Treatment of Flow Through Income from a K-1 into an S Corp
sabrina.crone3
Lee Reams
Sabrina,
In your scenario, the flow-through of the LLC portion of the net income to the shareholder of the S Corporation would generally be considered passive income. Here’s why:
Material Participation in the LLC: The S Corporation has invested in an LLC but has no material participation in the LLC. According to the IRS rules, income from an activity in which the taxpayer does not materially participate is considered passive income. Since the S Corporation does not materially participate in the LLC, the income from the LLC is passive to the S Corporation.
Flow-Through to Shareholder: When this passive income flows through the S Corporation to its shareholders, it retains its character as passive income. The involvement of the shareholder in the S Corporation does not change the nature of the income from the LLC. The key factor is the level of participation in the LLC, not the S Corporation.
Therefore, even if a shareholder is actively involved in the S Corporation, the portion of the net income from the LLC that flows through the S Corporation to the shareholder would still be considered passive income. This is because the S Corporation itself does not materially participate in the LLC, and the passive nature of the income is preserved as it passes through to the shareholder.
Also, the shareholder that is active in the S Corp is supposed to be receiving reasonable compensation (W-2) from the S-Corp to compensate for the active involvement.
Lee
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