Subchapter K: A Tax Status for Partnerships
The Subchapter K tax status, also known as “Partnership Taxation” prevents a business from being taxed at the federal level. Instead, it passes through all income and losses to the owners, who are taxed only on amounts allocated to them. Which allows them to avoid double-taxation. This can significantly reduce a business’ tax burden.
Partnership Taxation
Subchapter K is the default tax status and only available for these types of entities:
- LLCs
- Partnerships
- Limited Cooperative Associations
Partnership taxation is when income and losses are passed through to the owners (i.e. partners), who are subject to self-employment and income tax on all amounts allocated to them, whether distributed in cash or not. This pass-through tax status allows the entity to avoid double taxation at the federal level. Under this tax status, entities are not subject to income tax at the federal level. Rather, income and losses are passed through to the owners, who are subject to self-employment and income tax on all amounts allocated to them, whether distributed in cash or not. States typically do tax LLCs; in California they are subject to a minimum franchise tax of $800/year, plus a tax on gross receipts.
In addition, the 2017 tax bill created a 20% deduction of “qualified business income” from pass-through entities. This essentially means that only 80% of the profits allocated to a member are subject to income tax (the full amount is still subject to self-employment tax, however). The deduction doesn’t apply to guaranteed payments. If the taxpayer has an income over $157,500 (or $315,000 if married filing jointly) then the deduction may be reduced or unavailable depending on the business type, wages paid, and investment property. Incidentally, this 20% deduction also applies to patronage dividends in a Sub-T cooperative.
Why might a cooperative choose Subchapter K?
The main reason to choose partnership taxation is to avoid employee status. If a startup cooperative cannot afford to pay their members minimum wage and overtime, employment taxes, unemployment insurance, and the like, they might start as a LLC taxed under Subchapter K. Likewise, a cooperative might prefer to avoid employee classification due to the immigration status of the members, or simply to avoid the costs involved with being an employer. For tax purposes, the members would be considered self-employed, and due to this status, they will more likely be able to avoid employee classification for other purposes, assuming they structure the entity’s governance such that the owners are all equal co-owners and managers of the business. Since they will not be on W-2s and instead will be sharing all the profits and losses, they will function more as business partners than as employees. An additional benefit to this tax status is that business losses in the early years of launching the cooperative would “pass through” to the members, allowing them to offset their personal income and pay less tax.
Drawbacks to Partnership taxation
There are a few important drawbacks to partnership taxation for a cooperative:
- The cooperative cannot have an unallocated reserve account, because all income, loss, deductions, and gains must be allocated to the owners.
- Owners must pay self-employment tax on all net income allocated to them.
- The entity must redeem a member’s capital account at departure, including retained working capital allocated to them.
Workarounds
A Sub-K cooperative will need to consider workarounds to the drawbacks of the tax status. For instance, cooperatives generally do not allow worker-owners to profit off of non-owner labor; that is, profits made from a non-owner employee labor would be allocated to a collective account rather than distributed to members. Under Sub-K, this cannot be done easily. Rather than create a collective account, members can agree to retain earnings attributable to non-members, rather than pay those profits out as cash to the members. However, those profits would still be taxable to the members, and the entity would need to pay them out to the members when they leave or if the cooperative dissolves. To address this, the members could have an agreement to donate such profits back to the entity, or to a nonprofit cooperative developer. But this is a clunky workaround and may not be satisfying to members who have been taxed on profits they do not get to keep.
Generally, partnership tax status is best used temporarily as a cooperative gets off the ground, or when the cooperative has compelling reasons to avoid employee status for its members.
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