differ.

[Wealthinvestigator]

Thanks for the information McWagner. In addition, does the rate of captial gains tax vary depending on the time frame that you sell the property? (Higher within a year). In addition can you provide the current capital gains tax rate?

[mcwagner]

less than a year is taxed as ordinary income.  over a year is capital gain at 15%.  

However, if you have to recapture any depreciation, that recapture could be taxed up to 25% (I think that's right [haven't done a recapture in a while] but I'm sure someone here will correct me if I'm wrong).

[Wealthinvestigator]

Thanks for the information McWagner. If I acquired a business partner for a investment endeavor and we decided to form an L.L.C. with the distribution of profits being 70/30. We sell a home within the period of a year and make a profit of $90,000. We will have to pay ordinary income tax rates because we acquired and sold within a year.  I will be entitled to $63,000 and my partner will be entitled to $27,000. If we sell within a year that will subject us to ordinary income tax rates, I will have to pay $15,750 dollars in taxes plus $4,220. [The tax rate is 25% for an individual that receives income between $30,000 and $74,200 (single filing status)]. My business partner will have to pay $4,050 plus an additional $755.00. [The tax rate is 15% for an individual that receives income between $7,550 and $30,650. (single filing status)].

How can both investors minimize the amount of taxes they have to pay? (Especially the one that is being tax the most)

[mcwagner]

you could consider a 1231 exchange to defer the gain.

[Wealthinvestigator]

Thanks for all the information that you have provided McWagner.

[krish1]

I think there is a minimum holding period of 1 year to
qualify for a 1031 exchange.

The LLC accomplishes the following from a Flippers standpoint.
a) Avoid the Self employment tax of 10%.
b) Liability isolation from personal assets.
c) Taxation is a flow through. If you chose to be taxed as a
 Corp rather than a partnership, you will be hit with double
 tax is what i was told.

-Krish

[Wealthinvestigator]

Krish1, I appreciate you providing further information concerning the tax benefits that the L.L.C. enjoys and the 1031 exchange process.  Good luck with your investment endeavors.

[Dave T]

Krish,

There is no minimum holding period required to qualify for a 1031 exchange.  

I would appreciate knowing your authority for avoiding self-employment income taxes for a property flipping activity within an LLC.  

As near as I can tell from my readings, the self-employment income tax is 15.3%.  If the LLC is treated as a sole proprietorship (disregarded entity) or as a partnership for tax purposes, then all the LLC's net income from flipping is taxed as ordinary income and is subject to self-employment income tax as well on the member's personal tax return.

If the LLC is treated as a C-corp, then there is no self-employment income tax but the LLC pays corporate taxes on its net income while the member-shareholders pay ordinary income taxes on dividends issued by the corporation.

If the LLC elects to be treated as an S-corp for tax purposes, then the net income from flipping that is passed through to the managing member is still taxed as ordinary income and is also subject to self-employment income tax.  However, if the member-manager is paid a reasonable salary by the corporation, then only the salary paid is subject to self-employment income taxes while the rest of the LLC earnings will be taxed as a dividend at the member's ordinary income tax rate.

I don't see that the members of a non-corporation LLC avoid self-employment income taxes at all from property flipping.  Perhaps you could elaborate.