Multi-Member LLCs and Partnerships: Flexible Business Options with Complex Taxes

As your business grows and you bring in partners or investors, choosing the right structure becomes very important. Multi-Member LLCs and Partnerships offer a lot of flexibility, especially when it comes to profit-sharing, ownership, and taxes. However, they also come with more complicated tax filing requirements and potential tax responsibilities, such as self-employment taxes. It is essential to understand both the benefits and challenges of these business structures so you can make the best decision for your needs.

In this article, we’ll look at the differences between Multi-Member LLCs and Partnerships, how they are taxed, and the pros and cons of each structure. We’ll also provide real-life examples to show you how these structures work and offer some strategies to help reduce your tax burden. 

By understanding these details, you can decide which option is best for your growing business and plan for your future.

Multi-Member LLC: A Flexible Business Structure with Liability Protection

A Multi-Member LLC is a type of business where two or more people, called members, own the company. An LLC (Limited Liability Company) helps protect the members’ personal assets, like their houses or cars, from the company’s debts or legal problems. 

This means if the business owes money or gets sued, your personal assets are generally safe. The main advantage of an LLC is that it can provide liability protection, which helps give members peace of mind.

When it comes to taxes, a Multi-Member LLC is considered a pass-through entity. 

This means that the profits and losses of the company pass through directly to the members, who report them on their personal tax returns. The LLC itself does not pay federal income taxes, which helps avoid double taxation.

NOTE: Even though the LLC pays no Federal income tax, there may be a State franchise tax, business tax, or fee imposed by the State or States that you are registered to do business in.

Tax Filing for Multi Member LLC’s

A Multi-Member LLC must file a form called Form 1065, which is the U.S. Return of Partnership Income. 

This form is used to report the company’s income, deductions, gains, and losses. Each member gets a document called a Schedule K-1 that shows their share of the LLC’s income or loss. 

They then report that income or loss on their personal tax return. Tax filing is a bit more complex because each member must handle their share individually.

Members of a Multi-Member LLC also have to pay self-employment tax on their share of the income. This tax includes Social Security and Medicare taxes, which amount to 15.3% of net earnings. This is similar to what sole proprietors and Single-Member LLC owners pay. 

The self-employment tax can be a significant burden, especially as the business becomes more successful and earns higher profits.

Pros and Cons of a Multi Member LLC

Pros:

• Liability protection: Your personal assets are generally protected from the company’s debts and liabilities. This protection makes a Multi-Member LLC a good choice if you are worried about risk.

• Pass-through taxation: The business income is only taxed on the members’ personal returns, which avoids the double taxation that you would face with a corporation.

• Flexibility: Members can decide how to split up profits and losses among themselves. They can share profits in a way that makes the most sense for their contributions to the business.

Cons:

• Self-employment tax: Members have to pay self-employment taxes on their share of the profits. This can be costly, especially as the business grows.

• Complex filing: You need to file Form 1065, Schedule K-1, and follow state regulations, which can make things more complicated than a simpler business structure like a sole proprietorship.

• State fees: Many states charge annual fees or franchise taxes for LLCs. These costs vary but can add up over time, especially in states with higher fees.

(Please note, that at Make Taxes Fair we are not attorneys and this information is educational in nature. We encourage you to consult an attorney regarding the ins and outs of what legal protection an entity such as an LLC or Corporation may or may not afford you.)

Real-World Example

Imagine you have a Multi-Member LLC with three members where the LLC earns a net profit of $150,000 total. Each member gets an equal share, so they each receive a K-1 that shows $50,000 in income. Each member will then pay self-employment tax on their $50,000 share, which would be $7,650 (15.3%). 

In addition, they must also pay their personal income taxes on this amount. This means that planning ahead to save for taxes is very important.Now, let's say one member works full-time on the business while the other two are only part-time. The members might decide to split the profits differently to reflect their different levels of effort. 

This flexibility is one of the key benefits of an LLC. 

They could decide that the full-time member gets 50% of the profits, while the other two split the remaining 50%. This way, everyone feels fairly rewarded for their work.

An arrangement where one partner receives more income or profit than the other is something called a GUARANTEED PAYMENT and is allowed in an LLC or partnership arrangement.

The Guaranteed Payment to the partner is subject to the same taxes as before such as the Social Security and Medicare taxes as well as the personal income tax.

Partnership: Sharing Profits and Responsibilities

A Partnership is when two or more people agree to run a business together and share the profits. 

Like a Multi-Member LLC, a Partnership is treated as a pass-through entity, meaning the profits and losses go directly to the individual partners to report on their personal tax returns. 

However, unlike LLCs, Partnerships often do not provide liability protection, which means partners can be personally responsible for business debts. This lack of liability protection is something to seriously consider, especially if your business involves any risk.

Types of Partnerships

General Partnerships: All partners are involved in running the business and share the responsibilities. They are also personally liable for the business’s debts. This means that if the business can’t pay its debts, creditors can go after the personal assets of each partner.

Limited Partnerships: This type has both general partners (who manage the business and have unlimited liability) and limited partners (who only invest money, don’t manage the business, and have limited liability). Limited partners are only responsible for the amount they invest and are not involved in daily operations, which helps protect their personal assets.

