Multi-Member Limited Liability Company

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 by default since you have more than one member (same check-the-box regulation from earlier in this chapter), and as a result you will file a Form 1065 Partnership tax return.

Is a Multi-Member LLC a Partnership?

Technically, no. 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 underwhelming but important.

Therefore, we must be technically sound on the nomenclature. Smart people rarely 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. The tax code is the one doing the lumping; IRC Section 7701(a)(2) says a partnership “includes a syndicate, group, pool, joint venture, or other unincorporated organization, through or by means of which any business, financial operation, or venture is carried on, and which is not, within the meaning of this title, a trust or estate or a corporation.” Governance, and the rules encompassing that, is different than taxation. Easy to confuse the two.

Can You Be a Partnership Without an LLC?

Yes, and it happens by accident all the time. If you and a buddy start selling used copiers together, split the profits and never form an entity, you might have created a general partnership under applicable state law whether you meant to or not. Most states have adopted some version of the Uniform Partnership Act, under which a partnership can arise whether or not the owners intended to create one. That can also mean each partner has personal exposure for partnership obligations under state law. The IRS sees the arrangement through its own lens. Treas. Reg. 301.7701-1(a)(2) says a separate entity exists “if the participants carry on a trade, business, financial operation, or venture and divide the profits therefrom,” which means a Form 1065 might be required even though no one ever went to the Secretary of State. Skip it and the late filing penalty runs per partner, per month, for up to twelve months under IRC Section 6698. Married couples get an out in certain situations through the qualified joint venture rules under IRC Section 761(f), which we touch on later in this chapter.

Co-Owning a Rental is Not Necessarily a Partnership

Rentals are murkier, in a good way. The same regulation says “mere co-ownership of property that is maintained, kept in repair, and rented or leased does not constitute a separate entity for federal tax purposes.” Two people who simply co-own a long-term rental and divide the rent can often report their respective shares on Schedule E without filing a partnership tax return.

A short-term rental is a different animal. If the activity looks more like two people jointly operating a business and dividing the profits, the partnership analysis comes roaring back. Guest turnover, booking management, cleaning coordination, supplies, marketing and services can all make the arrangement look less like mere co-ownership and more like the used-copier business we just discussed. The regulation’s own example involves co-owners of an apartment building who lease space and also provide services to occupants. We cover this in our Rental Partnerships section later in this chapter, and the rental book goes deeper.

Operating Agreements and Special Allocations

MMLLCs also 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 similar to 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 transfer of each member’s interest.

One more wrinkle that trips up new MMLLCs. Members who work in a partnership-taxed business are not employees and generally cannot be paid W-2 wages for services performed in their capacity as partners (Rev. Rul. 69-184). Compensation for those services is handled through the partnership rules, commonly through guaranteed payments under IRC Section 707(c), the member’s distributive share, or in narrower circumstances a payment under Section 707(a). Guaranteed payments are reported through the K-1 and are generally subject to self-employment tax. File this away, because the S Corp election flips the basic compensation model: shareholders who work in the business generally must be paid reasonable W-2 wages, which is the conversation that fills most of Chapter 9.

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 separate economic and tax allocations among the members, including capital, profits and losses. Commonly profits and losses are tied together. Again, you could have a 20% capital interest and a 50% allocation of profits and losses, but the tax allocation must satisfy the rules under IRC Section 704(b), including substantial economic effect where applicable. In plain English, the economics and the tax reporting need to tell the same story. You generally cannot give one person the tax deduction while giving someone else the corresponding economic benefit just because everyone agreed to it over beers.

Spoiler Alert: the S corporation election blows this flexibility up with its single class of stock rule… standby, since we have a solution with the Mothership Baby S Corp construct in Chapter 2.

Operating Agreements also become critical when the entity has value. Issues that must be handled within the agreement include-

• Death, divorce or incapacitation of a member
• Required distributions, at a minimum enough to cover the income tax on each member’s K-1 (phantom income, where you owe tax on money you never received, is a partnership classic)
• Dispute resolution
• Exit strategies, which might call for a separate Buy-Sell Agreement, usually funded with life insurance (we can help navigate this)

You and your business partner are besties today. Neat. Wonderful. However, our job at WCG is twofold: to not unnecessarily complicate things, and to protect your future with a malleable arrangement that endures and provides for a graceful exit when besties becomes exes.

