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Lane
Lane, JD, CFP, MBA, CRPS
Category: Tax
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Experience:  Juris Doctorate, CFP and MBA, Providing Financial & Tax advice since 1986
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My company, Halestorm Media (sole proprietorship) has been

Resolved Question:

My company, Halestorm Media (sole proprietorship) has been hired as a contractor, performing email marketing/web design work for a Canadian company, Expert Fundraiser (www.expertfundraiser.org). I have been a contractor for this company for 3 months now, billing the Canadian company through my business PayPal account.

For the last few months, I have been contracted out to create email newsletters, edit/add articles to expertfundraiser.org, and create marketing strategy for the website transformation.

Now, before we go any further with the project, my client, Joshua (a Canadian citizen) would like to start a partnership with me (U.S. citizen) and Ron (another Canadian citizen) to continue the transformation of the blog to comprehensive website.

This is the email I received from Joshua a few days ago:

----email start---
The partnership would be to continue transforming the current blog, www.expertfundraiser.org, into a comprehensive website that offers e-learning online courses ($99 each) and memberships to a library of fundraising tools ($99 for memberships).

My idea for the partnership is to have Heidi (Halestorm Media) own 25%, Ron 25%, and me 50%. I would pay for all the start up expenses until the company begins to turn a profit. Tasks and responsibilities of each partner would need to be clarified to ensure everyone is bringing the same value of work and commitment.

For the e-learning online courses and new services we create apart from our existing businesses, we can have equal share in the profits.

For the existing services that each of our companies offer (we would have links from Expert Fundraiser to each of our existing companies) we can negotiate a profit sharing aspect for the business created through www.expertfundraiser.org.
-------email end-----

MY QUESTIONS

1. If we go into this partnership, Joshua would own 50% of expertfundraiser.org and Ron and I would only own 25%. However, he wrote in the 3rd paragraph in his email that we would have equal share in the profits of the new services and digital products we sell from expertfundraiser.org. To me, this does not make sense as we would already have in our agreement that he would own 50% of the business, which translates to me 50% of the profits, correct?

2. How would a partnership like this affect me tax-wise as a U.S. citizen becoming a partner in a Canadian partnership?

3. What would be the tax consequences for me as I would be receiving a 25% interest in the partnership in return for my contribution of services?

4. Because the "start-up" costs are mainly online marketing and website design (all work that Halestorm Media would provide for the partnership) could I still receive a salary from the business? What would be some options here?

5. Would it be possible to not become a partner but to remain a contractor receiving a salary with a profit-sharing option, like salary + 15%? If so, how would I set up a profit-sharing agreement with a Canadian company, as Halestorm Media is a U.S. sole proprietorship?

6. I am worried that although my partnership share of 25% would be too low, as I would be contributing more services to the partnership than Ron, who would be receiving a 25% partnership as well. Most of the work of this website transformation are my services (website design, integration, graphic design, marketing, etc.). Also, Joshua is willing to pay for all up front costs, which are really my services + advertising costs, but he wouldn't be contribution much work other than executive decisions. Is there a different way to structure this that would work better for me?

7. Overall, what is the best plan of action for my business in this situation? What should be my action plan?
Submitted: 1 year ago.
Category: Tax
Expert:  Lane replied 1 year ago.

 

To me, this does not make sense as we would already have in our agreement that he would own 50% of the business, which translates to me 50% of the profits, correct?

 

Not necessary. It's only in corporations that profits must be shared in proportion to ownership. (In an S-Corp that's the ONLY way it can be done) In a C-Corp you can accomplish non-proportional sharing of profits through having different share classes.

 

HOWEVER, one of the reasons that the LLC is becoming so popular is that profits, losses, voting rights, ownership interest, capital gains, capital losses … ALL these things can be shared in any way that the partners decide (through delineation in the operating agreement) … You can do MANY of these things through a partnership as well, but the LLC is the MOST flexible.

 

 

 

 

 

How would a partnership like this affect me tax-wise as a U.S. citizen becoming a partner in a Canadian partnership?

 

US Citizens have to pay tax on ALL worldwide income, (see this: http://www.irs.gov/Businesses/Income-from-Abroad-is-Taxable so you'd report it as just as you do now, on your 1040 (could be from a a k-1 from partnership or multi-member LLC, and it will end up on line 12 – business income or loss – just as you sole proprietorship income does now, from the schedule C) . If you DID end up setting things up as a corporation then you may end up receiving both wages AND dividends)

Because the "start-up" costs are mainly online marketing and website design (all work that Halestorm Media would provide for the partnership) could I still receive a salary from the business

 

Sure, OR you can receive your share of the profits as self employment income, OR you can receive both as mentioned above, just depends on you you both decide to structure things.

