How Do You Create Cash Reserves in an LLC?

Uncategorized Nov 23, 2021

Limited Liability Companies, or LLCs, are pass-through entities. That means sometimes owners have to deal with "phantom income," which occurs when profits are passed through only for tax purposes. That means owners are paying taxes on money they never received in their personal pockets. That is a bitter pill to swallow. What can you do?

Think of a Limited liability company, or LLC, like a colander. LLCs are pass-through entities that allow profits to “flow through” to the owners. Let’s do a quick recap.

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.

For 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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