Tax Filing for Partnerships

Just like a Multi-Member LLC, a Partnership files Form 1065 and gives each partner a Schedule K-1 that shows their share of income or loss. 

Partners then report this on their personal tax returns. The tax filing process is similar for both types of business structures. General partners have to pay self-employment tax on their share of the profits. 

Limited partners, however, do not have to pay self-employment tax on their share of the profits as long as they are not actively managing the business. 

This difference can make Limited Partnerships appealing to investors who want to contribute financially without being involved in the day-to-day activities.

Pros and Cons of Partnerships

Pros:

• Flexibility: Partnerships allow partners to decide how to split profits, even if it doesn’t match ownership percentages. For example, partners can decide to share profits based on the work they put in or based on their initial investment.

• Simplicity: General Partnerships are easy to set up and operate, and they don’t need a lot of formal paperwork. This makes them a good choice if you want to get started quickly without dealing with too much red tape.

Cons:

• Unlimited liability for general partners: General partners are personally responsible for business debts and legal claims, which can put their personal assets at risk. This can be risky if the business runs into financial trouble or gets sued.

• Self-employment tax: General partners have to pay self-employment tax on their income, which adds to their tax burden.

• Limited liability for limited partners: Limited partners are protected from business liabilities, but they have less say in how the business is run. This can make them feel less involved, which might not be ideal for some investors.

Real-World Example

In a general partnership with two partners sharing profits equally, a net profit of $100,000 means each partner gets a K-1 for $50,000. Each general partner would owe self-employment tax on their share, which amounts to $7,650. 

If one partner is a limited partner who only invested money but does not manage the business, they wouldn’t owe self-employment tax on their $50,000 share. 

This makes being a limited partner attractive for those who want to invest without getting involved in managing the business.

Self-Employment Taxes for Members and Partners

One of the biggest challenges for members of a Multi-Member LLC and general partners in a Partnership is paying self-employment taxes. 

This tax helps cover Social Security and Medicare. It is 15.3% of your earnings, up to a ceiling of $168,600 for 2024. If you make more than this amount, only the 2.9% Medicare portion applies, plus an extra 0.9% for individuals earning more than $200,000.

This tax can be a big burden for small business owners, so it’s important to understand how much you must pay and plan for it in advance. 

This is especially true if your business is doing well, as your self-employment taxes can add up quickly.

Strategies to Reduce Self-Employment Taxes

• Electing S-Corp status: LLC members can choose to be taxed as an S-Corp, which lets them receive a salary and take distributions that aren’t subject to self-employment taxes. This can save you a significant amount of money, especially if your business is earning a lot of profit.

• Instituting an Accountable Plan: Implementing an Accountable Plan to reimburse partners for expenses incurred on behalf of the business can help to reduce the overall net income of the business by capturing all write offs possible thereby reducing the Self Employment tax bill.

• Leveraging the Augusta Rule: The Augusta Rule can be implemented to increase deductions for the business thereby reducing the Self Employment tax bill as well.

Strategies to Reduce Taxes

While these strategies do not reduce the Self Employment taxes, they can help to reduce overall taxes for a partnership member.

• Retirement contributions: Setting up a SEP-IRA or Solo 401(k) allows you to make contributions that reduce your taxable income. This means you pay less in taxes now while saving for retirement. It’s a great way to plan for the future while cutting down on your tax bill.

• Health insurance deductions: If partners or members pay for their health insurance directly, they can often deduct those premiums from their taxable income. This can help reduce your overall tax liability and make healthcare more affordable.

When to Choose a Multi-Member LLC or Partnership

Choosing between a Multi-Member LLC and a Partnership depends on several factors:

• Liability protection: If personal liability protection is important to you, a Multi-Member LLC can be the better option, as it protects your personal assets from business debts and legal claims. General partnerships do not offer this protection, though limited partnerships provide limited liability for passive investors.

• Flexibility in profit-sharing: Both Multi-Member LLCs and Partnerships allow for flexibility in allocating profits and losses among members or partners, but LLCs typically offer more formal protections and operating agreements that can outline specific provisions.

• Equity ownership: If you’re considering taking on new partners or investors, a Partnership or Multi-Member LLC can offer equity ownership opportunities, but the LLC provides additional legal protections and easier transfer of ownership.

• Taxation considerations: If minimizing self-employment taxes is a goal, consider electing S-Corp status for your Multi-Member LLC, or exploring the benefits of Limited Partnerships for passive investors.

Final Thoughts

Both Multi-Member LLCs and Partnerships offer flexibility, especially regarding profit-sharing and ownership, but they also come with complex tax requirements. Whether you're looking for personal liability protection or flexibility in allocating profits, these structures can be tailored to meet your business needs.

However, it's essential to carefully consider self-employment taxes and how they affect your overall tax liability. Understanding the tax implications of each structure will help you make an informed decision as your business grows.

Next in our series, we’ll explore S-Corporations—a structure that offers significant tax-saving potential for business owners looking to minimize self-employment taxes.