Would it be possible to not become a partner but to remain a contractor receiving a salary with a profit-sharing option, like salary + 15%? If so, how would I set up a profit-sharing agreement with a Canadian company, as Halestorm Media is a U.S. sole proprietorship?

 

Yes, or as mentioned above, you can do both, OR a combination. You could also just ask for an employment contract as an individual, where a bonus, based on profit, is paid.

I am worried that although my partnership share of 25% would be too low, as I would be contributing more services to the partnership than Ron, who would be receiving a 25% partnership as well. Most of the work of this website transformation are my services (website design, integration, graphic design, marketing, etc.). Also, Joshua is willing to pay for all up front costs, which are really my services + advertising costs, but he wouldn't be contribution much work other than executive decisions. Is there a different way to structure this that would work better for me?

 

As mentioned above, when a partnership or a multi-member LLC is formed as the business entity here, all of these percentages can be set up any way you want … just write them into the operating agreement. … The fact that you are now operating as a sole proprietor shouldn't be the constraint here.

You need to, first, think about what really IS fair, in terms of compensation, guarantees and share of profits AND how much risk you want to assume. Make a counter offer where the percentages are in line with what you want.

Then the business entity that's chosen OR the employment contract OR a combination of the two can be drafter to make (wages) or allow (profits and losses) that to happen.

On last thought; You MAY want to do the design and then only LICENSE the limited rights to the other company … giving you the ability to CONTROL this intellectual property and license it to other organizations as well.

From a tax perspective THERE, you may want to look at assigning (selling) the intellectual property, which would generate the lower CAPITAL GAINS tax, as opposed to the ordinary income tax that all of the previously discussed options will drive.

Finally, DO remember that with the partnership offer (regardless of which entity type you use) it will only be the profits, on which you are taxed.

Hope this helps

Lane

Customer: replied 1 year ago.

Thanks for the reply Lane. I did have one last question that wasn't addressed above:


 


7. Overall, what is the best plan of action for my business in this situation? What should be my action plan?


 


 


 


 

Expert:  Lane replied 1 year ago.

I would seriously consider setting up an LLC.

The LLC is really the best of both worlds ... providing the liability protection of a corporation and the flexibility (mentioned above) of a partnership.

This means that you'll still file a schedule C with your tax return (as a single member LLC) ... (IRS sees single member LLCs as a "disregarded entity" for TAX purposes), which means that you'll still be able to deduct your business expenses and only pay tax on profits BUT, because you have the LLC in place - a state law/incorporation issue - no one can come against you personally for business debts, lawsuits, etc.

And as I mentioned above, if you have designs and things that you've created than can not be easily replicated, you MAY even want to license (get a royalty from this other business) which is still taxable GROSS income to the LLC or whatever entity you choose, but they will not OWN the software, you will.

The best plan for you really has to do with what you have to offer, how easily they could get it from someone else, etc.

And as I mentioned before, you should ask for whatever you think you're worth ... sometimes it's amazing what they will go for when you simply ask. The offer is there for a reason. They already obviously see value.

If it were ME, again not knowing ANYTHING at all about the personalities here, or exactly what your ding for them, or how exclusive it is ... I would still always err on the side of retaining all the ownership myself, and ask for a contract that does not allow them to use your work product, allows you to deduct ALL the expenses of doing business through (and be protected liability-wise) through your own LLC.

If what you're doing for them can not easily be replicated, I would consider sitting down with an intellectual property atty and design a contract that would license your development work to them for a royalty, where you keep the ownership AND then can even market that system or a configurable version of it to OTHER companies as well

Lane
Customer: replied 1 year ago.

Thanks for the reply.


 


So, from my understanding, you think I should set up a separate LLC in the USA in addition to the sole proprietorship that I already own, Halestorm Media. Then, I would add Josh and Ron to my USA LLC, correct?


 


The thing is, that Joshua wants to set up the partnership or LLC in Canada, as that is where he lives. And, he wants to have the majority interest of the business, as he owns the website and lists, which is how we will end up marketing our product.


 


The website design will not be unique, we are just setting it up like a online e-course type of thing. So it can easily be replicated and it is all of the time.


 


So, the botXXXXX XXXXXne is that Joshua will be the majority partner with the business setup in Canada, with Ron and I the minority partners. In fact, the business is already setup in Canada.


 


So, my question actually is, is it better to go into this Canadian business from a tax-point of view (what's best for me tax-wise) as a:


 


a) Maintain contractor status & have bonus/profit-sharing plan


OR


b) Be in a Canadian (not USA) partnership/LLC, but negotiate


 


Thanks, Heidi


 

Expert:  Lane replied 1 year ago.

