Unequal capital distribution

[PatD]

This is probably a very basic question, but here goes…

Andy and Ben form AB, LLC, which for income tax purposes will be treated as a partnership. Andy and Ben each contributes $5,000 cash and will have 50/50 interests in capital, income, and loss.

In the first year, AB, LLC earns a net profit of $20,000, with $10,000 allocated to Andy and $10,000 allocated to Ben. Andy makes no draw against his capital account, while Ben takes a cash draw of $10,000.

Ben’s capital account is still $5,000 ($5,000 original contribution plus $10,000 income allocation minus $10,000 cash withdrawal). Andy’s capital account is $15,000 ($5,000 original contribution plus $10,000 income allocation).

What started out as a 50/50 capital structure now appears to be 75/25.

What consequences result from this change to the capital accounts? Does Andy now have 75% of the voting power? Is there a deemed sale of a capital interest? Are there any other unintended consequences?

Please send me to a link if this has already been answered, and thanks in advance.

[Ed Loughrey]

Unequal Capital

The original sharing of the profits remains at 50 50.The fact that one A has not taken out his money does not have any effect whatsoever on this %.

That money ( $ 10,000) has been taxed to A and is available to him whenever he feels
like taking it out. If in the next year they share a $ 6,000 gain, A would be eligible to take up to $ 13,000 and his partner $ 3,000..

[PatD]

K-1 capital percentages

So you're saying that on Schedule K-1, Part II, Line J, profit and loss ending percentage values remain at 50% for both Andy and Ben. What values would be entered as the capital percentages for Andy and Ben?

[BHoffman]

So you're saying that on Schedule K-1, Part II, Line J, profit and loss ending percentage values remain at 50% for both Andy and Ben. What values would be entered as the capital percentages for Andy and Ben?

Andy has his partnership basis, and Ben has his partnership basis.

If Andy draws out more cash than Ben, then Andy's basis will be lower but his partnership ownership percentage will remain at 50%.

Not sure if that will answer your question

[PatD]

So does that mean...

I am interpreting your response to mean that if one partner has withdrawn all of the income allocated to him while the other partner has never withdrawn any income allocated to him that they continue to have 50/50 capital interests.

Capital Interest Definition, per Rev. Proc. 93-27
“A capital interest is an interest that would give the holder a share of the proceeds if the partnership’s assets were sold at fair market value and then the proceeds were distributed in a complete liquidation of the partnership. This determination generally is made at the time of receipt of the partnership interest.”

So each partner is entitled to half of the liquidation proceeds even if one has already withdrawn all of his share of income?

[BHoffman]

I am interpreting your response to mean that if one partner has withdrawn all of the income allocated to him while the other partner has never withdrawn any income allocated to him that they continue to have 50/50 capital interests.

Capital Interest Definition, per Rev. Proc. 93-27
“A capital interest is an interest that would give the holder a share of the proceeds if the partnership’s assets were sold at fair market value and then the proceeds were distributed in a complete liquidation of the partnership. This determination generally is made at the time of receipt of the partnership interest.”

So each partner is entitled to half of the liquidation proceeds even if one has already withdrawn all of his share of income?

Let's say all of the assets were sold at FMV for $100. Andy and Ben properly split the proceeds.

Andy's basis is $0 due to his taking cash distributions. Andy will have capital gains of $50.

Ben's basis is $50 due to not taking any cash distributions. Ben will have no capital gain.

Our trusty Tax Book has a nice chapter about Partnerships.

[PatD]

Thanks for the info

Thank you for your responses. I have gone over the partnership chapter, and I understand the points you make about basis and capital gains. I guess what seems unfair (fairness in the tax code?) is that a partner who has already withdrawn all of his earnings would still get the same liquidation proceeds as the partner who withdrew nothing.

[BHoffman]

Thank you for your responses. I have gone over the partnership chapter, and I understand the points you make about basis and capital gains. I guess what seems unfair (fairness in the tax code?) is that a partner who has already withdrawn all of his earnings would still get the same liquidation proceeds as the partner who withdrew nothing.

The partner who withdrew everything would pay more capital gains tax.

[Nashville]

Loans

Pat, I would create a balance sheet payable to the partner who did not take distribution for $10,000 in your example, and report capital balances at 50-50. This would have the same effect as declared dividends paid to one owner and not yet paid to the other.

Or, if the situation warrants, create a balance sheet receivable from the partner who DID take the distribution.

At any rate, under either of the above scenarios, the capital accounts remain in a 50-50 balance, and the existence of a payable/receivable, the rights of both parties remain intact in the event of liquidation.

[PatD]

Thanks

Thanks. I like that.