Taxing a reinvesting business

November 28, 2006 2:42 PM

Can I start a LLC (or similar) who's only business is to manage investments and reinvest any gains? What are the tax implications?

If I always reinvest all the gains and dividends of the investments my theoretical net income will always be 0, right?

However, I am sure there is some way I (or the company) would have to pay taxes on this. What would the taxes be, and how can you be taxed if you have no profit? Or, would there be a profit? If so, how is this calculated? Can you be taxed if you reinvest the gains and never take a distribution? What are the different implications for different legal stuctures (LLC, S corps, C corps, etc)?

I will eventually seek legal and CPA tax advice on this matter, but wanted to feel out the Mefi community first.

posted by blueplasticfish to Law & Government (13 answers total)

If I always reinvest all the gains and dividends of the investments my theoretical net income will always be 0, right?

Hell no! When you get those dividends, that's a realization event, jacko. You must pay tax, and ... I don't think it's taxed as a capital gain, even, since it's actually a distribution. Here's a brief explanation of why and how you get taxed.

Consider two $10,000 stock portfolios, A and B. Say that, in the first 6 months, A pays a $1000 dividend, but maintains its value, and B increases in value to $11,000 but pays no dividend, and then remains steady at that value after the 6 month period.

Taxation of A. The moment you receive the dividend, you are responsible for income tax at your marginal rate. "But what if I reinvest the dividend," you ask. In that case, you must come up with the corresponding tax amount (between $50 and $300, ish, I forget the marginal tax rates at the moment) from other income, or sell the newly acquired stock.

Taxation of B. The increase in value of B has not been realized until you sell the stock, and the tax treatment depends on when you sell it. If you sell within 1 year of the purchase date, it will be taxed as regular income at your full marginal rate. But if you wait until after 1 year, it will be taxed as a capital gain, at a special rate of 15% or less.

I imagine I've shot your whole plan out of the water right there and you'll no longer be interested in creating the LLC, but the short answer to that aspect of the question is that you get passthrough taxation, so there aren't really any consequences. LLCs are really only useful as liability firewalls; might be worth looking into if you plan to buy on margin, but not otherwise.

Take some business classes at the local college or something before you bother spending money on tax lawyers over this.
posted by rkent at 3:23 PM on November 28, 2006

Why don't you just do a limited partnership? You would of course have to pay taxes on your personal salary and capital gains. You could take loans out against the investments and conceivably not pay taxes, which would be an idea if you can get returns better than the cost of the loan ...
posted by geoff. at 3:25 PM on November 28, 2006

I would suggest googling around for investment clubs. If you're the only one putting money into this it would be smart to be a sole proprietorship, otherwise you'd have double taxation on a corporate structure. Otherwise a general or limited partnership depending on the liability your partners wish to take on.
posted by geoff. at 3:30 PM on November 28, 2006

Response by poster: rkent, i am a business major at a large university. however, none of my classes have gotten very deep into tax law. what you say, i was aware of... i was just not sure if you could expense a reinvestment. guess you can't.

if this is the case, then, why do some financial advisors find it virtually necessary for every "financially smart" household to setup some sort of business structure for their assets? What are the benefits?
posted by blueplasticfish at 3:37 PM on November 28, 2006

LLCs and partnerships both give you pass-through taxation too, geoff.
posted by mullacc at 3:39 PM on November 28, 2006

LLCs and the corps he mentioned do, yes, but they have requirements. Partnerships usually require little, if any formality. Variable by state, so it would be helpful to know a lot more about how many people he is investing with, etc.
posted by geoff. at 3:44 PM on November 28, 2006

Response by poster: it would be just me for now, but perhaps more in the future.
posted by blueplasticfish at 3:54 PM on November 28, 2006

blueplasticfish: I didn't get very deep into taxation while an undergrad either. You can probably pick up a basic primer at a bookstore. Wikipedia has some decent basic info (S-Corp, C-Corp, LLCs, LPs, sole proprietorship). Also poke around the IRS and SBA websites for more resources.

LLCs are attractive because they provide protection from liability (meaning "acts and debts of the LLC", not tax liability) while avoiding the double-taxation problem inherent in other corporate structures. But they aren't going to get you out of paying taxes as rkent explained. Whether or not you'll be facing potential liabilities will depend on what kind of investing activity you're talking about. I know some individual real estate investors form LLCs. If you plan on investing other people's money, that's another can of worms and was what geoff. seems to be getting at.

why do some financial advisors find it virtually necessary for every "financially smart" household to setup some sort of business structure for their assets?

This doesn't sound right to me. What kind of situation are you envisioning? Just one household investing its own savings? Lots of families set up trusts for estate planning purposes, is that what you're getting at?
posted by mullacc at 4:14 PM on November 28, 2006

Response by poster: mullacc... setting up a business structure like an LLC for tax benefits. you can potentially expense things like rent, car payment, gas, meals... but again i really have no idea about this stuff.
posted by blueplasticfish at 4:29 PM on November 28, 2006

You say a "business structure", but is there an actual business being run? If you're looking for a way to run your personal expenses through a corporate structure in order to reduce your taxes...well, I don't know how that's done. But be careful if you try.
posted by mullacc at 4:40 PM on November 28, 2006

If I always reinvest all the gains and dividends of the investments my theoretical net income will always be 0, right?

If you're investing in real estate, you can absolutely accomplish this via a 1031 exchange, but I doubt that's what you're looking for here.
posted by gd779 at 5:27 PM on November 28, 2006

I agree with mullacc, see if you can borrow a "business law" book. It will usually have a chapter or two explaining the differences in corporate structures. Undergrad work will not get into taxes unless you're going into accounting (at least that has been my experience).

If you wish to defraud the IRS and expense things not related to the business you can, and then get in trouble.

You would be best to create a thorough business plan and go to a lawyer to figure out what structure would work best for you in your locale.
posted by geoff. at 5:34 PM on November 28, 2006

if this is the case, then, why do some financial advisors find it virtually necessary for every "financially smart" household to setup some sort of business structure for their assets? What are the benefits?

D'oh - sorry, didn't mean to insult your business-major-dom. These are very fundamental biz-orgs and tax law questions, so hopefully there's a class on these things eventually...

Anyway, there are a couple reasons that setting up some organization(s) might be beneficial to family finance, but only where there's a good amount of money flying around. The organizations are many and varied, from corporations to trusts, so I'll just go over a few of the benefits people are looking for, without going into any particular organizations.

Tax: granting property to a family member doesn't save the high-bracket tax payer any money up front, but it might cause the residual income (capital gains, rents, dividends) to be taxed at the relative's lower marginal rate. This is sort of an arms race though and no particular strategy might work for long. Could be implemented via trust.

Liability: certain investments, like rental property, have a particularly high risk of rapid value decline, and tend to be highly leveraged. If the value disappears, the mortgage doesn't, and a liability firewall could be appealing. Likewise, if the primary earner is a member of a partnership, professional liability can be an issue and it makes sense to put assets in other peoples' names. This is related to -

Bankruptcy: Some arrangements, like spendthrift trusts, are frequently exempt from collections under state laws and/or under federal law. They are thus exempt from siezure by creditors during bankruptcy proceedings, if someone (or someone's company, or professional partnership) is considering filing.
posted by rkent at 6:29 PM on November 28, 2006