S Corp shareholders are distributed profits as a percentage of ownership whereas multi-member LLC’s use an Operating Agreement. Electing S Corp status in certain situations can create headaches for silent partner or angel investor situations and other non-traditional ownership structures.
Fluctuating Revenue Splitting
However, if this multi-member LLC elected to be taxed as an S corporation the arrangement blows up since shareholder distributions must be made on a pro-rata basis of ownership. In using the above example, an insurance agent might be a 50% shareholder but should only receive 40% of the distributions according to the revenue split. No bueno which is Spanish for no bueno.
Here is why this is a problem-
In this example, Batman is receiving 60% of the distributions as a 50% shareholder. The negative ending basis cannot happen without ugly consequences in S Corps (we call this a shareholder distribution in excess of shareholder basis which causes a capital gains tax event).
You could solve this by changing salaries- however this usually creates unnecessary additional payroll tax burdens in the attempt to equalize the income. Let’s say you have to pay Batman $15,000 more in salary to “equalize” the eat what you kill revenue split. This would cause about $2,000 in additional payroll taxes to be paid unnecessarily. Furthermore, the equalization calculation is circular since as you increase wages for one shareholder it reduces the remaining income for both shareholders. Yuck.
A more elegant way to solve this problem, as mentioned in our chapter dedicated to customized entity structures, is to simply create two more S corporations who are 50-50 members in the LLC. The Operating Agreement will still dictate the pro-rata share of distributions on a fluctuating basis yet the income is sheltered by the taxation of an S Corp. We did this in the insurance agency example, and each insurance sales agent was 100% owner of his respective S Corp.
The minority shareholder, the 10% guy, was constructively ousted from the daily operations of the business. He was not paid a salary. He did not receive any money from the business. Distributions were not made to any shareholder, but the husband and wife team paid themselves a salary and used expense reimbursements as a way to funnel money out.
The business began earning money, lots of money, and the minority shareholder was getting K-1s showing taxable income of several thousands of dollars. Good right? No. Not good. He had to report taxable income, but never saw any money in the form of a shareholder distribution. The husband and wife team were upset too since they could not take distributions without having to pay the minority shareholder. No one was willing to budge.
Sidebar: Had this entity had a strong Operating Agreement which forced distributions, minority problems can be avoided. One of the provisions we advocate for when working with attorneys is to establish a cash reserve for operations and then distribute 40% of the remaining amount once a year. This forces the entity to at least cover the shareholders’ typical tax obligation associated with the K-1 income.
Taxpayer's Comprehensive Guide to LLCs and S Corps : 2019 Edition