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socrateaser
socrateaser, Attorney
Category: Business Law
Satisfied Customers: 33915
Experience:  Retired (mostly)
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My partner and I have 50:50 ownership of an LLC. Our capital

Resolved Question:

My partner and I have 50:50 ownership of an LLC. Our capital structure, per our
Operating Agreement, provides that we each have 500 LLC Units, a Unit being
defined as a measure of ownership in the capital of the Company. We propose to
bring in a new partner, granting him a profits share interest. We want the new
partner to participate in the management of the company and we are planning that
he would have 20% of the vote (my partner and I 40% each). Currently the OA
defines a "Vote of interest of LLC Members" as a "vote in which each LLC Member
shall have one vote per LLC Unit possessed." My question concerns how to
restructure the voting rights to account for a partner with a profits interest,
within an amended OA, while accommodating the additional risk exposure of the
partners with a capital interest. If an LLC Unit is tied to capital, should
voting somehow be expressed in some other measure in lieu of capital?
Submitted: 2 years ago.
Category: Business Law
Expert:  socrateaser replied 2 years ago.
Corporations Code 17103(a) permits members of an LLC to create a voting mechanism under the operating agreement in an unrestricted manner. Thus, you can have each member have a capital interest, a profit interest and a voting interest. The default, where both the articles of organization and operating agreement are silent on voting rights, is that each member votes in proportion to his/her profit interest.

I can't advise you re what you should do, but now that you know what you can do, you should be able to craft an operating agreement to protect your interests in the management of the LLC.

Hope this helps.


And, if you need to contact me again, please put my user id on the title line of your question (“ToCustomerrdquo;), and the system will send me an alert. Thanks!

Customer: replied 2 years ago.
What would go in the articles of organization and what in the operating agreement regarding these rules?

And if I understand you correctly, with three parties, you could have for example hypothetically:

50, 50, 0 for capital interest
33, 33, 33 for profit interest
40, 40, 20 for voting interest

Is that right?

Does a profit interest make any money when the LLC is acquired or sold or purely profit up until that event?
Expert:  socrateaser replied 2 years ago.
What would go in the articles of organization and what in the operating agreement regarding these rules?

A: Nothing need go in the articles of organization, unless the articles already specify voting rights and interests, and they do not provide that the interests may be modified in the operating agreement. In that case, you would have to amend the articles -- otherwise everything can be done in the operating agreement.

And if I understand you correctly, with three parties, you could have for example hypothetically:

50, 50, 0 for capital interest
33, 33, 33 for profit interest
40, 40, 20 for voting interest

Is that right?

A: Yes. You have unlimited discretion as to the nature of the membership interests.

Does a profit interest make any money when the LLC is acquired or sold or purely profit up until that event?

A: Profit is the ongoing revenue, not the capital gain on sale.

Hope this helps.


And, if you need to contact me again, please put my user id on the title line of your question (“ToCustomerrdquo;), and the system will send me an alert. Thanks!

Customer: replied 2 years ago.
Ok, well I suppose what I'm alluding to is that I have read (and am very confused by)...

That if the company was valued at say $100 today... and the new member was added and given a 25% profit share... and three years from now the company sells for $200, that the aforementioned new member would get $25 for the sale of the business (25% of the $100 difference between $100 and $200).

This nomenclature confuses me... to me it sounds more like old capital equity vs. new capital equity, but maybe my understanding is wrong altogether?

How do you give someone a share of future-generated company value (capital) without allowing them to get a piece of prior capital?

So confused...
Expert:  socrateaser replied 2 years ago.
The following is quoted from IRS Pub 541 (page 9):

Contribution of Services

A partner can acquire an interest in partnership capital or profits as compensation for services performed or to be performed.

 

Capital interest. A capital interest is an interest that would give the holder a share of the proceeds if the partnership's assets were sold at fair market value and the proceeds were distributed in a complete liquidation of the partnership. This determination generally is made at the time of receipt of the partnership interest. The fair market value of such an interest received by a partner as compensation for services must generally be included in the partner's gross income in the first tax year in which the partner can transfer the interest or the interest is not subject to a substantial risk of forfeiture. The capital interest transferred as compensation for services is subject to the rules for restricted property discussed in Publication 525 under Employee Compensation. The fair market value of an interest in partnership capital transferred to a partner as payment for services to the partnership is a guaranteed payment, discussed earlier.

Profits interest. A profits interest is a partnership interest other than a capital interest. If a person receives a profits interest for providing services to, or for the benefit of, a partnership in a partner capacity or in anticipation of being a partner, the receipt of such an interest is not a taxable event for the partner or the partnership. However, this does not apply in the following situations.
  • The profits interest relates to a substantially certain and predictable stream of income from partnership assets, such as income from high-quality debt securities or a high-quality net lease.

  • Within 2 years of receipt, the partner disposes of the profits interest.

  • The profits interest is a limited partnership interest in a publicly traded partnership.

