Return of Capital or Profit Distribution?

Question

We have a multi-member LLC are at the point that we want to begin taking money from our rental business. We can choose that the return is either counted as "return of capital" or "profit". If I take a return of capital, I do not have to pay any taxes now, but my basis in the business will be larger and I will owe regular income tax on any earnings if we sell. For example, if we put in $30,000 capital, but the business is sold for $100,000, we would only owe taxes on $70,000 when we sold. Since the $70,000 is business profit and not rental income, it would be taxed at the regular income tax rate. If I take return of capital now, I will have no capital in the business anymore and when we sell I will owe tax on the full $100,000. Alternatively, if I take profit now, any profit is taxed at the capital gains rate because it is rental income and my capital remains in the business.

I am in the 25% personal tax bracket, but my partner is only in the 15%. We do not anticipate selling anytime soon (intend to keep the business a couple decades) and it is doubtful either of us will change tax brackets.

Pros and Cons of one vs. the other?

I am in the 25% personal tax bracket, but my partner is only in the 15%.  We do not anticipate selling anytime soon (intend to keep the business a couple decades) and it is doubtful either of us will change tax brackets.

Pros and Cons of one vs. the other?

Linda Weygant · Answer

@Brandon Hall and @Ned Carey have explained things very accurately.  However they are explaining things at a pretty sophisticated level.  It's hard to figure out if you're understanding what they're telling since this is the internet and I can't see if you're nodding in understanding or if your brow is furrowed in continuing confusion.  I'm going to explain it a little differently.  If it's too simple, please know that I'm not trying to be condescending or belittle you.  But I do want to make sure you understand.

What I'm about to say applies if your LLC is taxed at the default partnership method or if you've elected to be taxed as an S-Corp.  This will not apply if you're under a C-Corp taxation method.

Every dollar of profit increases your equity in the LLC

Every dollar of loss decreases your equity in the LLC

Every dollar you take out decreases your equity in the LLC.

Generally it works like this:

You invest $30,000 in the LLC, so your equity is $30,000.

In year 1, your LLC profits $5,000, so your equity in the LLC is $35,000

At the end of year 1, you take out $2,000, so your equity in the LLC is $33,000.

Designating the $2,000 as a return of capital or a distribution of profit makes no difference as it's all a reduction in your overall equity in the LLC.

I think where you are getting confused is with equity distributions for a non pass through entity such as a C-Corp.  When a C-Corp distributes profits, it's dividend income to the shareholders.  When it designates a return of capital, then it's a capital gain/loss situation.

In pass-through entities, there's no difference.

Brandon Hall · Answer

@Amy E. you should jump on the phone with a CPA and hash everything out.

How is the LLC taxed? I'm assuming as a partnership. If so, you have already paid taxes on the income as it is "passed through" to your personal returns. Therefore, a distribution is generally non-taxable. However, if the distribution is in excess of your basis in the partnership, it may become taxable.

Hope this helps.

Brandon Hall · Answer

@Amy E. again, pulling your money out will not affect your tax position, regardless of whether you try to classify it as "return of capital" vs. "profit" because LLCs are pass through entities. This means when the profit is earned, it passes through to the partner's 1040 and the partner's pay income taxes in the year earned. You can leave all the money in the partnership and you will still have to pay income tax on the profits earned.

Generally, partners will be distributed enough money to cover their tax bill caused by the partnership while leaving their remaining capital in the partnership. This is a great strategy if you and your partner agree to it as it keeps the partnership flush with cash.

A capital distribution has no affect on the reported profits, thus it does not decrease revenue.

Back to your real questions about leaving the money in vs. not - it's always a good idea to leave money in a partnership. You cannot let your basis fall below $0, otherwise you pay capital gain taxes on the amount below $0. Let's say you pull all your money out this year and your basis in the partnership becomes $0. Next year, your partnership shows a net operating loss, therefore decreasing your basis further. Now your basis is below $0 and you will have tax problems.

Again, pulling the money out of the partnership has no tax affect unless your basis is below $0. Please please please talk to a CPA before you make any moves.

See this link for more info:

http://www.nolo.com/legal-encyclopedia/how-partnerships-are-taxed-29710.html

Ned Carey · Answer

@Brandon Hall has given you good advice. I will describe it in a different way which may make it more clear however he is the CPA. If my information conflicts with his - go with his.

Simple answer

No one can definitively answer that question unless we know how the LLC is taxed. This is a choice made at creation, or shortly after the LLC is created.

This decision on how your LLC is taxed is basically permanent. You generally do not decide on a case by case, or even annual basis, how money goes into and out of the LLC.

More detail.

An multi member LLC is by default taxed as a partnership. This is a pass through entity. You can elect to have it taxed as a corporation. You can then elect to have sub-chapter S taxation.   The decision which to chose will depend on your specific situation.

Let's presume your LLC is taxed as the default partnership status.  You are taxed on how much money the LLC makes, period. This is regardless of whether you take any money out of the LLC or not. If the company makes a profit you pay tax, if the company takes a loss you can use that loss as appropriate on your personal return. Putting money into or taking money out of the LLC is not a taxable event.

The above are general rules - there are always exceptions.

Amy E. · Answer

@Brandon Hall

Hi Brandon!  Thanks for the response.  I was told that if I make return of capital distributions that I can subtract that from my total revenue and thus it will look like I had less (or none) profit, even though members were distributed some cash.  Is this correct?

And back to my real question, is it a good idea (from a tax standpoint) to return the capital or leave it in the business long term (I'm sure the answer will be, it depends, just want to know what factors are involved).

Amy E. · Answer

Whoops, I'm sorry the post makes no sense because I hit go while I was copy/pasting....:

You're right, its taxed as income, just not earned income.  And I do not intend to sell this year, or anytime soon.  So what I'm really asking is would it be better to return capital now , or keep my capital in and return it later?  From the business' perspective, if I have to make return of capital payments, then there is no profit and thus no taxes on the personal side (until I've returned all the capital, of course).

It's kinda the Roth IRA vs. Regular IRA question.  If tax brackets remain equal, its a wash.  But if tax brackets change, then one is better than the other.

I just want to make sure I am considering all the factors, and not just the taxes now vs. later issue.

Erik Sell · Answer

"Alternatively, if I take profit now, any profit is taxed at the capital gains rate because it is rental income and my capital remains in the business."

Little confused by the whole post but mainly this part.  Rental income is not treated as a capital gain, it's taxed as ordinary income.  Also, if you are being taxed as a partnership (I'm assuming multi-member LLC this is the case) you pay tax on your share of the net income whether you take cash out of the LLC or not.

Return of Capital or Profit Distribution?

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