I am by no means a “precog”, nor can always predict when minority ownership in a small business will result in disaster, but my 14 years of experience with small business clients has taught me a great deal about what not to do when structuring a business and offering ownership to employees.
If you are currently a minority owner (<50% interest) in an LLC taxed as a partnership or a traditional partnership, or you are being offered such ownership, you may want to consider running away from the ownership if certain warning signs are present. Also, I highly recommend having your tax professional and/or lawyer look everything over before you sign anything. Business ownership is a lot like marriage, so know what you are getting into.
Minority Ownership Warning Signs in LLCs and Partnerships
The entity does not increase guaranteed payments by 5% to cover self-employment tax
When an employee becomes a partner or LLC member, their tax burden increases substantially because of the self-employment tax. Generally, an employee pays social security and Medicare tax of 7.65% on gross wages, and the employer pays another 7.65%. However, an active partner or LLC member is considered self-employed and has to pay both the employee and employer portions of social security and Medicare tax, which total 15.3%. Fortunately, the IRS allows a deduction for one half of the self-employment taxes paid (just like the deduction available to employers), which results in an approximate net rate of 12%. This means that a employee who becomes a partner or LLC member will incur a tax increase of approximately 5%.
Most companies do the right thing and give an employee transitioning to ownership enough additional income to cover this 5% tax increase. The most effective means of doing this is to provide the additional income to the new partner or LLC member in the form of an increase to their regular guaranteed payment. Employees are accustomed to predictable cash flow and regular tax withholdings, so the transition to making quarterly estimated tax payments at a higher tax rate can be difficult. Additional income that is guaranteed and paid on a regular basis is going to ease that transition and insure that there is a tangible benefit to ownership.
Unfortunately, a surprising number of partnerships and LLCs do not provide additional income to employees transitioning to minority ownership, and often it can result in ownership that is actually a detriment to them as a result of the additional tax. Usually, future profits are promised when selling ownership to the employees, and in some businesses, this works very well when consistent profits easily eclipse the 5% tax burden. However, taxable business profits can be very unpredictable due to current accelerated tax depreciation rules and other complications, and in order to distribute profits during the year when they are helpful to the owners, a business has to keep very accurate accounting records. Owners have to pay estimated tax payments quarterly, so the unpredictability of having to rely on distributions of profits can create a lot of dissension among owners – especially during periods of low profits or losses. The sad irony for these businesses who are unwilling to pay the additional 5% in income to partners/LLC members is that they often make ownership offers to employees for the sole purpose of keeping them at the company, and often the tax burden on the new owners does the exact opposite after several years of seeing no benefit to ownership.
The entity is providing capital interest ownership in exchange for services
Giving ownership to an employee in exchange for services can actually work very well if structured correctly and all parties are properly informed of the tax ramifications. However, ideal situations like this rarely happen in the real world, and usually such an arrangement results in a surprise tax bill for the employee receiving ownership. Avoiding such a disaster requires an understanding of the most common types of interests available in small business organized as LLCs.
Capital Interest – this is the default type of LLC interest, as it is a complete ownership that entitles the holder to a share of profits and losses as well as a share of the proceeds from the sale of the LLC’s assets if the LLC liquidates. A capital interest is most commonly given to employees brought on for succession planning purposes.
Profits Interest – this interest is like the capital interest, except a profit interest holder does not receive liquidating distributions from the LLC. In other words, it is only an interest in future profits of the LLC and there is no initial capital balance for the member. A profits interest is often given to key employees much like stock options are given to employees of corporations. It is often intended as a form of additional compensation and a method to retain key personnel.
If you receive a capital interest in exchange for services, it is treated as current compensation in an amount equal to the fair market value of the capital interest at the grant date. The problem is that most small businesses owners organized as LLCs are not aware of this, and rarely do they tell their CPA about such transactions in advance, so it often becomes an ugly year-end or tax-time surprise for the recipient, as they have taxable income to recognize and no cash to pay the tax with. To make matters worse, most small business owners have no idea what the fair market value of their LLC is, so the transaction becomes very complex can create many problems down the road if not done correctly. As an employee being offered such an interest, I strongly recommend asking the LLC to involve their CPA and/or lawyer so that the compensation is determined ahead of time. This will allow you plan accordingly and look into options like the 754 election that can minimize the tax impact.
If you are granted a profits interest in an LLC, no taxable income is recognized as long as the interest satisfies the Revenue Procedure 93-27 safe harbor rules. Most LLCs that offer a profits interest have already had a CPA and/or lawyer setup it up so that the rules are met, so in most cases it is a good deal for the employee receiving the interest. However, it is important to get some prior financial statements and/or tax returns so that you can know what to expect, as sometimes start-ups give profit interests and then go several years without any recognized profit.
The entity does not have a method of equalizing expenses
Single-owner businesses have it very easy in the area of expenses, as they can spend how they want without having to justify to other owners or worry about trying to keep things equal. In multi-owner businesses, there is a constant problem with equalization, as business partners are usually wired differently when it comes to spending and often have different tastes. One LLC member may be tech savvy with smart phones and tablets and another may still prefer a flip phone and a paper legal pad, so it is crucial for a minority owner that an LLC or partnership have an established method of expense equalization in place.
The most flexible method of expense equalization is to have the operating agreement specifically state that the LLC or partnership will not reimburse partners for certain expenses and that they are required to pay for these expenses. As long as it is properly setup in this way, each partner or member can deduct their unreimbursed partnership expenses on their own 1040 tax return on Schedule E page 2. This allows each partner or member to be as lavish or frugal as they want without having to worry about the expenses of the other owners. Often, meals and entertainment, automobile, travel, and office expenses are treated in this fashion.
The second best method is devising a special allocation where certain expenses are allocated 100% to certain owners against their guaranteed payments. This can be elaborate or just a simple calculation done with the tax return preparation, but either way – LLCs and partnerships are extremely flexible in this area. Just make sure the allocation is decided on well in advance, as it is much more difficult to agree on after expenses have already been paid.
That’s it for LLCs and partnerships. In Part 2, I will concentrate on minority ownership issues in S corporations.