Multi-Member Limited Liability Company
By Jason Watson, CPA
Posted Tuesday, July 6, 2021
Once you take your single-member LLC and add a member, you are now a multi-member LLC (MMLLC). Boom! Instant increased complexity. The IRS will now call you a partnership since you have more than one member and as a result you will file a Form 1065 Partnership Tax Return.
However, you are technically not a partnership, you are a multi-member LLC with an Operating Agreement as opposed to a partnership with a Partnership Agreement. Adding your spouse typically counts as a MMLLC unless you are in a community property state which is explained a bit later in this chapter (it’s a underwhelming but important).
Therefore, we must be technically sound on the nomenclature. Rarely do people interchange the Bears and professional football team, yet many people often interchange 401k and IRA, and multi-member LLC and partnership. This is incorrect. A MMLLC might be taxed as a partnership, but the underlying entity is a limited liability company which has different rules and state statutes as compared to partnerships. Governance, and the rules encompassing that, is different than taxation. Easy to confuse the two.
MMLLCs are similar to sole proprietorships and SMLLCs in terms of self-employment taxes, but enjoy a bit more financial protection through the concept of Charging Orders (more on that later in this chapter as well). Transfer of ownership is the same as a SMLLC since you have a member interest that can be gifted, sold, inherited, painted purple, etc. However, most MMLLCs will have an Operating Agreement governing the transaction of each members’ interest.
Operating Agreements will also define the sharing of expenses and income. For example, you could be an angel investor at 20% injection but demand 50% of the income. Expanding this concept further, a partnership tax return (Form 1065) generated from a MMLLC will have three “allocations” for each member; allocation of capital, profits and losses. Commonly profits and losses are tied together. Again, you could have a 20% allocation of capital and a 50% allocation of profits and losses (spoiler alert: S Corp blows this flexibility up… standby!).
Operating Agreements also become critical when the entity has value- issues like death, divorce, incapacitation, required distributions, dispute resolution and exit strategies must be handled within the agreement. Perhaps a separate Buy-Sell Agreement is required(usually funded with life insurance- we can help navigate on this).
You and your business partner are besties today, but our job at WCG is to not unnecessarily complicate things. Additionally, our job is to protect your future with a malleable arrangement that endures and provides for a graceful exit.
In terms of self-employment taxes, the taxation of a MMLLC is very similar to a sole proprietorship or SMLLC as alluded to earlier. Partnerships and those mimicking partnerships (MMLLC) commonly require a separate partnership tax return on Form 1065 (with an allowed exception for those living in community property states), which create K-1s for each member or partner.
This might be your first brush with the term K-1. A K-1 is similar to a W-2 since it reports income and other items for each member, partner, shareholder, owner or beneficiary, and is coded to tell the IRS how the business activities should be treated.
A K-1 is generated by an entity since the entity is passing along the income tax obligation to the K-1 recipient (hence the concept pass-through entity, or PTE for TLA lovers). There are three basic sources for a K-1, and the source dictates how the income and other items on the K-1 are handled on your individual tax return (Form 1040). Here they are-
- Partnerships (Form 1065)
- S Corporations (Form 1120S)
- Estates and Trusts (Form 1041)
All of these are PTEs with the exception of a trust, which might or might not a be pass-through depending on the purpose of the trust. A K-1 is usually electronically filed as a part of the tax return that is generating the K-1. As such, it is preferred to prepare and file your individual income tax return after the PTE’s tax return is filed.
We say preferred because it is not absolutely required. However, you run two risks; the first risk is that the K-1 information could change once the PTE’s tax return is finalized. The second risk is that too much time lapses between the tax returns, and the IRS sends a tax notice based on a database mismatch (mismatch between what you report and what the IRS has… like a bad game of Go Fish… “Do you have a K-1?” “Go fish.”).
A K-1 from a Form 1065 Partnership Tax Return and a K-1 from a Form 1120S S Corporation Tax Return are scarily similar. We could hold two K-1s about three feet from your face and you couldn’t tell the difference- heck, we couldn’t either. What makes matters worse, is that they both are reported on Page 2 of your Schedule E, and ultimately on line 5 on Schedule 1 of your Form 1040.
But here is the crux of the matter, so please pay attention- one is subjected to self-employment taxes and the other is not simply based on which form created it (1065 versus 1120S). Read that again! There is another subtle difference. Expenses associated with K-1 income from Form 1065 are deducted immediately on Page 2 of Schedule E as Unreimbursed Partnership Expenses (UPE) while shareholders of S corporations do not have a place to deduct shareholder expenses.
Sidebar (we love these by the way): In Tax Court Memo 2011-289 McLauchlan v. Commissioner, the court states-
The parties dispute whether the expenses at issue are deductible as unreimbursed partnership expenses. Generally, a partner may not directly deduct the expenses of the partnership on his or her individual returns, even if the expenses were incurred by the partner in furtherance of partnership business. Cropland Chem. Corp. v. Commissioner, 75 T.C. 288, 295 (1980), affd. without published opinion 665 F.2d 1050 (7th Cir. 1981). An exception applies, however, when there is an agreement among partners, or a routine practice equal to an agreement, that requires a partner to use his or her own funds to pay a partnership expense. Id.; Klein v. Commissioner, 25 T.C. 1045, 1052 (1956).
Having said that, most S corporation shareholders are also considered employees so they would deduct unreimbursed employee business expenses on Form 2106 and Schedule A. With the recent passage the Tax Cuts and Jobs Act of 2017, Form 2106 expenses are no longer deductible on Schedule A.
Regardless of S corporation or partnership, expenses should be reimbursed by the business through an Accountable Plan and therefore deducted on the business entity tax return. We’ll talk about Accountable Plans, and the office politics when you have multiple shareholders, in a later chapter. Good stuff!
As a reminder, entities being taxed as a partnership or S Corp do not pay Federal tax- the partners or the members of a MMLLC do as individuals (again, hence the pass-through nature). But note the word Federal. States can do a lot of crazy things, and there is a whole chapter about the 185 reasons not to elect S corporation taxation that touches on state related issues such as franchise taxes and obscene corporate taxes including what some call the “pleasure to do business in our state” tax.
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