We encounter a common misconception from flow-through business owner clients every year and I want to try and clear the air.
That misconception? That distributions from partnerships, S corporations and other pass-through entities get taxed. (They usually don’t, by the way.)
The misconception regularly leads to a minor financial tragedy. Because often times a business owner sits on a huge cash balance in their business checking account. That money, they actually need to use on, you know, life things like rent or mortgage payments, insurance, taxes, day care, food, clothing, vacations and so forth.
But the business owner doesn’t want to distribute the profits. Because she or he fears paying tax on the money. Which is ironic. And wrong.
So this article explains what’s going on here. I’ll discuss what you get taxed on. When you get taxed. I’ll explain how the mysterious thing the accountants call “basis”works. And then I’ll end with a warning about a common error you want to avoid because it unnecessarily triggers additional taxes.
To start, a quick discussion about taxable income and basis…
Each business entity type calculates taxable income in basically the same way. Taxable income equals taxable revenues minus deductible expenses. This number gets reported in box 1 of the K-1 form you receive from the business, which in turn gets plugged into and taxed on your individual 1040.
For example, you start a business at the beginning of the year and collect $100,000 of revenues and pay $50,000 of deductible expenses. Your business’s taxable net income at the end of the year equals $50,000. Suppose you only used the revenue you collected to pay the business expenses and now have $50,000 in your business checking account.
Money left over in the bank is the confusing part. Because you might think you avoid taxes on this money if you leave it in the business. And that you only pay taxes on the money when you take it out of the partnership or S corporation or sole proprietorship.
But that’s not the way the accounting works. You pay taxes on the business profit. Not, usually, on the distributions of profit paid to an owner.
Now let’s have a quick chat about basis.
Basis and Why It Matters
I want this discussion to remain as simple as possible. (If you would like to dive deeper, you can read the statute for S Corporations here and the statute for Partnerships here.) But to generalize, a business owner’s basis consists of the cash and adjusted-for-depreciation cost of property contributed to a business, adjusted for certain items that increase and decrease said basis.
Let’s look at the common increases and decreases…
Increases to Basis:
- Contributions of cash and property into the business
- Taxable income from the business
- Sale of appreciated property the business owns
- Non-taxable income (think PPP and EIDL grants)
- Recourse and qualified non-recourse debt for partnerships
- Partner loans to the business
- Credit cards used for business issued personally to the shareholder for S Corporations
Decreases to Basis:
- Distribution of cash and property from the business
- Loss from the sale of property the business owns
- Non-deductible expenses (meals, entertainment, etc.)
- Decreases in partner loans and decreases in recourse and qualified recourse debt
- Payments made by the business to pay off S Corporation owner owned credit cards
The general rule: As long as you have basis, you pay no taxes on distributions. Which is why basis matters.
Examples Show How Mechanics Work
But the problem here? Basis constantly fluctuates from year to year. That reality means you or your accountant need to carefully track the basis each tax year in order to know whether distributions trigger tax.
Let me show you some examples so you see how this works.
Let’s circle back to our example where you earned $50,000. Pretend you spent no money funding the startup for this business because there is little to no overhead.
Your basis at the beginning of the year is $0.00. The $50,000 of net income increases your basis by $50,000. Now what?
You can take the total $50,000 as a distribution and pay $0.00 in taxes. In this case, your basis at the beginning of year 2 is $0.00. Remember, your basis increased by the net income of $50,000 (what you paid tax on), and decreased by the distribution of $50,000.
Alternatively, you decide to leave the whole $50,000 in the business in year 1. Maybe you are living off of savings.
But remember, you are still taxed on $50,000 of income, regardless of where the money goes.
By the way? If in year 2 the business loses $25,000 and you never extracted any profits from year 1? You can still distribute $25,000 to yourself tax free at the end of the year, so year two, ending year 2 with $0.00 basis.
Another example. You start your business with a personal contribution of $100,000. You use the money to buy some equipment, lease an office space, and hire an employee. Year 1 net income equals $200,000, and you distribute $100,000 to yourself to pay your personal expenses. Your basis looks like this:
|Capital Contribution||$ 100,000.00|
|Net Income||$ 200,000.00|
|Year 1 ending basis:||$ 200,000.00|
You pay tax on $200,000 of income, the distribution is tax free, and you end the year with $200,000 of basis.
Year 2 profits are down a bit, and net income equals $50,000 for the year. You took the same distribution of $100,000, and your basis at the end of the year is $150,000.
|Beginning Basis||$ 200,000.00|
|Net Income||$ 50,000.00|
|Year 2 ending basis:||$ 150,000.00|
Year 3 you try to aggressively expand and require more capital to do so. Your business secures a $500,000 loan to pay for more equipment, employees, advertising and general overhead. This year you are also purchasing an investment property to take advantage of the deductions offered by a short term rental.
The aggressive expansion is a success, and you end the year with $200,000 of net income. But you had to distribute $400,000 to yourself to put a down payment on your rental property and pay the same living expenses. Whoops, now part of your distribution is taxable. Lets break it down:
|Beginning Basis||$ 150,000.00|
|Net Income||$ 200,000.00|
|Year 3 ending basis:||$ –|
You probably noticed that doesn’t foot out. And it’s because basis can’t dip below $0.00.
In this third year, you are taxed on $200,000 of net income (taxed at ordinary income tax rates) and are left with $350,000 that can be distributed tax free.
But the additional $50,000 of distribution? This is called “a distribution in excess of basis.” The $50,000 of distribution which you do not have basis for becomes a capital gain and gets taxed at capital gains rates.
Guaranteed Payments or Distributions?
One final important point. I want to discuss a mistake we often see on partnership returns.
Distributions to partners are commonly but incorrectly coded as guaranteed payments. And this can have negative income tax consequences.
But first, a little background on guaranteed payments. A company uses guaranteed payments to incentivize a potential partner to join a partnership, most often in professional service firms. The partnership pays a specified amount to the partner each year, regardless of how the company performs. Their payment is “guaranteed,” kind of like a salary.
However, a majority of partnership agreements I read have no clause for guaranteed payments. And still, tax preparers frequently incorrectly code distributions as guaranteed payments. Why does this matter?
Guaranteed payment income is not eligible income for the Section 199A, Qualified Business Income Deduction (QBID). The partner forfeits a 20% deduction because their distribution is coded incorrectly.
Limited partners are not subject to self-employment taxes. But guaranteed payments are subject to self-employment taxes. A limited partner unnecessarily pays an additional 15.3% in taxes when their distribution is incorrectly coded as a guaranteed payment.
Pretend a tax preparer codes a $50,000 distribution as a guaranteed payment. The partner pays income tax on $50,000 instead of $40,000 by missing out on QBID. Assume a 25% tax rate and that’s an additional $2,500 they pay in income taxes.
Additionally, the partner pays $7,065 ((92.35% x 50,000) x 15.3%) of self employment tax on the $50,000!
The point I’m trying to make is you want to get this right for partners.
I hope this clears up some confusion on what actually gets taxed when a flow-through business generates profits. And also that the discussion not only eases your anxiety about taking distributions–but allows you to avoid the one or two bookkeeping blunders that trigger tax.