Investing in LLCs - The Difference Between Taxable Income and Distributions

A Limited Liability Company (LLC) is considered a flow-through entity (FTE) for tax purposes, which means the tax attributes (income, losses, etc.) of the entity flow through to the owners of the entity. This is in contrast to a Corporation, where tax attributes live at the entity level.

The purpose of this post to provide you with a brief overview of the tax consequences of investing in an LLC and to help you understand the difference between taxable income and distributions from an LLC.

FTEs do not pay income tax at the entity level. Instead, income (or loss) flows through to the owners. The owners of the entity, rather than the entity itself, pick up the tax bill. This is accomplished by the FTE providing owners a form K-1 on an annual basis, which gives the owners the information they need to report, and pay tax on, their pro share of the taxable income generated by the FTE.

It is possible that taxable income could flow through to you without receiving cash distributions from the entity (sometimes called phantom income). Conversely, an LLC can distribute cash without generating taxable income. Cash received does not equal taxable income (and vice versa). You should understand this relationship before investing in an LLC.

To illustrate, let's assume LLC I generates $1,000 in taxable income and distributes $100 in cash during the year. Assume you are a 10% owner in the entity. You receive a K-1 reporting $100 in taxable income. You report the income on your individual tax return, and pay the associated tax. At a tax rate of 37%, the tax liability would be $37. You also received $10 in distributions during the year, so your net after-tax cash return for the year is -$27.

Compare this to LLC II, which generates $1,000 in taxable income and distributes $500 in cash during the year. Assume you are a 10% owner in the entity. You receive a K-1 reporting $100 in taxable income to you. You report the income on your individual tax return, and pay the associated tax. Assuming you are in the highest margin tax bracket (37%), the tax liability would be $37. You also received $50 in distributions during the year, so your net after-tax cash return for the year is $13.

Here's the takeaway. If you are planning to invest in an LLC, be sure to understand the relationship between the expected amount of taxable income to be generated compared to the expected amount of cash distributions. Your understanding will allow you to plan accordingly. You will also be able to more easily compare one investment to another, by using after-tax, rather than pre-tax return on investment.