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S Corp "Silent" Partner

I am 33% owner in LLC. I have two partners, each owning 33%. I and Partner One are active contributors to the company. We each draw a $100K salary. The third partner was an early financial investor but has become more or less "silent." We are considering moving to an S Corp structure for various reasons, but our situation with 3rd partner complicates matters.

My question: With an S Corp, our net income must be distributed according to our respective ownership positions. We have no doubt that our salaries of 100K will be considered "reasonable" by IRS, but our third partner receives no salary, since he is not actively engaged in operations. If we move to S Corp, will we draw a red flag with IRS if the third partner receives a distribution but does not receive any salary? Can an S Corp take a "silent partner" into consideration without fear of audit? Or do we have to move our 3rd partner into a "reasonable salary" structure in order to pay distribution to him?

Thanks.

MW

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Silent partner in S Corp

I am 33% owner in LLC. I have two partners, each owning 33%. I and Partner One are active contributors to the company. We each draw a $100K salary. The third partner was an early financial investor but has become more or less "silent." We are considering moving to an S Corp structure for various reasons, but our situation with 3rd partner complicates matters.

My question: With an S Corp, our net income must be distributed according to our respective ownership positions. We have no doubt that our salaries of 100K will be considered "reasonable" by IRS, but our third partner receives no salary, since he is not actively engaged in operations. If we move to S Corp, will we draw a red flag with IRS if the third partner receives a distribution but does not receive any salary? Can an S Corp take a "silent partner" into consideration without fear of audit? Or do we have to move our 3rd partner into a "reasonable salary" structure in order to pay distribution to him?

Thanks.

MW

Passive S Corp Shareholders

No, since the third partner does not materially participate in the business, s/he wouldn't normally receive a salary.

However any profits must be shared evenly as reported on the K-1. So say your S corporation has $30K of profits after you & Shareholder One received your $100K salary. Each shareholder's K-1 would show $10K of profit. For you & Shareholder One, that would be ordinary income. But for the "investor", that would be passive income. And subject to the Net Investment Income Tax. That tax would not apply to you & Shareholder One because you materially participate.

If the S corp generated a loss, Investor shareholder's losses would be subject to passive loss limitations that would not impact you & shareholder one.

Salary can be "uneven". It's fine for you & Shareholder One to get a salary and nothing for Investor. That is not true for distributions. Any distributions of cash or property must be made based on percentage of ownership. So if the S corp made a distribution of profits of say $15K, each shareholder should receive $5K whether that shareholder materially participates in the corporation or not.

Hope this helps.
L:)

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