So, from my understanding, you think I should set up a separate LLC in the USA in addition to the sole proprietorship that I already own, Halestorm Media. Then, I would add Josh and Ron to my USA LLC, correct?


Not exactly, I was saying that if you simply continue to contract with them, you should do that through the LLC RATHER than the sole proprietorship. You'd be incorporating Helstorm ... just a more protected way to do business. Taxation would be the same.

 

 

 


The thing is, that Joshua wants to set up the partnership or LLC in Canada, as that is where he lives. And, he wants to have the majority interest of the business, as he owns the website and lists, which is how we will end up marketing our product.

 

K, then we're really back to just negotiating the percentages ... You can still run the income through your LLC or Sole proprietorship. Any (non-employee income that you receive is, by default, contractor income which, if it's just one person, is a sole proprietorship, if you haven't done anything more formal)


 


The website design will not be unique, we are just setting it up like a on line e-course type of thing. So it can easily be replicated and it is all of the time.

 

OK, was just trying to be sure that you protect your interests


 


So, the botXXXXX XXXXXne is that Joshua will be the majority partner with the business setup in Canada, with Ron and I the minority partners. In fact, the business is already setup in Canada.

 

Gotcha, (still relates to the above)


 


So, my question actually is, is it better to go into this Canadian business from a tax-point of view (what's best for me tax-wise) as a:


 


a) Maintain contractor status & have bonus/profit-sharing plan


OR


b) Be in a Canadian (not USA) partnership/LLC, but negotiate

 

Honestly there's not a lot of difference. As a US Citizen, you'll pay tax on the income either way (We've really kind of come full circle back to this: http://www.irs.gov/Businesses/Income-from-Abroad-is-Taxable)

 

 

The only difference I can see, really, is possibly the ability to control more f the expenses, if you remain a separate entity.

 

Really now that we're on the same page here, it comes down to two things.

(1) Be sure to deduct everything you can on that schedule C (which you will do as an attachment to your tax return as a sole proprietor OR as a single member LLC)

 

(2) Moving Halestorm to an LLC status WILL protect the business income and assets you keep under the LLC separate from lawsuits and other liabilities.



Lane
Lane, JD, CFP, MBA, CRPS
Category: Tax
Satisfied Customers: 4532
Experience: Juris Doctorate, CFP and MBA, Providing Financial & Tax advice since 1986
Lane and other Tax Specialists are ready to help you
Expert:  Lane replied 1 year ago.
Thanks for the rating Heidi

Lane
Customer: replied 1 year ago.

Your welcome thank you

Expert:  Lane replied 1 year ago.

If you'd like to work with ME again just say "For Lane only," at the beginning of your next question


OR set me up as your preferred expert on your home page.


Regardless, thanks again,

Lane

Customer: replied 1 year ago.

Will do Lane. I don't want to take any more of your time, but I did just read something that pertains to my questions above that we did not address and I think it very important to conclude on (no more questions after this).

 

I did read in my book, "Form a Partnership: The Complete Legal Guide" this:

 

<-----"Form a Partnership: The Complete Legal Guide" excerpt start---->

 

Contribution of Services

 

So much for property. Now let's look at the tax consequences if a person receives an interest in a partnership in return for contribution of services. Under the tax laws, services aren't property. If the contributing partner receives a capital (ownership) interest in the partnership in exchange for (the promise of) services, that partner has received taxable income.

 

EXAMPLE:

Alicia, Rose, and Ruby form a partnership to operate a hair salon. Alicia and Ruby each contribute $15,000 for start-up capital and plan to work part-time in the business. Rose has no cash to contribute, but she receives one-third ownership of the partnership in exchange for promising to work full time for a year. As far as the tax laws are concerned, Rose has received taxable income by this agreement. The cash contributions to the business total $30,000; Rose owns one-third of the business. According to tax law, Rose has received taxable income of $10,000.

 

Unfortunately, Rose hasn't really received any money. If
the business was sold, and she got one-third of the cash for the sale, it would be easier for her to pay tax on her share. But here, the tax code essentially treats her partnership interest as payment for her work (income).

 

Now, suppose the partnership agreement doesn't give Rose a present ownership (capital) interest in the partnership but only the right to receive one-third of the future profits in return for her services. In other words, if the business is sold, Rose gets nothing. But as long as the business continues, she gets one-third of the profits. Tax experts used to believe there were no tax consequences if only future profits were involved. However, in a case that involved receipt of future profits in a partnership in exchange for the promise of future services, the tax court held that this amounted to a cash depreciation, and the present value of the right to receive future profits was taxable income to the services-contributing partner (Sol Diamond, 56 T.C. 530 (1971), aff'd 492 F.2d 286 (7th Cir. 1974), questioned and narrowed in Campbell v. Commissioner, 943 F.2d 815 (9th Cir. 1991)).