Form 1065 and the K-1

Partnerships and those mimicking partnerships (MMLLCs) require a separate partnership tax return on Form 1065 (with an exception for spouses in community property states, explained later in this chapter), which creates K-1s for each member or partner.

This might be your first brush with the term K-1 (formally Schedule 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. It 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)

Partnerships and S corporations are classic pass-through entities. Estates and trusts are slightly different animals since income may be distributed to beneficiaries and reported on Schedule K-1, retained and taxed at the fiduciary level, or some combination of both. A K-1 is usually filed electronically as part of the tax return that generates it. As such, it is generally preferable to prepare and file your individual income tax return after the entity or fiduciary tax return generating the K-1 is completed.

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.”).

Partnership K-1 Versus S Corp K-1

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 Schedule E and ultimately flow through Schedule 1 to your Form 1040.

But here is the crux of the matter, so please pay attention. S corporation pass-through income generally is not subject to self-employment tax. Partnership income might be. IRC Section 1402(a) generally pulls a partner’s distributive share of trade or business income into net earnings from self-employment, subject to exceptions such as the limited-partner rule in IRC Section 1402(a)(13). Rev. Rul. 59-221, on the other hand, confirms that S corporation pass-through income itself is not self-employment income. Read that again! That little distinction is the engine behind a lot of this book.

Self-employment tax inside a partnership gets more complicated. A general partner’s share of business income is subject to self-employment tax, while a limited partner’s share generally is not (IRC Section 1402(a)(13)). The fight is over who counts as a limited partner. In 2026 the Fifth Circuit (K Alain, formerly Sirius Solutions) and the Second Circuit (Soroban) both landed on a role-based test: a limited partner is one who plays no significant role in managing or running the business. State-law labels and limited liability alone are not enough. Neither court answered how an LLC member is treated, a question that has been murky since the IRS’s 1997 proposed regulations went nowhere. With an S Corp, none of this matters, since S Corp pass-through income is not self-employment income to begin with. One more thing: whether your income is passive under IRC Section 469 is a separate question from whether it is subject to self-employment tax. Do not confuse the two. We revisit this later in the book.

Unreimbursed Partnership Expenses (UPE)

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, affirmed by the Fifth Circuit in 2014, 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), aff’d. 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 who work in the business are also employees, and employees used to deduct unreimbursed employee business expenses on Form 2106 and Schedule A. The Tax Cuts and Jobs Act of 2017 suspended the miscellaneous itemized deduction for most employee business expenses, and the One Big Beautiful Bill Act made that suspension permanent under IRC Section 67(h). Therefore, Form 2106 is effectively a dead end for the typical shareholder-employee. Not just temporarily dead, but dead dead.

This can be a surprise to an unaware new S Corp owner. When WCG prepares a business entity tax return, we ask for Accountable Plan reimbursements which include things like home office, mileage, cell phone and internet. At times the business owner figures that we do not need this information since they will deduct home office and mileage, as they’ve always done, on their 1040 tax return. To make matters worse, the business entity tax return is usually prepared and filed long before the 1040 tax return. See our Accountable Plan Expense Reimbursements section on page 286 for more information on this and other pitfalls.

Regardless of entity type, the cleaner approach is generally for the business to reimburse properly substantiated business expenses. For an S corporation shareholder-employee, this is done through an Accountable Plan under Treas. Reg. 1.62-2, allowing the corporation to deduct the expense without treating the reimbursement as taxable wages. For a partner, the partnership agreement and reimbursement policy should generally provide for reimbursement of partnership expenses. If a partner is instead required to bear those expenses personally, the expenses might qualify as Unreimbursed Partnership Expenses on Schedule E. We’ll talk about Accountable Plans, partnership reimbursements, and the office politics of home office fairness when you have multiple owners in a later chapter. Good stuff!

Pass-Through Entities and State Taxes

As a reminder, entities being taxed as a partnership or S Corp generally do not pay federal income tax (there are a few exceptions like the built-in gains tax, which we also cover later). The partners or the members of a MMLLC pay income taxes as individuals (again, hence the pass-through nature). As such, two partners can have wildly different tax effects from the same income depending on their overall household income.

Also, 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. Then again, about three dozen states now let the entity pay your state income tax for you through a pass-through entity tax election, which is one of the few state things that works in your favor. More on that later as well.

Yeah, we have a lot of “more on that laters” and seeming punts, but there is a lot to unpack with this section.