Passive Investor - How to report on tax return?

Question

One of my friend has business of flipping houses. He offered me to invest in his business on profit sharing. I will be just an investor and will get my money back with profit once he sells property after fixing it.

How do I report my income on my tax return?

Does he need to issue 1099? Do I have to pay social security tax/Medicare tax on this extra income?

If he sells property after a year - can I report this as long term gain?

I would appreciate if someone can help us.

Thanks.

Eamonn McElroy · Answer

@Mike Steffen

You don't need to be a partner in his company to trigger a 1065 obligation.

The mere agreement to share profits of a venture might rise to the level of a general partnership and trigger the 1065 obligation. You in your individual capacity would be one partner and your friend's LLC would be the other partner.

The tax reporting depends heavily on how you structure this venture, and that heavily depends on both you and your friends facts, circumstances and goals. I recommend you both speak with an attorney and CPA.

Ashish Acharya · Answer

You are considered a limited partner if its a partnership. He will file a partnership return and you will receive your share of Income/loss via K-1. If you at truly limited, the income that gets to you is not self employment income and is not subject to SE taxes.

If he has an S-corp, the income that gets to you is never subject to SE taxes. You are consider one of the owners of the S-Corp. You will get K-1 once he files S-Corp return.

Both of this is considered passive income for you. If you have rental loss, this income from flipping partnership can be sheltered with passive loss.

It is an ordinary income, not capital gain no matter how long he hold the property.

Basit Siddiqi · Answer

@Mike Steffen

You should first determine how you will be involved in the business from a tax standpoint.

Will you be a partner/member in his LLC/partnership. If yes, then you should receive a K-1 indicating your share of the profits. If you are a limited partner/non-managing member, then you shouldn't be hit with self-employment tax requirements.

You mentioned not being a member/partner in the LLC/Partnership. If this is the case, I would be very suspicious. If he is not going by the book here, who is to say that he will show you the accurate financials of the business?
Maybe he will earn $50,000 from the flip but only say he earned $25,000 and give you a share of $25,000 instead of $50,000.

Another thing is you can only have a debt/creditor relationship with your friend where you do not get a share in the profits but get a rate of return based on the capital provided.

Mike Steffen · Answer

Thanks both for your quick reply. My friend has llc firm but I am not partner in the company. He does multiple flipping project under his company and I am investing only in a couple of projects. So I dont think I can get K1 from his company. Sorry I was not clear in the beginning. Can you help to understand tax reporting purpose?

Thanks.

Eamonn McElroy · Answer

@Ashish Acharya

Doubtful they formed a legal entity based on OP's language. Was probably a handshake deal.

I'm leaning toward general partnership based on the limited facts provided.

To dial everything in the agreement needs to be analyzed (hopefully it's in writing) and state law needs to be considered.

@Mike Steffen

If it truly is a GP, it will be hard for you to avoid SE taxes even if you were a capital partner. Optimal entity structuring could have avoided SE taxes. The best way generally would be to form an LLC and write into the operating agreement language that makes you the 'functional equivalent' of a limited partner for tax purposes.

Ignoring SE taxes, the income will be ordinary, not capital gains.

Passive Investor - How to report on tax return?

Passive Investor - How to report on tax return?

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