LLC earned income, IRS requirements

[Guest forohonek]

A LLC or partnership issues a Sch K-1 showing Guaranteed Payments to Partners (GPP) on line 4 and shows Self-employment (S/E) earnings on line 14A.

I am now getting a little confused about the "normal way" of computing the maximum contribution made to a retirement plan.

I'm wondering if things can be structured to reduce the net S/E income taxed on the form 1040, and still get a maximum contribution made to a retirement plan.

Generally, I have considered the S/E on line 14A as the number to use for simple, basic computations for determining the amount to pay into a retirement plan. The amount listed as GPP is ignored for purposes of computing the maximum contribution made to a retirement plan. Pretty straight forward, but a year with low income can result in the partner/member being limited from contributing the maximum annual amount into his retirement plan.

SO WHAT IF THE TAXPAYER WANTS MORE RETIREMENT PLAN DEDUCTION?

Generally if the GPP payment is increased the expense of the GPP offsets any increase to S/E. So any year-end changes to GPP do not affect the S/E income (other than to the extent of minority interests in the entity).

But when the operations of the business are not enough to allow the maximum retirement plan contributions, then generally if the GPP payment is capitalized (rather than expensed) then a larger GPP results in a larger S/E income. So by increasing his GPP, he is allowed a larger retirement plan deduction.

My new thought today is in lieu of capitalizing additional GPP, the partner/member is paid for services outside the entity and is issued a 1099-MISC which is reported on the taxpayer's Sch C.

In this case he'd show S/E income on the Sch C, and could establish a retirement plan for the Sch C income.

As a result, the LLC/partnership would have additional expense for the service fees paid out to the individual. This would reduce S/E income (perhaps even to a negative) on line 14A of the Sch K-1.

When preparing form 1040-ES the positive S/E income from the Sch C is netted with the negative S/E loss shown on the Sch K-1, and the result would be a reduction in S/E tax.

As an example, taken to an extreme: a LLC with zero net income and no hope for a retirement plan deduction – could otherwise pay $200,000 as a sales commission to the member and report a $200,000 loss. The $200,000 Sch C would support a retirement plan deduction.

The $200,000 loss on Sch K-1 would totally offset the S/E income from Sch C when preparing form 1040-SE. In this extreme example, the taxpayer would then have a maximum retirement plan deduction and would have paid zero S/E tax.

I am looking for cites to attack or to support this extreme example.

Comments please?

[Guest forohonek]

I'LL SIMPLIFY THE ABOVE QUESTION-EXAMPLE

Husband and Wife have a bona-fide business selling widgets. They file a federal partnership tax return. They gross $10,000,000 each year, but they also have about $10,000,000 in expenses.

Individually they have substantial investment income.

Goal: to maximize contribution into a retirement plan.

Problem: No earned income.

Possible Solution: Have the partnership-LLC pay the husband $200,000 sales commissions for the sales he brings in. Ditto for the wife.

Husband files a Sch C showing $200,000 S/E income and using that he establishes a retirement plan.

Wife files a Sch C showing $200,000 S/E income and using that she establishes a retirement plan.

When doing Sch 1040-SE for each of them, each of their $200,000 Sch C incomes will be offset by a $200,000 Sch K-1 loss - with a resulting net S/E income of zero.

Results: taxpayers are able to each get a sizeable retirement plan deduction, with no NET S/E taxable income and no S/E tax due.

I am looking for cites that can attack this situation or support this situation.

[Ron Snyder]

Of course the could always incorporate and avoid the potential problem altogether.

The scenario you describe raises the inevitable question: how can they both fund the plan and stay in business? If their expenses are necessary for the business, they will need to be paid. If the money is drained from the business to fund a retirement benefit, they will be short at least by the after tax cost of the contributions.

[Guest forohonek]

Of course the could always incorporate and avoid the potential problem altogether.

The scenario you describe raises the inevitable question: how can they both fund the plan and stay in business? If their expenses are necessary for the business, they will need to be paid. If the money is drained from the business to fund a retirement benefit, they will be short at least by the after tax cost of the contributions.

True, but that's the goal in my example!

The taxpayers have significant investment income, so in a given year when the widget business barely breaks even, they still have significant IRS and State income taxes anyway - from the investment income. But if they were able to contribute capital into the business, and then useing that capital, the business pays them commissions, thereby creating earned income.

Then *IF* they could legitimately deduct a retirement plan contribution, they'd win in the following ways:

1) Their retirement plan would be funded - growing tax deferred in future years.

2) Their current year federal and state income taxes would be lower, due to the retirement plan deduction.

3) and to top it off, they'd not have to pay any S/E tax for the current year, as explained in my example above.

I'm not clear what is meant by avoiding the issue by incorporating?

1) If this was a c-corporation there's no pass-thru of the losses to be deducted on the shareholder's form 1040.

2) If this was an s-corporation then they'd in theory HAVE to pay W-2 wages and if so, those MUST be subjected to FICA and Medicare.

3) Only of the s-corporation paid out a commission via a 1099-MISC could it work - and in that case the LLC-partnership would wrok as well, or better.

[Ron Snyder]

An excellent candidate for a DB plan is a C corporation where the principle has already established a high 3-year compensation history. The principal needs no current compensation other than to show he/she is an eligible employee. The funding is not limited to earned income, but may be used to create a sizable loss.