 

Many tax practitioners believe that the Sol Diamond case is an aberration - a case that's exaplained by, and limited to, its peculiar facts. Among these was the fact that the present value of the right to receive future profits had actually been calculated because the right to receive future profits had been sold. In other words, Sol's idea was a tax scam, disguising a present ownership interest by calling it "the right to receive future profits."

 

Returning to our example of Alicia, Rose, and Ruby, it's quite possible that Rose will have no tax liability if all she receives is a right to share in future profits. After all, who can tell if there will be any profits? However, if the partnership had been running profitably for a while when Rose was invited to join in exchange for her promise to work full time, Rose might have incurred a tax liability. The track record of the business profitability might provide a reliable way to value Rose's present right to receive future income.

 

If you're considering giving a partner an ownership interest, or even the right to receive future profits in exchange for services, see a CPA.

 

<-----"Form a Partnership: The Complete Legal Guide" excerpt end---->

 

 

My comments: This is a situation that I am concerned about. Let's say that Joshua contributes $25,000 as the 50% partner. This would mean that I would need to contribute $12,500 worth of "future" services to be a 25% partner and would also mean that I would have to claim $12,500 of income on my tax return, correct?

 

In this hypothetical example, I am not sure how I would be able to incorporate getting paid a salary from Josh in addition to being "in the hole" $12,500 in services for my 25% contribution? It seems that this is a big different from becoming a partner vs. remaining a contractor with bonus that we did not discuss.

 

 

Expert:  Lane replied 1 year ago.


Let's say that Joshua contributes $25,000 as the 50% partner. This would mean that I would need to contribute $12,500 worth of "future" services to be a 25% partner and would also mean that I would have to claim $12,500 of income on my tax return, correct?

If this is done as part of the operating agreement as an exchange, you're exactly right. In other words, if, in the capital accounts of the partnership, you are credited with a positive balance of $12,500 of equity "in exchange for your future services," you should recognize $12,500 of gross income.

This would IN NEGOTIATIONS give you every right to ask for enough additional compensation to pay the tax on this (although you never completely catch up) AND that you get AT LEAST 25% of all profits - although remember that in a partnership (or a multi member LLC, which is TAXED as a partnership) - you are not automatically entitled to that by law, as you are in an S-Corp, so it needs to be in the operating agreement (partnership agreement if its actually a partnership).

HOWEVER, what gets VERY complicated, terms of whether you have been given anything at all because this interest you have been given in this partnership has a market value of zero at the onset of the business. THere is in partnership accounting the terminology; profits interest vs capital interest.

You should consider VERY seriously asking that you be given a PROFITS interest in the partnership:

Investopedia defines a profits interest this way:

A monetary right awarded to the general partner, investment manager or a service provider of a partnership. The award consists of receiving a percentage of profits from a partnership without having to contribute capital to the partnership. Profits interests are often criticized as recipients can generate large profits for themselves while not incurring sufficient risk.

This method serves as an incentive for partners to become more proactive in pursuing bigger and better profits thus contributing towards the companies' growth. This situation presents a tax benefit in that beneficiaries of this instrument can be taxed under long-term capital gains versus the higher federal tax rate.

Further, capital gains rates for those in the 10% and 15% tax brackets are zero and only hit 15% at the 25% bracket:


  • 2012 Tax Brackets (For taxes due this year)
  • Tax rateSingle filersMarried filing jointly or qualifying widow/widowerMarried filing separatelyHead of household
    10%Up to $8,700Up to $17,400Up to $8,700Up to $12,400
    15%$8,701 - $35,350$17,401 - $70,700$8,701- $35,350$12,401 - $47,350
    25%$35,351 - $85,650$70,701 - $142,700$35,351 - $71,350$47,351 - $122,300
As a result of the IRS’s publication of Rev. Proc. 93-27 (as clarified by Rev. Proc. 2001-43), the receipt of a profits interest is not a taxable event, and any resulting distributions received by the service provider upon a sale of the company will be taxed at long-term capital gains rates if held for more than 1 year.

Lane



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Customer: replied 1 year ago.

Thank you! I will remember to use you anytime I have a financial question in the future Lane. i

Expert:  Lane replied 1 year ago.

Thanks so much Heidi.

Good luck with it!

If you WOULD like to work with ME again just say "For Lane only," at the beginning of your next question.

OR you can also add me as your preferred expert on your home page if you'd like.

Regardless, thanks again for the feedback!

Lane

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Lane
Lane
JD, MBA, CFP, CRPS
3661 Satisfied Customers
Juris Doctorate, CFP and MBA, Providing Financial & Tax advice since 1986