A profits interest transferred as compensation for services is not subject to the rules for restricted property that apply to capital interests.

Basis of Partner's Interest

The basis of a partnership interest is the money plus the adjusted basis of any property the partner contributed. If the partner must recognize gain as a result of the contribution, this gain is included in the basis of his or her interest. Any increase in a partner's individual liabilities because of an assumption of partnership liabilities is considered a contribution of money to the partnership by the partner.

 

Interest acquired by gift, etc. If a partner acquires an interest in a partnership by gift, inheritance, or under any circumstance other than by a contribution of money or property to the partnership, the partner's basis must be determined using the basis rules described in Publication 551.


Comments: The "voting" interest has no pecuniary value, so it is not of interest to the government. California law expressly permits LLC members to craft their ownership interests as they wish.

The capital interest receives the profit from the sale of the business (the capital gain). The profits interest receives the profit from the income stream of the ongoing business. Each is a profit, different in kind, and taxed differently.

Hope this helps.


And, if you need to contact me again, please put my user id on the title line of your question (“ToCustomerrdquo;), and the system will send me an alert. Thanks!


Customer: replied 2 years ago.
So what do you call it when you give a capital interest that does not include the capital that pre-existed the new partner's involvement? I will accept after this last question. Thanks so much!
Expert:  socrateaser replied 2 years ago.
So what do you call it when you give a capital interest that does not include the capital that pre-existed the new partner's involvement?

A: If you mean to simply create capital out of thin air, rather than to require that the new partner contribute capital to the partnership, then I would call that "imanginative," because it is mathematically impossible (except perhaps in the world of quantum mechanics).

Hope this helps.


And, if you need to contact me again, please put my user id on the title line of your question (“ToCustomerrdquo;), and the system will send me an alert. Thanks!

Customer: replied 2 years ago.
I don't think I explained myself property. If a company is worth $100 currently, how do you give a new partner a share of equity that does not include the $100, only the value that is created beyond the $100 so say if a company sells down the line for $200, the new partner would only get a share of the difference of $100, not the whole $200. That's what I mean.
Expert:  socrateaser replied 2 years ago.
What you are attempting is impossible. You cannot expand the pie plate without the pie spreading out to fit. If there was $100 to begin with, and it's split two ways, then each partner has $50 ownership. If you add another capital interest, of say 20%, then that partner will receive $20 ($10 from each existing partner). And that is a taxable event, because the new partner has just received $20 in ordinary income from the partnership.

Hope this helps.


And, if you need to contact me again, please put my user id on the title line of your question (“ToCustomerrdquo;), and the system will send me an alert. Thanks!

Customer: replied 2 years ago.
I'm trying to account for the eventual selling of the company. How do you give him a share of the value that is created after he comes in but not let him have a share of the value the pre-existed him? The difference between the selling price if it were sold today and what it sells for eventually.
Expert:  socrateaser replied 2 years ago.
I explained this in my very first answer to you concerning this subject matter. If you want the partner to have an interest in the capital gain of the business, then the partner must own some portion of that capital. The partner can contribute capital from ongoing profits, buy-in with his/her own capital, or you can transfer a portion of existing capital to that partner. However, if you do the latter, then the partner will have a tax liability because he/she will have received ordinary income from you and any other existing partners.

I realize that this isn't what you want, but that's just the way it works, and there is no way to avoid this outcome (at least, not legally -- unless you want to claim that the transfer is a nontaxable gift).

Hope this helps.

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Customer: replied 2 years ago.
See this link:

http://www.myllcagreement.com/llc-operating-agreement-glossary.html?AspxAutoDetectCookieSupport=1

Is what is defined as "Profits Interest" not possible then?
Expert:  socrateaser replied 2 years ago.
I gave you a quote from IRS publication 541 which unequivocally states that "A capital interest is an interest that would give the holder a share of the proceeds if the partnership's assets were sold at fair market value and the proceeds were distributed in a complete liquidation of the partnership," and that "A profits interest is a partnership interest other than a capital interest." You respond with a contradictory quote from a commercial website with no legal authority for its assertions, whatsoever, which states that a profits interest is the same as a capital interest.

Now, when your new partner is audited and he points to the commercial website as authority for his treatment of the profits interest as if it were a capital interest, what do you think the IRS will say?

You cannot do what you are attempting to accomplish. If it were possible, then anyone could use the technique to create tax shelters that would avoid all taxation by forming partnerships and transferring assets tax free to others partner in exchange for nothing. Every taxpayer would quickly climb on board the scheme and all U.S. Income Tax revenue would evaporate!

Hope this helps.


And, if you need to contact me again, please put my user id on the title line of your question (“ToCustomerrdquo;), and the system will send me an alert. Thanks!

socrateaser, Attorney
Category: Business Law
Satisfied Customers: 33915
Experience: Retired (mostly)
socrateaser and 7 other Business Law Specialists are ready to help you

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