There are roughly 20,000 New Hampshire multi-member LLCs — i.e., LLCs with two or more members. Almost all of them are taxable as partnerships, and the members of all of these LLCs, even if they hate tax, should have at least a basic understanding of partnership tax. Partnership tax can be overwhelmingly complex, but the basics of it are simple:
If your LLC is a multi-member LLC, it will automatically be taxed under federal partnership tax law unless you elect out of this law. In other words, from a legal viewpoint your business entity in this situation will be an LLC (a purely legal term) and you will be an LLC member. But for federal tax purposes, your LLC will be a partnership (unless you elect out), and you will be one of its partners.
In most New Hampshire multi-member LLCs, the partners’ shares of LLC income, losses, deductions and credits (their “tax items”) will be the same as their shares of cash contributions to their LLC unless their operating agreement provides otherwise. This kind of partnership is called a “straight-up partnership.”
Whether your LLC is a straight-up partnership or a “special allocation partnership” (discussed below), you will be taxable on your shares of LLC tax items (called LLC “allocations”), not on distributions to you of LLC cash or other assets, and you must make quarterly payments of your estimated tax on these allocations.
Federal tax rules let the partners of a partnership elect out of partnership taxation, and many LLCs should elect to be taxable not as partnerships but as S corporations. An S election may be best for your LLC (a) in order to reduce the Social Security Tax liabilities of the members; or (b) in order to maximize Section 199A annual 20% federal income tax deductions available to you as owners of a “pass-through business.” (Pass- through businesses consist of state-law sole proprietorships and entities taxable as partnerships or S corporations.)
For many members of multi-member LLCs, the best way to maximize their Section 199A deductions is to receive their compensation for services for their partnership not as salaries (called “guaranteed payments” in partnership terms) but as distributions of profits. This is because compensation to them must be deducted by the partnership and thus will reduce their partnership’s net business income. But the greater the partnership’s net business income, the greater will be the partners’ Section 199A deductions.
In many cases, the operating agreements of multi-member LLCs taxable as partnerships should provide for “special allocations.” Special allocations are LLC allocations of its tax items among the members that are not proportionate to their shares of contributions to the LLC. LLCs taxable as S corporations can’t make special allocations. LLCs taxable as partnerships can.
There are two kinds of special allocations. The first kind are “regulatory” special allocations — i.e., special allocations required by federal tax law. These may include, for example, certain mandatory allocations of partnership debt among the partners. The second kind are “contractual” special allocations. As the name implies, these are special allocations that are not required by partnership tax law, but rather, are based on contracts among the partners.
Partnership special allocations can be powerful tools to attract investors and managers. For example, the partners of an LLC taxable as a partnership might agree to offer Mary Jones, a first-rate LLC manager in their field of business, 10% of LLC profits without having to make any contribution to the LLC in exchange for her membership. In partnership terms, Mary, because of this special allocation, will be a “profits partner.”
But don’t use contractual special allocations without the advice of a partnership tax expert. If the IRS thinks the motive of your contractual special allocation is tax avoidance, things will get ugly.
John Cunningham is a lawyer licensed to practice law in New Hampshire and Massachusetts. He is of counsel to the law firm of McLane Middleton, P.A. Contact him at 856-7172 or [email protected]. His website is llc199a.com. For access to all of his Law in the Marketplace columns, visit concordmonitor.com.