As every business owner knows, one of the advantages of an LLC is the ability to take profits from the company as pass-through income. This allows for a lower tax burden than if profits were taken out through salary. However, there are also disadvantages to taking pass-through income that can lead to disaster. Here we will have a look at the casualty loss on rental property.

The 20% Pass-Through Deduction Explained

Because pass-through business income is treated as business profits, for tax purposes, it is taxed at the owner’s marginal tax rate. In general, that means that companies can deduct 20% of such profits.

However, this deduction does not apply to deductions (such as those for taxes) or items outside of net income (such as capital expenses).

Example: If a business makes $100,000 in profit and pays $20,000 in taxes, the business would be subject to a 20% tax on its profit but could only deduct $80,000 from its profits.

On the other hand, if the business paid $25,000 in taxes on profits of $100,000, the amount deductible would be $100,000. The business in this example would not be taxed on its full profit.

Pass-through income can also qualify for the 18% dividend tax rate. In trying to maximize income and minimize tax liability employees may choose to "defer" their salary from a small number of profits from a business so as to minimize their overall tax liability on those profits.

There are many variables that will be affected by the chosen way to take profits from a business.

Many individuals, particularly in the start-up stage, prefer to form LLCs and other limited liability companies (LLCs) even though they may not actually be required to do so by law. For them, this is simply a matter of convenience since they want to pursue self-employment without the burden of having all their personal assets tied up in an entity. It is frequently argued that they may have more control over both their financial and work lives if they have an LLC rather than if they simply work for someone else, e.g., employees of a company who own stock or an S corporation. However, they may wind up paying higher taxes due to the limitations placed on them by the tax code. There are some arguments in favor of not forming an LLC at all and instead simply working for someone else.

Income from a pass-through entity is usually taxed more favorably than if it had been taken out as a salary. For example, with an individual who currently files as single, a salary of $100,000 would result in an income tax of $16,865 (20%, $16,865 × .1 or 20%). The same amount taken out as distribution would only result in an income tax of $13,336 (20%, $80,000 × .1 or 20%, plus the 3.8% NIIT). The salary would be treated as ordinary income while the pass-through income would be treated as capital gains.

Consequences Of Incomplete Tax Planning

Under current tax law, a pass-through entity can be formed with a single member in which all profits and losses are passed through to that member from any other business activities. This can lead to unusual outcomes if business owners forget to consider what happens if they were to die or become disabled.

Current tax laws permit a member to take a loss of up to $3,000,000.00 in one year if the losses can also be applied against other ordinary income such as salary. If the member is married they must each have a separate pass-through entity and the maximum loss is $3,000,000.00 for both pass-through entities combined – not $6,000,000.00 as one might expect (although this may change in the future). This may not be enough to offset all of their income and they are likely to owe taxes on the remaining income unless they use enough of their capital losses from another source (such as an asset sale). If the member does not have enough capital losses then they may have to sell assets in order to offset the remaining income with capital losses.

You may have heard of the term "death tax." It is a colloquial term for estate tax and it is levied on everything you own at your death. The estate tax is due on property that is more than $5,000,000.00 for married couples and $4,000,000.00 for singles. It should be noted that only about 0.2% of the population has to file a Form 706, United States Estate (and Generation-Skipping Transfer) Tax Return. The estate is usually not subject to income tax. The estate pays any taxes due on the property that is more than the exempted amount at death.

However, you may be able to avoid paying estate tax by structuring your LLC in a way that permits you to be taxed at the capital gains rates provided you die after the current applicable "applicable exclusion amount" (which is $5,000,000.00 for married couples and $4,000,000.00 for singles).

Let's say you own an LLC with two other people. You separate from one of the owners and merge your two businesses into one – this will be the "pro-rata owner" or "checkbook" scenario. Your remaining LLC's worth $3,000,000. You may also have a substantial amount of personal assets that you wish to pass on to your loved ones so you decide to sell them on your death for $5,000,000.00 without any estate tax by selling everything at an "applicable exclusion amount." Only about 0.2% of all deaths are subject to estate tax making this unlikely in most cases.

In many cases, assuming your LLC retains its value after your death, the remaining owners may be free from estate tax. What might happen is if the two other owners leave a large number of their personal assets to your children in order to better place them as part of their estate. They would not do this unless they believed it wouldn't trigger any estate tax liability for you. If they or their children inherit a big amount of money from you then there is a good chance that this will cause estate tax liability for you and this could occur even if you die before the federal "applicable exclusion amount".

Because the capital gains tax rates are lower than the income tax rates, some people prefer to pass their business interests to their children through a trust. If the business is structured properly, then the children are given an interest in the business and it may also pay them a salary. The trust agreement will specify that money from the sale of any assets is used to buy more stock for the trust rather than being distributed directly to them. This can allow a family-owned business to pass down as much as $11 million (in 2012) without any gift or estate taxes on any generation transfer that occurs after death. If certain asset protection planning is used, this amount could be increased substantially.

The biggest danger of this approach is that it may not be feasible if the trustor LLC is forced into bankruptcy. In general, unsecured creditors are paid out of assets at the end of a bankruptcy proceeding and secured creditors are paid out first. The secured creditors can be paid 100% of what they are owed, while the remaining assets can then be used to pay off the unsecured creditors.

In a case where you have an LLC with multiple members and one member has been forced into bankruptcy the funds in that member's LLC could be used to pay off any secured creditors even though there might not be enough money left to pay all of their unsecured debts. This type of bankruptcy can make it difficult or impossible for your LLC to continue operating, and it also makes it more likely that your LLC will be liquidated and the property sold off.

The easiest way to avoid this risk is to create trust. Many asset protection planners advise you to place your business interests and non-business interests in separate LLCs. In this situation, you could have one person with a 50% or more interest in the assets of the LLC and then have the remaining percentage of ownership held in trust for that person's loved ones. This way there would be a greater likelihood that the assets of the LLC would not be liquidated by creditors, and therefore they would pass on to your beneficiaries at death rather than being subject to estate tax.

Another possible scenario is where you own a business jointly with someone who has a larger net worth than you do unless you are married. In this case, it may be counterproductive to put the business in trust because the business-owning owner would want to keep his or her larger share of the business. This is a much more common situation than you might imagine. If you own an LLC jointly with someone who has a larger net worth than you do, then these decisions become very important.

Now let us have a look at the casualty loss on rental property

If you rent the property you own, it’s very possible that your tenants will cause some damage. You can’t control this completely, but you can make sure that you have insurance to cover any damages.

Rental properties come with a whole different set of rules and variables than other real estate purchases. If the property is your primary residence, then there is no tax deduction for depreciation (over time). When a rental property becomes an income-producing investment, the IRS allows an owner to write off depreciation over 27.5 years (a whopping $27,500 per year). There are a few exceptions — like if the owner uses their rental property as an operating expense (i.e. to hold the tenants for you, rather than to make money), or if they are renting out a property that is valued below $2 million.

If you find yourself in situations where you can’t deduct all your depreciation, there are still ways to manage the write-off of your losses on your tax return. For example, if you have purchased a rental from another person and want to use all of your loss on those first two years, you can reduce the amount of income that comes from rental occupancy by deducting only half of what was spent on repairs.

For more information, you can visit Calculate investment property return without a spreadsheet.