Letting a New Partner "Earn" Their Way In
Let's say you want to offer someone (such as a family member or a valued employee) an ownership interest in your business, but they don't have any money to pay for it. They are, however, willing to work for their "sweat equity." You may want to consider an "earn-in," which is the subject of this week's e-mail:
"I am setting up a limited liability company (LLC) with my daughter. She is enthusiastic about working with me, but she has small children, and I'm not sure how much time or energy she will be able to devote to this business. Initially, she will have a 10 percent ownership interest in the LLC (I will have the remaining 90 percent), but I want to set up an incentive where at the end of each year, if my daughter is still involved in the business, she will automatically get an additional 10 percent. This would happen again each year until the two of us are 50-50 partners after four years."
Sounds simple enough, doesn't it? Yet according to New York CPA Alan E. Weiner, even a simple earn-in such as this one may create significant tax hassles for both parent and daughter if it is not structured very carefully.
The first step, according to Weiner, is to determine if the earn-in will be considered an "arm's-length" transaction for tax purposes. He explains that an arm's-length transaction is one in which the daughter receives her 10 percent ownership interest each year for "fair market value," the same amount the parent would have accepted from an unrelated party in either cash, property or services. Since it seems the daughter is receiving her ownership interest solely for services rendered (i.e., she is not paying cash), both the LLC and her services will have to be valued (at possibly significant expense), by a "qualified appraiser," who may not necessarily be the LLC's accountant or financial adviser.
Assuming this earn-in is deemed to be an arm's-length transaction, Weiner says, the daughter will have to report the value of her services as income on her tax return for that year and pay self-employment tax on it as well. The daughter may or may not have the cash to pay the taxes due on this "phantom income," and the parent or LLC may have to help her out with a loan or a cash advance. The LLC will get a deduction, which may be allocated to the parent as the only other member of the LLC.
If the earn-in is not arm's-length, then the daughter will still be required to report as income that portion of the 10 percent ownership interest deemed to have been given her in exchange for services rendered to the LLC during each year, as determined by a qualified appraiser. If the value of the 10 percent interest exceeds the value of the daughter's services, then Weiner says the excess will be considered a "gift," and the parent may have to pay federal gift tax each year (at rates between 18 and 49 percent for gifts made in 2003) if the excess value is greater than $11,000, the parent has made more than $1 million in taxable gifts during his or her lifetime, and certain other conditions are met. The value of the 10 percent interest, the value of the daughter's services, and the amount of taxable gift will all have to be determined at significant cost.
One possible solution, Weiner says, is to include a provision in the LLC operating agreement that any 10 percent interest received by the daughter as part of her earn-in is an interest in future profits only, such that she will have no interest in the assets of the LLC. In that case, the daughter's interest will not be treated as income, and the LLC will not be entitled to a deduction.
As the radio advertisers say, though, "certain conditions and restrictions may apply." Earn-ins have serious and often complex tax consequences, and you should always seek an accountant's help and understand the tax tradeoffs before you consider putting in place any kind of earn-in arrangement.
However the earn-in is structured for tax purposes, if I were the parent in this situation, I would talk to my attorney about the right to buy back the daughter's LLC ownership interest at a pre-determined price if the daughter quits the business. If the daughter leaves the business for any reason, she will still retain the ownership interest she earned up to that point, unless she is legally required to sell it back. Without a written buyback agreement, if the daughter quits the business and refuses to sell out, the parent may end up working with (actually, for) a "partner" who no longer contributes to the business but is legally entitled to a significant percentage of the business's profits.