Discussion:Value of sweat equity
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Discussion Forum Index --> Tax Questions --> Value of sweat equity
| 23 August 2007 | |
| Can someone tell me if I am thinking this through clearly? I have a client that is a 3 member LLC. Their capital and profit interests are: A=67.5, B=22.5, C=10. Initial contributions are member A = 250,000, member B = 100,000 and member C contributes sweat equity. They agree to value the sweat equity using the minority discounted value of the "relinquishment of capital". So C's value is 350,000 x 10% x 70% (from a "typical" discount of 30%) = 24,500. So then I book 24,500 to C's capital account with an offset to Guaranteed Payments. At this point now A's capital contribution is no longer 67.5% of the total capital of 374,500 but is 66.7% and B's has gone from 22.5% to 26.7%. Is this change in % a normal result of using the discounted value or am I doing something wrong? I've never had to deal with sweat equity values before so wanted to run it by others with more experience in this area before I finalize anything. | |
Michaelstar (talk|edits) said: | 23 August 2007 |
| It does not look to me by the info provided that the initial capital interests are the %'s you have stated. Member C made no initial capital contribution and thus had a beg capital % of zero. Capital %'s and agreed upon profit %'s can be different. In your example, member C has an ending capital account of 6.5% (plus rounding) in year 1 - certainly not equal to the 10% profit's interest that may be stated in the LLC agreement.
I agree with your ending capital %'s but unless member A & B contribute $$ in year two, as long as member C continues to contribute his services, his capital account will increase by this "contribution/GP" formula you have described. Certainly the LLC agreement defines such matters but the intent of the agreement may not be what actually has taken place. | |
| 23 August 2007 | |
| Oh it's even worse than that, Michael. If $250K represents 67.5% then total capitalization is $370,370.57. If $100K represents 22.5% then total capital is $444,444.44. If $350K represents 90% total capital is $388,888.88. But then why should math be a CPA requirement? For whatever it's worth, if you want to determine the capital account based on discounted sweat equity you determine the amount to be discounted based on profit percentage. You will always have a profit/capital imbalance. If sweat equity contribution covers more than year one you prorate. | |
| August 23, 2007 | |
| Does the debit in this transaction go to Guaranteed Payment or does it pull from A & B's Capital Account? | |
Michaelstar (talk|edits) said: | 23 August 2007 |
| I agree Dennis. Those stated beginning capital %'s are either incorrect or something here is missing.
Paul - I would book the debit to GP. It will eventually flow to A & B's capital account via the p/l and their profit %'s. | |
| 23 August 2007 | |
| I tried to save this earlier and got a error message. Just got back from a meeting and saw it hadn't saved so I'm trying it again.
ok, first, I missed something in the operating agreement - the original %'s relate only to profit, loss and distribution. It states that the memebers will make INITIAL contributions of 250,000 (A), 100,000 (B) and "management services on an ongoing basis" for "C". It also states that any additional contributions will be in proportion to their capital% which it says "The percentage interest of each member shall be determined as of the date required for the Capital Contribution". So you are right the capital %'s are not the same as the profit % in this case. "My bad" as my son would say. Amazing what pops out at you after rereading something for the 10th time. :) That explains why I couldn't make sense of the capital account balances (I had the same reaction you did Dennis to the gross up of %'s, I knew it wasn't adding up to what I THOUGHT was the right %'s. But it does seem like we need to value the sweat equity for initial contribution and yes Dennis it does cover more than one year but C is vested immediately according to the agreement so wouldn't I show her initial contribution as the 24,500? On the k-1's the profit %'s would be 67.5, 22.5 and 10 but the capital %'s would be 66.7, 26.7 and 6.6 based on these initial contributions, right? I don't think the members realized their capital %'s would change. | |
| August 23, 2007 | |
| This sounds like a C has a partial profits-only interest. If the LLC is dissolved after the 1st day of operations before any activity, do A & B get all of their initial contributions back? or does C get a piece of it?. | |
| August 24, 2007 | |
| Because C is vested, a hypothetical liquidation of the partnership the day after formation should result in C walking away with $24,500 (i.e., C has a capital interest). In accordance with Reg. 1.721-1(b), a debit to guaranteed payment expense and a credit to C's capital account seems appropriate.
SKPCPA: the valuation of C's capital account at $24,500 does not increase the partnership's pool of capital from $350,000 to $374,500. Although the $24,500 guaranteed payment increases C's capital account, the partnership has a corresponding deduction which reduce's the capital accounts of A and B by the same amount. On a hypothetical liquidation the day after formation, C would get $24,500 to zero out her capital account while A & B would split the remaining $325,500 of liquidation proceeds pro rata based on their respective contributions (less their share of the guaranteed payment deduction). In effect, A's & B's capital percentages changed because they gave some of their capital to C. If they did not realize their percentages would change, maybe this is not what they intended?? | |
