Question: My colleague and I will become equal owners of a new limited liability company we are creating. My colleague will be contributing cash and I will be rendering services in return for our ownership interests. Are there any tax consequences?
Answer: The tax aspects of any business arrangement must be carefully considered at the time of formation. You raise a question frequently posed in the creation of a limited liability company (“LLC”).
Property contributions to an LLC are generally not taxed to the contributing member. This tax-free treatment is available whether the contributed property consists of cash, other liquid assets or non-liquid assets such as real estate. Where LLC interests are issued in return for services rendered, however, the contributing member is generally taxed on the value of the membership (e.g., ownership) interest received. Ifyou proceed with your new venture as planned and the two of you equally share in all LLC cash distributions, one-half of the LLC value will be taxable to you upon formation.
Ifyou are willing to alter the economics of your arrangement, you can avoid the recognition of income at the time you receiveyour membership interest. Instead of receiving a full 50% membership interest in the LLC, you can receive a 50% profits interest which need not be taxable to you. While the allocation of LLC profits will be taxed toyou as they will be to your colleague, your receipt of the profits interest at the time of formation need not be a taxable event.
To illustrate the distinction, assume your colleague contributes $100,000 of cash to the LLC and you agree to render services for a full 50% membership interest in the company. If the LLC Operating Agreement entitles you to share equally in all distributions including those made upon liquidation, as a full member you would receive $50,000 if the company liquidates following formation. As a result, you would have to report $50,000 of ordinary income in the tax year the company is formed. Having received a capital interest in the LLC, you are taxed at the time of formation even though the company has yet to report any profits.
This tax consequence can be avoided if instead the LLC Operating Agreement provides that upon liquidation, proceeds are first distributed to members based on the capital contributions made to the company. This means that upon the LLC’s liquidation, your colleague would receive the first $100,000 of cash available for distribution with the balance distributable to the two of you in equal shares. You would of course still be sharing in one-half of all the profits generated by the company. In this case, you would be the owner of a profits interest in the LLC and would not be taxed on the receipt of your profits interest.
There are some circumstances where profits interests received in LLCs can be taxed at the time of issuance. In most cases, however, your objective of avoiding tax on formation can be avoided if the LLC Operating Agreement is carefully crafted to distinguish between the different types of interests being issued, the capital interest to your colleague and the profits interest to you. To further establish the non-taxable nature of your profits interest, a safe harbor election can be made by the LLC on the LLC’s initial tax return to take advantage of the tax savings opportunity.
In today’s business world, most contributors of cash to business ventures want their capital back first before service providers receive payment, whether on liquidation or otherwise. If you are willing to modify the arrangement in this matter, you can accomplish a meaningful tax savings.
The Tax Corner addresses various tax, estate, asset protection and other business matters. Should you have any questions regarding the subject matter, you may contact Bruce at (312) 648-2300 or send an e-mail to [email protected].
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