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Real Estate Investing Forums †|† Real Estate Investing †|† Asset Protection, Legal and Contract Issues, Income Taxes, 1031 Exchanges (Moderators: $Cash$, Bluemoon06, kdhastedt, Mdhaas, motivatedceo) †|† Topic: Active vs. Passive losses and taxation on S.corp and LLC « previous next »
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Author Topic: Active vs. Passive losses and taxation on S.corp and LLC  (Read 12528 times)
bmanuel77
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« on: September 11, 2008, 09:41:16 AM »

Hi,
I recently became involved with an investment group, an LLC.  My initial investment was $65,500 using real estate as collateral.  I am receiving a check of $917.00 per month (17% annual return) and will be receiving this over the course of the next 3 years.  At the end of 2.5 years, i will obtain my initial investment of $65,500 and at the end of 3 years, I will obtain an additional $91,700 (140% return on initial investment).

I currently have this investment placed under an S. Corp.  I did this not only for asset protection but also for tax write-offs.  I would have rathered placed it in an LLC taxed as an S. Corp, but already had the S. Corp in place and did not want to dissolve it just yet.  Would I be taxed at an ordinary income tax rate on the monthly checks?  I am assuming I will not be taxed on the initial investment I receive at 2.5 years.  Would I be taxed at the long-term capial gains rate of 15% on the $91,700 since that money was committed for greater than 1 year?  I also understand that for write-offs I am only allotted $25,000 per year in passive investments, but if I am actively involved with this group, would I be taxed actively and how does that involve the amount of loss I can take?  Is there a limit on losses with active taxation.  Thanks for any help that can be provided.

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BLL
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« Reply #1 on: September 11, 2008, 09:53:35 AM »

How does the LLC operating agreement define the payments? Is it interest and principal for a loan? Is it return of capital? Is it a partnership distribution? The character of the payment will determine it's tax treatment. What did your CPA say when you advised him of your interest in this investment?


I currently have this investment placed under an S. Corp.  I did this not only for asset protection but also for tax write-offs.
What asset protection do you get? Your creditors aren't limited to a charging order. They will get your shares and then own the corporation.

What tax write offs do you get? What is available to an s-corp that is not available to you if you own the investment in your own name or a different entity?
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bmanuel77
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« Reply #2 on: September 11, 2008, 12:25:36 PM »

The distributions are made to the partners based on their ownership interests.  Each distribution shall indicate what portion thereof, if any, represents a return of capital.  The monthly checks pertain to only interest payments of the initial investment.

I will be better off not using the S. Corp. and will just have to create a new LLC taxed as an S. Corp to limit creditors to a charging order.

I thought I would get tax write offs such as business expenses, mileage, home office expenses, meals, travel, etc. all based on the business.  I assumed I could only write off these items under a business name and not my personal.

I have not yet spoken to a tax advisor but will be doing so when I create the LLC.

Thanks for all of your advice,
Brad
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BLL
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« Reply #3 on: September 11, 2008, 01:00:03 PM »

The distributions are made to the partners based on their ownership interests.  Each distribution shall indicate what portion thereof, if any, represents a return of capital.  The monthly checks pertain to only interest payments of the initial investment.
Sounds like you owe taxes on the interest payments. There is a CPA in this forum who can confirm the specifics.


I will be better off not using the S. Corp. and will just have to create a new LLC taxed as an S. Corp to limit creditors to a charging order.
That is one way to get charging order protection. I prefer to hold business interests in trusts for the benefit of children. You are not the beneficiary and an innocent third party is harmed if the trust assets are removed from the trust. However, you maintain complete control of the assets.


I thought I would get tax write offs such as business expenses, mileage, home office expenses, meals, travel, etc. all based on the business.  I assumed I could only write off these items under a business name and not my personal.
Business deductions are always deductible. It's only a question of which form to use.
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« Reply #4 on: September 12, 2008, 12:32:56 PM »

The income of the S-corp is taxable to the shareholders.  Note that income and cash received are not the same thing. 

If the S-corp loaned money to the 3rd party LLC, then the interest received is interest income and the return of principal is not income.  Remember this:  return of principal is not income - we'll get back to this in a minute.  If it was something other than a loan, then other rules will apply.

Everything the corp receives over and above the initial investment is income in some form or another. It's just a matter of what kind of income it is & where it's reported, and what year.  This income is taxable to you as passthru.  Once the income is taxed correctly, how you receive distributions is irrelevant.

Now, if you are providing personal service to the S-corp (by making investment decisions) that income is considered salary to you EVEN IF the underlying investment is passive.  This makes 100% of the corp income subject to both income and self employment taxes.  ~45% total tax bite.

If you can afford to pay yourself a reasonable salary as an employee - reasonable defined as consistent with someone of your experience and education performing similar work for another company - then you may be able to avoid self employment taxes on the remainder of the income.

However, you do NOT want to pay salary on the return of principal, as this cash is not taxable to you - it's not income.  Why turn it into taxable salary?

But by the time you pay yourself a salary of $30k a year to manage the S-corp, you have little or nothing left to pay out as a non-salary distribution. 

So, the lesson here for readers is that it is theoritically possible to achieve tax savings using an S-corp (or LLC taxed as one) in practice it takes a LOT of cashflow to make it worthwhile.  Even this super investment that will make $50k of cashflow each year is only at the breakeven point.

Bmanuel, give me a call if you want to look at more specific numbers.  But in general terms, I'm not sure it's worth the hassle and $$ to set up.
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bmanuel77
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« Reply #5 on: November 16, 2008, 11:05:59 AM »

The income of the S-corp is taxable to the shareholders.  Note that income and cash received are not the same thing. 

