Discussion:LLC "sweat equity" contributions
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Discussion Forum Index --> Tax Questions --> LLC "sweat equity" contributions
January 3 2007 | |
| I have a client that recently formed an LLC. Some of the members are contributing cash, and some are contributing time and "creative" talents...
My question relates to their capital accounts in the LLC. Are the rules similar to contributing labor to a corporation (taxed as income to the individual equal to the basis given in the corporation) or does the LLC agreement govern/override what the capital account balances will be? Thanks! | |
| 3 January 2007 | |
| Depends on whether the members contributing creative talents are receiving an interest in profits only (in which case no taxable income) or an interest in the equity of the LLC. If the latter, the FMV of the interest received will be taxable. | |
| January 5, 2007 | |
| Although I think JD's response is probably true most of the time, the granting of a capital interest (i.e, an interest in the equity of the LLC) for services may not be immediately taxable if there are restrictions imposed on the non-cash contributor's interest. For example, if the non-cash contributor's capital interest was subject to a vesting period, the capital interest would not be taxed to the non-cash contributor until the vesting period lapsed. A good way to determine if the interest granted to the non-cash contributors is taxable, is to conduct a "hypothetical" liquidation of the partnership immediately after the granting of the interest. If the non-cash contributor is entitled to some of the liquidation cash immediately after receipt of the interest, then the interest received is a taxable exchange of property for services. Example: A & B form new partnership that will be owned equally. Partner A initially contributes $100k of cash and Partner B initially contributes "creative" talents. If immediately after formation the partnership were "hypothetically" liquidated so that the cash were distributed $50k to A and $50k to B, than there are no restrictions on Partner B's interest and Partner B would have $50k of taxable income upon receipt of the partnership interest.
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Libera nos a malo (talk|edits) said: | 4 February 2008 |
| A related question: when a member contributes services in exchange for LLC interest and no money changes hands, his capital account is credited, but what is debited? | |
| 4 February 2008 | |
| Here's the citation Jdugan was referring to: Rev. Proc. 93-27 | |
| February 4, 2008 | |
| Pegoo, do you mean Goodwill? If the LLC is taxed as a corporation, wouldn't the answer be wages? | |
Libera nos a malo (talk|edits) said: | 5 February 2008 |
| To elaborate on the question I posed earlier, per Rev. Proc. 93-27 services contributed in exchange for a profits interest, as opposed to capital interest, are not taxable. For this reason, I don't think the answer could be wages; otherwise a giant loophole would result. Consider this scenario: A and B form an LLC. Each contributes $100,000 worth of services. No money changes hands and nothing else happens. The LLC has $200,000 in the equity account. But what's the offset? If it is an expense, then A and B end up with $0 bases and $100,000 worth of pass-through losses a piece. For the same reason, I don't think it could be an asset account, such as Goodwill, since this would create a similar opportunity to squeeze amortization/depreciation out of nothing. But what's the alternative? | |
| February 5, 2008 | |
| The answer to your original post depends on whether the service member is receiving a capital interest or a profits interest. If the service member is receiving a capital interest, such member's capital will be credited and the corresponding debit would be to guaranteed payment expense [see Reg. 1.721-1(b)(2)]. This expense should be specially allocated to the non-service member or members that gave up a portion of their capital in order to admit the service member.
On the other hand, if the service member is receiving a profits interest, such member's capital would not be credited so there is no corresponding debit. Note: the issuance of a profits interest (under current law) does not create a capital account; however, there are proposed regs under Sec. 83 that could change this if enacted in proposed form. As for your second post with the example: although A and B might agree to contribute $200k of services, this “contribution“ has no tax basis so, on day 1, A and B do not have any basis for their service “contribution“; however, if someone actually pays the partnership $200k for the services (remember the services are worth $200k which implies that someone is paying for them), then the partnership has $200k of income that is allocable to A & B. In addition, the partnership might be able to deduct $200k of service expense if it subsequently pays A & B each $100k. At the end of the day, this boils down to the fact that A & B each have a $100k of income for services rendered. | |
| 5 February 2008 | |
| Another saver. FTF, your postings on the LLC in general, and concerning the devilish "profits interest" in particular, are always appreciated. | |
Libera nos a malo (talk|edits) said: | 5 February 2008 |
| Thanks, FTF, for an insightful post. This is the conclusion I was leaning towards simply by the process of elimination. It appears, then, that the contribution of services by a profits-interest member does not create a tax basis, but it does establish his percentage vis-a-vis his share of income/loss per operating agreement.
But what about a profits-interest member who is making an intangible contribution, such as patents, copyrights, etc? It seems that these intangibles can be transferred to the LLC at FMV without triggering capital gains at the time of contribution. And this raises an intriguing possibility of creating an amortization deduction essentially out of thin air. | |
| February 5, 2008 | |
| Re: the contribution of intangibles: the possibility of a tax deduction would only exist if the intangible had depreciable basis (i.e., if the partner "paid" something for the assets prior to contribution). Just because an asset is marked to value at the date of contribution, doesn't mean that tax basis is created. I think you might be confusing Sec. 704(b) economic capital accounts with tax basis.
If an asset with a FMV of $1M and zero basis is contributed to a partnership, the contributing partner's Sec. 704(b) capital account would be $1M but the same partner's tax basis would be zero (assuming nothing else impacts basis) and the partnership's basis in the asset would also be zero. Thus, there would be no tax deductible depreciation. Also, note that the $1M "built-in" gain would be allocable to the contributing partner under Sec. 704(c) [so, when you say that the FMV could be transferred "without triggering capital gains at the time of contribution" this is true; however, such built-in gain will be allocated back to the contributing partner when/if it is triggered]. | |
| February 5, 2008 | |
| Thank you, FTF. I've never worked with a profits-only interest. Your posts are very informative. | |
Libera nos a malo (talk|edits) said: | 6 February 2008 |
| I take your point, FTF. On careful re-reading of Sec. 722 & 723, it's clear that I was wrong about the basis of contributed property, which should be the partner's adjusted basis, rather than FMV.
And thanks for bringing my attention to Sec. 704. Correct me if I'm wrong, but I read it as an attempt to supplant the partnership agreement when the latter either fails to assign percentages to partners or does so in a manner inconsistent with econimic reality. So, for example, if I'm a 10% partner in a partnership that derives 90% of its income from, say, a patent that I contributed, then Sec. 704(b)(2) & 704(c)(1)(A) would override the partnership agreement and assign me a greater distributive share of profits. I'm afraid I just don't see how it's going to work in practice. | |
- Several different series of posts from non-tax-pros (and related responses) have been moved here.
