Recently a tax client was upset that their K-1 indicated that they had “Ordinary business income” of $1425, when they didn’t actually receive any cash from the business. This was my explanation..
“The K-1 doesn’t necessarily show money you received. It shows your share of the business’ income for the year. As one of three equal partners/owners, you are entitled claim to 1/3 of any losses the company may experience, but you are also responsible for paying 1/3 of the tax on any gains the company may experience.
“This does not mean that you actually received the money. The cash itself can stay in the business’ checking account. The place where each year’s gain and/or loss shows up is on the balance sheet. Each owner’s share of the gains and losses are reflected in that particular owner’s “Equity” in the company. If you were to take a draw (take money out), it would then reduce your equity in the company.
“So your share of the company’s 2009 gains was added to your equity in the business, on the balance sheet. If you want to take a cash draw, you will need to arrange that with your partners, since the business checking account may not have the funds available at this time.
“The tax on your portion of the earnings of the company needs to be paid whether you received the cash or not. In the future, you will not have to pay tax on any draws you take, up to the amount of equity you hold in the business. If your withdrawals total more than your equity, then you would pay tax only on the withdrawals over and above the amount of your equity.
“For an LLC, the company’s gains and losses flow through to each owner’s personal tax return at the end of each year. If you want the gains and losses to stay within the business as a separate entity, you would need to convert the business from an LLC to a C-Corporation (the standard corporation type). Then, the gains and losses will stay within the business and be carried forward on the business’ tax return from one year to the next.
“However, keep in mind that if the business were to experience a loss during a particular year, that loss would not be able to be carried over to your personal tax return and you would therefore not be able to take the loss as a write-off on your personal taxes. A C-Corporation’s gains and losses cannot be transferred to the individual owner’s tax returns, until that owner sells or relinquishes their interest in the business, at which time, they may take the gain or loss (whatever the case) on their personal tax return.
“Again, the decision to incorporate is something you would need to discuss with your partners, since it would affect their tax status as well. Generally, it is not advised to incorporate for a business as “small” as yours, but if it really bothers you that the business’ gains and losses are flowing through to your personal tax return, then you may want to explore that option.”