Active Income (LLC or S Corp)

Last year, we formed an S Corp to manage several LLC’s who co-invest with owner-builders of custom homes in S. California. Our S Corp takes a percentage of each LLC. Our CPA tells us that active manager shares of the S Corp will be taxed as ordinary income even if our investment in the LLC is over one year (normally long term capital gains). She says we will also be subject to self employment tax. She then told us that this could be avoided in the future by converting the “mother ship” entity to an LLC. Are the active vs. passive rules not applicable to managing LLC members? This seems punative especially if we have opted not to pay ourselves salaries.

Any thoughts on this are appreciated.

I don’t see how you can convert active income to passive income just with a change in business entity. Perhaps someone who is smarter or more experienced can tell us how that can happen.

Income is income, and S-Corp, is almost the same as if you did a Sch C for income and expenses. Any sort of income or profit taken from one entity, and transferred to another, is income. Even dividends are income, it’s all on how it is officially documented, and transferred from one entity to another. Was a 1099-DIV issued? If not, then it’s income being transferred from one entity to another.

Talk with your CPA, and sit down and set it up correctly, but it will be taxed, but at what rate? That’s where you need to nail it down.

Good Luck!

I’d need more details about the transaction to know for sure what’s what. With that said, if the investment in the LLC’s is itself not considered “active”, then the presence of an S-corp will not suddenly cause it to become active. The pass-through concept that applies to most LLC’s applies to S-corps, albeit in a modified form. Likewise, if the original investment in the LLC is not subject to SS/SE tax, the presence of an S-corp as the “mother ship” should not cause the income to be recharacterized as active. On the other hand, IF the S-corp is acting as a “management company” and is being paid “management income”, then you may have an “active income” issue. You should still be able to avoid at least SOME of the SS tax because S-Corp income is NOT subject to SS tax, BUT a minimum “reasonable” salary is required AND is subject to SS tax.

For many small investors, the “mother ship” model promoted by many speakers is completely inappropriate and complicates admin well beyond any of the real benefits provided by such a structure. Who advised you to set things up as they are?

John Hyre