Value of work

[DTS]

When an LLC gives a very small percentage, maybe 1-3 % of the LLC to people in exchange for services, what is the value of this work?

Is it worked out to be gifted or figured from charts we can find for comparable salaries we've discussed in prior threads regarding reasonable salaries for corps? I can understand larger percentages being given, but such small percentages? Hardly seems worth it unless the company is flush with profits.

Thank you,

Dennis

[Bees Knees]

It depends upon whether it is for a profits interest in the LLC (partnership), or it is for a capital interest.

TTB, page 20-6 says:

The treatment of services rendered in exchange for a partnership
interest depends on whether the partnership interest is a capital
interest or a profits interest.
Capital interest. A capital interest is an interest that would
give the partner a share of the proceeds if the partnership’s assets
were sold in a complete liquidation. When exchanged for a
capital interest, the value of the services is taxable to the partner,
and deductible by the partnership. The value of the services
becomes the partner’s basis in the partnership.
Profits interest. A profits interest is an interest other than a capital
interest. The exchange of services for a profits interest is not a
taxable event unless (1) the profits interest relates to a predictable
income stream from partnership assets, such as high-quality debt
securities or a high-quality net lease, (2) the partner disposes of
the profits interest within two years of receipt, or (3) the interest
is in a publicly traded partnership.

[Bees Knees]

Example of a profits interest. A small group of investors put up the money to start a business. They hire a bunch of skilled workers to do the job, but can’t afford to pay their labor up front. So they give each worker a 3% profits interest in the partnership, meaning if the partnership makes a profit, each worker gets 3% on top of whatever guaranteed payment is promised. If and when the partnership liquidates, the investors get the money.

Since future profits are not certain, the 3% profits interest is not a taxable event until profits are actually earned. The profits interest partner does not get any share of losses.

In some cases, a profits interest can turn into a capital interest. For example, rather than paying out cash, each year profits are earned, they are converted to a capital interest, giving the partner a share of the liquidation proceeds, and a share of any future losses.

It is actually an interesting way to form a partnership. It is a form of special allocation which has an economic purpose. It is also an advantage the LLC has over an S corporation, as you cannot have this 2 class of ownership arrangement in an S corporation.

[Lion]

Ownership

I just had an email from a client who's receiving a $30,000 plus check from his company and wanted to know how much tax he'll owe. He said his company sold an asset (a domain name) and received a large investment from an outside firm so is making distributions to all the owners. In the past client has received W-2s, no K-1s, but said he owns 4.2% of the company now. Company CFO told him the $30,000 is a guaranteed payment, taxed as ordinary income. Client said company has been giving him a small salary and stock options and this is the first chance he's had to exercise them. Told him to send in ES payments at 28% and 5% rates to handle income tax now. If really a guaranteed payment, then SE tax? If this is an S-corporation or an LLC taxed as a partnership, should he get both a W-2 and a K-1? This situation doesn't sound like either of the situations described in this thread. The company is definitely not liquidating, it's growing. In fact his salary on his W-2s has gone from under $45,000 to nearly $90,000 over a very few years. His wife is high income, so an extra $30,000 (it's probably $31,500) will push them into the next tax bracket and increase their AMT, too. Maybe the $30,000 is just the net after exercising his stock options and is actually a much larger amount.... My clients lives are getting more complicated faster than I'm getting smarter!

[DTS]

Bees

In your example of profits interest, is this the same as a "restricted interest" with vesting requirements?

This client of mine is going to offer this to all employees and managing members of the LLC and I've been trying to do some research on this. In my reading, Sec 83 is mentioned and there seems to be a possible conflict as to whether this is taxable or not, for the same reasons you mention in your example, most leaning towards not taxable.

My question on how to value the services is raised, again. When the profits are earned and become taxable, I suppose all we have to do is report this additional income because services were done. No correlation to the amount of work done to the amount of money (profit interest or restricted interest) that is earned.

Do I have this right?

Thank you,

Dennis

[Bees Knees]

Its taxable when the profits are actually earned.

For example, you have a 50% profits interest in a partnership, but a zero% share of capital and a zero% share of losses. The reason is because you didn’t put any money or property into the partnership at the time of formation. You are a partner only because of future services you agree to perform, and the value of those future services is entirely dependent upon profits.

In other words, if there is a loss in year one, you get zero for your services. Therefore, the value of your services is zero.

However, if there is a profit in year one, and your share is $10,000, you pay tax on that $10,000, as that is the value of your services contributed in year one. The value of your services is tied to future profits, so therefore, you pay no tax until there actually is a profit.

Section 83 is talking about paying tax at the time property is transferred in exchange for services. A profits interest in this case is property transferred (a partnership interest) at the time there is actually profits to transfer.

Now, depending upon the partnership agreement, maybe you are required for a period of time to reinvest that $10,000 profit into a capital interest in the partnership, meaning you now have a share of any losses, and a share of partnership property upon liquidation. That isn’t a requirement, as the partnership could just say you get your share of the profits in cash. It all depends upon the agreement.

[DTS]

Bees

Thank you for explaining further to me. It's becoming clearer. I want to do some more reading on this, which may lead me to more questions (it always does!). I hope you can jump in and lend some more insight, if I do.

Thanks again,

Dennis