President Perceptive Business Solutions Inc.
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The Best Ways for LLCs to Set Aside Cash Reserves

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Because limited liability companies, or LLCs, are pass-through entities, LLC owners sometimes have to deal with "phantom income," which occurs when profits are passed through only for tax purposes. Although there's no magic bullet to solve this problem, there are a few solutions that an accountant can suggest to clients.

Aug 16th 2021
President Perceptive Business Solutions Inc.
Columnist
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Limited liability companies, or LLCs, are a lot like colanders, those perforated bowls used in cooking to strain off liquids. LLCs are pass-through entities that allow profits to “flow through” to the owners. Let’s recap how this works as we address the best ways for LLCs to set aside cash reserves.

A C corporation (or C-corp) offers business owners many advantages, but come with one major disadvantage: double taxation. Corporations pay 21 percent taxes on net profits, and then shareholders pay income taxes on dividend distributions they receive. The individual’s income tax bracket can be as high as 37 percent.

Here’s where LLCs and S corporations enter the picture. Both are pass-through entities. For an LLC owner, their distribution is taxed as self-employment income. The IRS expects all income to flow through immediately. Because businesses often retain capital for future purposes, this can result in “phantom income.” The owner has a personal tax liability on the full amount of the calculated distribution, but hasn’t received the full amount because a cash reserve has been set aside.

One solution is for the LLC owner to choose the option of being taxed as a C corporation. This allows the business to retain some of the profits as a cash reserve, but they must pay the 21 percent corporate tax on the balance of the profits. If the owner is in the 37 percent tax bracket, this can be preferable for the short term.

Corporations are allowed to set aside $250,000 before triggering the accumulated earnings tax. Amounts in excess of that threshold are subject to an additional accumulated earnings tax of 20 percent. Fortunately, there are situations in which a corporation can set aside a larger amount without paying the additional tax. Corporations need a good business reason to do so, like expansion. Other less common reasons include setting aside cash for product liability issues or redemption needs. This might include paying off bonds or buying back company stock on the open market. A good accountant should be able to suggest legitimate reasons for keeping a larger cash reserve.

For smaller businesses, paying down their bank line of credit (LOC) can be a good use of profits.  If the business needs cash, it can draw on the LOC instead of keeping those funds as a cash reserve. 

Regarding the LLC, as long as the business remains an LLC and is taxed as an LLC, the IRS expects all taxable income to pass through. If earnings are retained, they are still taxed, resulting in “phantom income distributions” for the owners. The business should provide large enough cash distributions to at least cover the owner’s tax liabilities. If all profits are distributed, another strategy is for the owners to make additional capital contributions to the business, effectively returning the distributed profits to the business.

The bottom line, unfortunately, is that there aren’t any magic bullets when it comes to retaining cash within an LLC without incurring tax liability.

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