If the S-corp loaned money to the 3rd party LLC, then the interest received is interest income and the return of principal is not income.  Remember this:  return of principal is not income - we'll get back to this in a minute.  If it was something other than a loan, then other rules will apply.

Everything the corp receives over and above the initial investment is income in some form or another. It's just a matter of what kind of income it is & where it's reported, and what year.  This income is taxable to you as passthru.  Once the income is taxed correctly, how you receive distributions is irrelevant.

Now, if you are providing personal service to the S-corp (by making investment decisions) that income is considered salary to you EVEN IF the underlying investment is passive.  This makes 100% of the corp income subject to both income and self employment taxes.  ~45% total tax bite.

If you can afford to pay yourself a reasonable salary as an employee - reasonable defined as consistent with someone of your experience and education performing similar work for another company - then you may be able to avoid self employment taxes on the remainder of the income.

However, you do NOT want to pay salary on the return of principal, as this cash is not taxable to you - it's not income.  Why turn it into taxable salary?

But by the time you pay yourself a salary of $30k a year to manage the S-corp, you have little or nothing left to pay out as a non-salary distribution. 

So, the lesson here for readers is that it is theoritically possible to achieve tax savings using an S-corp (or LLC taxed as one) in practice it takes a LOT of cashflow to make it worthwhile.  Even this super investment that will make $50k of cashflow each year is only at the breakeven point.

Bmanuel, give me a call if you want to look at more specific numbers.  But in general terms, I'm not sure it's worth the hassle and $$ to set up.

I think I may have misunderstood the amount of the "reasonable salary" that I could take as a W2 employee.  I failed to mention that I am currently W2 employed which means that I could take much less than a 30K salary.  What would be a reasonable salary to take if I am already making 85K as a W2 employee?

Also, could I defer taking a salary if the LLC makes no profit in the first 3 years of business?

Thanks.

Brad Manuel
www.beatyourreturns.net
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mcwagner
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« Reply #6 on: November 16, 2008, 09:02:16 PM »

if a shareholder is providing services to the llc, ALL payment to shareholders is generally considered "compensation" and subject to self-employment tax.

however, as with most things, IRS provides an exception

the exception is that if the shareholder is receiving a reasonable salary for the services (ie: paying FICA/Medi on W-2 wages) then additional payment may be received as a "distribution" that is not subject to SE.

Reasonable, in this case, means typical of an employee of similar education and experience performing a similar service for a similar company for similar amount of time (40 hours a week, for example) in your local area.   It's up to you to be able to document this.  (I'd suggest that you document it well, since IRS position is that ALL payments are compensation and the burden of proof is on you to claim otherwise.)

It has nothing to do with what you earn at your "other" job. 

It has nothing to do with whether or not the LLC makes money. 

It has to everything to do with what service you are personally performing for the LLC.

Payment for personal services are compensation.  Period.  If, and only if, you are taking payment for the services as salary, and the salary is reasonable, will you be allowed to receive additional payment as a distribution.

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bmanuel77
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« Reply #7 on: September 22, 2009, 10:39:41 PM »

"Now, if you are providing personal service to the S-corp (by making investment decisions) that income is considered salary to you EVEN IF the underlying investment is passive.  This makes 100% of the corp income subject to both income and self employment taxes.  ~45% total tax bite."

I thought that passive income is not subject to SE taxes.  From the IRSís point of view passive income is any income that you get without having to to materially participate in. Examples of passive income include rental properties and partnership returns.  Income from this investment is characterized as a partnership return.

Thanks for any advice.
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Dave T
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« Reply #8 on: September 22, 2009, 11:17:35 PM »

Consider this.

Non-profit organizations generally don't pay income taxes because they have no net income.  However, when the revenues are used to compensate the employees who run the day to day operation of the business, the employee's income is compensation for services performed and subject to social security and medicare taxes.

Now apply this analogy to the investment LLC.  Even though the LLC's income might be from passive income sources, when the income is used to compensate the LLC members for their services in managing the LLC, the members have received "active" income.

Does this help?
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mcwagner
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« Reply #9 on: September 23, 2009, 07:29:55 AM »

the rental income is passive to the S-corp. stop.

you are not the S-corp.  stop.

Quote
I am actively involved with this group

the income you receive from the S-corp for services provided is not passive.  the income you receive from the S-corp has NOTHING to do with the rental income received by the S-corp.

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Mark Wagner, CPA, LLC
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bmanuel77
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« Reply #10 on: September 23, 2009, 07:55:29 PM »

I see your point.  Sorry for being a moron.  I probably should have started a new post since this one is so old.  I failed to clarify that I had dissolved the S-corp and created an LLC taxed as an S-Corp.  When I stated that I was actively involved, I am getting referral fees for others who also invest in the group.  Correct me if I'm wrong but is the LLC passively involved when receiving partnership returns from the investments. 

Is it possible to acquire passive and active income from one LLC?  Or would it be better to create 2 different LLCs, one for active income and one for passive.

Thanks.
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« Reply #11 on: November 17, 2009, 04:03:35 PM »

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Is it possible to acquire passive and active income from one LLC? 

 Yes

Quote
Or would it be better to create 2 different LLCs, one for active income and one for passive.

Why? 

Sorry for the late reply...I've been busy.
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Mark Wagner, CPA, LLC
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Real Estate Investing Forums †|† Real Estate Investing †|† Asset Protection, Legal and Contract Issues, Income Taxes, 1031 Exchanges (Moderators: $Cash$, Bluemoon06, kdhastedt, Mdhaas, motivatedceo) †|† Topic: Active vs. Passive losses and taxation on S.corp and LLC « previous next »
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