Assume that I have a property which I flip and make a profit of $50,000.
If I use an S-corp or LLC taxed under Sub S, then I can take a salary of $25,000 (and pay 15.3% Self Employment Tax on that sum), but the remaining $25,000 will flow through as a dividend. I’ve got that part.
SCENARIO: I was told that at a SEMINAR that if a Limited Partnership is used then:
Income to limited partners who work less than 500 hours in the business will be exempt from Self Employment Taxes.
As a result there will be savings if you use this approach and act as a limited partner of the general partnership. Of course you must use a corporation to act as the general partner due to the ‘joint and several’ liability of the general partners
QUESTIONS (alright so now assume the following structure):
Corporation acts as the general partner of an LP that ‘flips’ property. The corporation is made up of 2 general partners who are shareholders in the corp.
The limited partners are the corporation shareholders BUT they also hold partnership interests individually in their personal capacity.
Is it true that no self employment tax will be due on limited partner income)? (provided the requirements of less than 500 hours, etc. are met)
Obviously a limited partner who is actively involved in the business will lose their limited partner status. Assuming that a corporation is acting as the general partner (thus conducting the general management via the entity and not the limited partners) will this be sufficient to maintain the limited partner’s status as a limited partner EVEN THOUGH the limited partners are the same persons who hold stock in the corporation?
This approach seems rare…but I have heard of a few accountant ‘gurus’ and attorney’s suggest this. Obviously the costs of maintaining an LP and a Corp. are high and this must be balanced against the savings in self employment taxes. Nevertheless, this was an approach I heard from 2 well known trainers. THOUGHTS?
Lastly, regarding LLC’s taxed as S corporations and true S corporations. The only advantage I can see to using an LLC taxed under Subchapter S is that you do have the charging order protection.
With the Sub S corporation the stock shares are personal property and subject to attachment by a judgment creditor.
What are you feelings on the advantage of charging order protection for the Sub S LLC vs. the Sub S corporation. Does this warrant using the LLC or the corp. when an S election is desired?
people have been using the LP/corp-GP setup for years.
re: LLC/S-corp
corporate stock is an investment. as such it is available to satisfy judgement creditors. you rear-end someone, get sued, lose, they can be awarded your corporate stock. now they own the company that owns the investment.
LLC membership is personal property by statute. now when you lose the suit, they can only get a charging order, which you can easily frustrate. you still own the company that owns the investment
Both the corp and the LLC protect you from liabilities arising within the company. only the LLC protects the company from your personal liabilities.
Are there not conversion statutes so that an LLC can be converted to an LP with minimal tax ramifications?
Assume an investor starts out small and does not want to have a multiple entity strategy for her flips. The LP will require 2 entities and many different roles ,for the small business person etc (i.e., limited partner hat, general partner hat, etc.).
Can the LLC taxed under sub S later convert to an LP in order to further enhance the payroll tax avoidance?
My concern would be starting out as an LLC under Sub S and then needing to convert to the LP in order to save more Self Employment tax, but being taxed because of it.
My understanding is that most flow through entities can convert via a conversion statute if one is available. Does it work this way: LLC to LP?
I’ve never seen any state that allows “conversions” of entites. not that there may not be some, I just am not aware of them.
You’re comparing an LLC with an LP for taxing. this is an invalid comparison. Since the LLC has flexible taxation, you must first state which taxation method you are choosing for your LLC. ie: if you tax your LLC as a partnership, then it can be identical in every way to an LP.
Thus an LLC taxed as partnership gains all of the tax advantages and disadvantages of a partnership itself, within the simpler structure of the LLC entity. This also applies to limited partnership arrangements.
Further, you can change your tax method for the LLC should your needs change. the only limit is that you can only change once every 5 years.
The savings on self employment taxes for LPs only applies to the limited partners. This same savings can be attained with the LLC structure taxed as a partnership, but only for passive members.
S-corp taxation of the LLC can save self employment taxes when passive status is not possible for members who are actively managing the business.
Last Question (I think!). First thank you so much for you help Mark!
Every person on this board should hire you as thier CPA!
Ok…here is the crux of the biscuit: Which entity LLC (taxed under Sub S) or LP will save the investor the most in self employment taxes.
Assume 1 investor (FRED) who flips properties and makes $100,000 per year doing so.
SCENARIO # 1: Under an LLC taxed as Sub S:
FRED pays himself a ‘reasonable’ salary of $55,000 per year. This is subject to self employment taxes. The remaining $45,000 flows through as a dividend (no self employment tax).
We take the $55,000 x 15% SE TAX = $8,250
SCENARIO # 2: Using an LP with a corp. or LLC to hold the GP interest
Same income $100,000. Here FRED chooses to have his LLC hold the GP interest. He is also the limited partner. Can he have the corporation General Partner take $15,000 of the $100,000, yet allow the remaining $85,000 flow through to him as a Limited partner?
This would mean that he has potentially saved almost $6,000 or more in SI taxes.
scenario #1, don’t forget that the entire 100k will be subject to regular income taxes in addition to SE.
scenario #2. you have to address the question of Fred’s participation. Even as a limited partner, if Fred participates more than 500 hours a year, he materially participated and he will trigger the SE. (this is why most investors who are active in flipping choose S-corp taxation - they can’t meet the 500 hour rule)
also, the entire 100k will again be subject to regular income tax. but, yes, your basic understanding of one of the benefits of a GP/LP arrangement is correct.
and remember, “reasonable” salary means person of similar experience and skill, working a similar job. $55,000 a year for a part-time project manager sounds high to me. If you drop this to, say, $25,000 (remember it’s part time) you can potentially shield more of the income from SE.
In the example of bifurcating the investing and managing interests betwen two LLC’s: Can the members of the investing LLC all be limited partners? I have been told that an LLC partnership must have at least one G.P. The management company would be same same owners but would be G.P.'s. and subject to S/E taxes.
There is no concept of limited member in an LLC. There are members and managers. Members own the LLC. Managers run the LLC. One person can hold both titles, but that is not something I recommend. If you are going to actively participate in the LLC, then own it through some kind of trust that is exempt from your creditors.