How to Structure a Promote from a Tax Perspective

[Aaron Friberg]

Hi all. We are doing our first flip where we are partnering with other investors. We've established an LLC. We found the deal and are managing the construction so the business deal is we take 25% of the profits off the top and the remainder of the 75% is distributed to the equity (we're also contributing 51% of the equity so we'll have an equity position as well).

Question is: for the 25% promote payment (before the equity gets paid out) we were thinking of structuring that as a fee to my wife (she's handling all the remodel) pursuant to a separate contract so that basically she is an independent contractor. With the $20k or so she'll make off the promote, she could then treat that as income and contribute it to a 401k (or SEP/IRA or whatever) to get tax-free money. Basically she elect in taxes to be a sole proprietor and use the promote portion for tax advantaged retirement income purposes. Downside is that we'd have to pay employment tax on that money if she treats it as sole proprietor income from what I understand.

Is it better from a tax perspective to just treat the 25% promote in the same bucket of funds as the distribution from the LLC we'll receive for our equity portion? My understanding is that under the new tax law, 20% of the gains of the LLC distribution (and promote if we threw it into the same bucket) wouldn't be treated as income, so maybe best to just throw the promote into the remainder of the equity payout instead of doing the independent contractor/SEP contribution route described above.

Interested to hear thoughts from tax folks.

Thanks all.

Aaron

[Logan Allec]

@Aaron Friberg This depends on your individual tax situation.  For example, if your wife's W-2 earnings exceed the Social Security wage base, the self-employment tax on Schedule C income would be limited to the (smaller) Medicare piece.  But if she doesn't have W-2 or other income subject to Social Security, then the self-employment tax would be a bigger downside.