"Sweat Equity" RECEIVING LLC INTEREST IN LIEU OF SERVICES

RECEIVING LLC INTEREST IN LIEU OF SERVICES

Individuals often desire to invest in an LLC by performing services instead of paying cash.  In other cases, the Company may want to award a key employee with an ownership interest in the LLC.  Both of these scenarios are common in the corporation context.  However, in the LLC context, whether the Service Provider’s investment is characterized as an “initial capital account” or as a “future profits interest” will have significant tax consequences for the Service Provider.  The following is a very brief and simplified discussion of this complex area of tax law, intended to assist you in discussing the issue more fully with your tax advisor.

Basically, an “LLC Interest” is composed of three parts which can be computed separately: voting rights and two categories of economic interests: “capital accounts” and “future profits interests”.  In a corporation, the economic interests cannot be separated.  However, in an LLC they can be different, based on how the LLC Agreement is written and the how the Service Providers investment is characterized.

1.         An LLC investor’s “capital account” represents an undivided percentage ownership in the LLC’s underlying assets, equal to the amount it invested, plus profits, and minus losses, allocated to the investor.  The relative percentages of an LLC’s capital account are generally the basis for distributing the LLC’s assets on liquidation, but may also be used to determine voting, and other rights, depending on how the LLC Agreement is written.

2.         An LLC investor’s “future profits interest” is the percentage of the LLC’s future income and losses allocated to the investor, although the amount actually distributed to the investor will be governed by the LLC Agreement. 

Initial Capital Account

Cons.  If the value of the services invested is characterized as an initial Capital Account balance, the IRS looks at it as if Company has paid the Service Provider cash for the services, and then the Service Provider has turned around and invested that same amount back into the LLC.  The Service Provider will receive a Schedule K-1 from the LLC that reports a guaranteed payment equal to the value of the services.  This amount is taxable income to the Services Provider in the year the services were provided, even though the LLC did not distribute any cash to the Services Provider, i.e. it is “phantom income”.  Most Service Providers are not intending this result.

Pros.  Since the Service Provider receives a Capital Account balance equal to the amount of the services rendered, the Service Provider will also receive an allocation of the LLC’s profits or losses equal to its Capital Account percentage.  Any allocated losses may offset some part of the Services Provider’s taxable phantom income from the services investment, since the amount of those losses will reduce the Service Provider’s capital account balance.

Future Profits Interest

Pros.  If the Services Provider received a Future Profits Interest in exchange for the services, its initial Capital Account will be zero and it will not have taxable phantom income for the year the services were provided.  Each year that the LLC has profits, the Services Provider will be allocated its stated percentage of those profits, which will increase its Capital Account above zero.  The Service Provider will have taxable income equal to the amount of the profits allocated to it.    

Cons.  The Service Provider who receives only a Future Profits Interest generally will not be allocated any of the LLC’s losses so long as its Capital Account is zero.  Those losses are instead allocated among the investors who contributed cash in proportion to their Capital Accounts percentages.  As a result, the Services Provider will not realize any benefit from its investment until the LLC becomes profitable and begins to issue distributions.  In some cases, the value of the Services may be booked as an account payable, but in other cases this not feasible for various reasons.

Example.  Here is the analysis for a Service Provider who received a 2.08% Class A Interest in an LLC instead cash for its $18,000 fee. The Class A Interests were capital account investments and were entitled to a 10% preferred return before pro rata distributions to the Class A and Class B investors.  The Class B Interests were future profits interests only issued to non-cash investors.  

1.  If the $18,000 fee is accounted for as the purchase price of a 2.08% Class A Interest, then Service Provider will start with a capital account equal to $18,000 as if it had paid cash for the Class A Interest.  Each year, Service Provider's capital account will be increased by its percentage of the LLC's profits and accrual of the preferred return, and decreased by The LLC's losses and payments against the accrued preferred return.  For 2006 tax year, Service Provider will receive its percentage of the losses allocated to the members.  When the LLC liquidates, Service Provider will receive a maximum of its entire $18,000 capital account back, plus its pro rata share of the cash available after all of the capital accounts have been paid back, including whatever amount has accumulated in its capital account from profits allocations. 

2.  The IRS considers the value of Service Provider's capital account, ie. $18,000, as taxable income. Service Provider will then have to include this "phantom" income in its tax return and pay tax on it even though it did not receive any cash distributions from the LLC this year.  In order to address this cash flow issue, the LLC could make a cash "tax distribution" equal to an agreed-upon tax rate multiplied by the $18,000, so that he has the cash to pay that tax.  The amount of the distribution is also taxable, so the LLC could round up the tax distribution to approximate the actual tax burden.

In this case, if the LLC can't or doesn't elect to pay Service Provider a cash tax distribution, then the choices are for (a) Service Provider to accept the tax burden and retain its Class A Interest, or (b) for Service Provider's fee to be booked as an account payable, and for Service Provider to receive a Class B interest that starts with a zero capital account, i.e. a 2.08% "profits interests" as additional compensation. 

With a "profits" only interest, Service Provider will only be taxed on (1) payments it actually receives on the $18,000 account payable, and (2) 2.08% any profits which the LLC earns and allocates to its members in future years.  Service Provider will not receive the preferred return.  In addition, Service Provider will have to wait to use any losses allocated to the LLC's members until its capital account has been increased above zero by profit allocations in future years.

IRS Circular 230 Disclaimer:  To ensure compliance with requirements imposed by the IRS, we inform you that to the extent this communication contains advice relating to a Federal tax issue, it is not intended or written to be used, and it may not be used, for (i) the purpose of avoiding any penalties that may be imposed on you or any other person or entity under the Internal Revenue Code or (ii) promoting or marketing to another party any transaction or matter addressed in this communication.

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