Be Careful What You Wish For
Richard L. Lieberman
Burke, Warren, MacKay & Serritella, P.C.
312 840 7011
Congratulations! You have just been offered an opportunity to join a new limited liability company that is classified as a partnership for income tax purposes (the “LLC”). You anticipate receiving a monthly salary of $10,000, and, as an added incentive, you will also receive a membership interest in the LLC without having to make a capital contribution. According to the terms of your offer, you are to be granted a 2% membership interest in exchange for the services that you will provide to the LLC. The units you are to receive will be unvested on the grant date and will vest ratably at the end of each year over a seven year term (1/7th each year).
On first glance, this appears to be a great opportunity. Unfortunately, for too many people, the failure to properly understand the underlying tax issues can have costly consequences. The purpose of this summary is to briefly highlight a few of the key issues that you must consider when reviewing an LLC’s operating agreement.
Unlike an entity classified as a corporation for income tax purposes, you can receive a membership interest in the LLC on a tax-free basis. Such a membership interest is referred to as a “profits interest,” and is also sometimes called a “promote” or “carried interest.” What is especially important to understand is the distinction between the manner in which vesting is treated under the LLC’s operating agreement and how it is treated for income tax purposes.
Service providers receiving an unvested profits interest in an LLC often erroneously believe that they are only subject to tax on the income associated with the cash distributions paid to them. As a result, they believe it is not important to place too much emphasis on the tax issues associated with the profits interest because it may vest over a long period of time during which they may receive relatively insubstantial, if any, cash distributions from the LLC. Such an assumption can have very adverse tax consequences for the uninformed.
For example, under the LLC’s operating agreement you would be entitled to receive cash distributions from the LLC based on your annual cumulative vesting percentage. However, for income tax purposes, the grant of your unvested profits interest will not be taxed to you only if the LLC treats you as a full member beginning on the date of grant. That means the LLC must annually allocate income to you for tax purposes as if you received a vested profits interest. In other words, while you may be entitled to receive a cash distribution equivalent to a member holding 1/7th of a 2% membership interest at the end of your first year, you will be allocated income from the LLC and taxed as if you are a member holding a 2% membership interest. That distinction may not align with your preconceived economic expectation.
You also need to be cognizant of how the LLC distributes its available cash. For instance, assume that the LLC prioritizes the manner in which it distributes cash to its members. Assume that cash is first distributed to members who have made cash contributions until those contributions have been fully returned. Thereafter, any remaining cash is distributed to all members according to their respective percentage interest in the LLC. Further assume that the LLC has $1,000,000 of profit and unreturned contributions total $5,000,000.
As discussed above, you will be allocated LLC income as if your membership interest is fully vested as of the grant date. Therefore, you will be allocated $20,000 of LLC income ($1,000,000 x 2%) for tax purposes. Despite the fact that you might expect cash distributions based on the vesting schedule, the prioritization of distributed cash means that you will not receive any cash from the LLC to pay the taxes you owe on your distributive share of LLC income (even if the membership interest was fully vested on the grant date). Assuming that the LLC distributed its full $1,000,000 profit, all of it would be diverted to the capital contributors with no residual cash available for distribution to you.
To emphasize the point made earlier, the LLC’s members generally do not pay tax on the cash distributed to them. To the contrary, the LLC’s members generally pay tax on the income allocated to them (sometimes referred to as the member’s distributive share of LLC income), whether or not they receive any cash.
An allocation of LLC income without an accompanying distribution of cash is often referred to as phantom income. To address a member’s phantom income problem, most operating agreements include a provision allowing members to receive a special type of distribution known as a tax distribution. The tax distribution is nothing more than an advance against a member’s future cash distributions from the LLC. Characterizing the tax distribution as an advance ensures that the economic expectation of the capital contributing members is not unsettled and does not give a profits interest member a false impression that she is receiving greater distributions than provided for in the operating agreement.
The problem with a tax distribution is that it is nothing more than an advance against future distributions. In the preceding example, cash would be distributed to you in an amount sufficient to pay the tax on your phantom income. Sometime after the capital contributors have received a return of their contributions you would expect to start receiving regular cash distributions (let’s assume for example starting in year 6). Of course, contrary to your economic expectation, you will not receive any regular distributions in year 6 because you must first “repay” the advances you previously received as tax distributions (which are merely offset against what you would otherwise have received). Therefore, you must extend the horizon over which you expect to start receiving value for your profits interest to account for the later repayment of earlier tax distributions. In other words, when contemplating when you should expect to receive regular cash distributions, you must consider not just the time period required for the LLC to return capital contributions on a priority basis, but also the additional time it would take to repay your tax distributions.
Essentially, you could view your tax distributions as interest-free loans from the capital contributors to you. In fact, that is how many capital contributors view tax distributions to members such as you. Some tax provisions, but not all, include a sentence to the effect that a member who receives tax distributions exceeding the amount they would otherwise have received under the regular distribution provision (as if a tax distribution provision was not included in the operating agreement) must make a capital contribution to the LLC in the amount of such excess at the time of the liquidation and winding up of the LLC or the liquidation of a member’s interest. This is often referred to as a “claw-back” provision.
Assume you resign from the LLC at the end of year 4. Further assume you received tax distributions equal to $36,000 ($20,000 income/year x 45% combined tax rate for example purposes only). Under the regular distribution provision you would not have received any cash distributions during this time period because all of the LLC’s available cash was used to return the higher priority capital contributions. Therefore, as you end your relationship with the LLC, you would be required to make a $36,000 payment to the LLC in satisfaction of the “claw-back” provision. Of course, you are not going to be receiving a refund of the taxes you previously paid on LLC income.
Not all LLC operating agreements include a provision assigning the highest distribution priority to the return of capital without more. In fact, it is more common to see a distribution provision that provides a capital contributor with a preferred return followed by a return of capital, which is then followed by a sharing of the residual cash among the members according to percentage interest. For example, assume that the LLC is required to pay a 10% preferred return on unreturned capital. In that case, the LLC would have paid $500,000 to the capital contributors ($5,000,000 x 10%). The first $500,000 of LLC profit would then have been allocated to the capital contributing members, and only $500,000 of LLC profit would remain to be allocated among all of the members according to percentage interest (there is no tax associated with the return of capital, which is why the diversion of available cash to the return of capital causes the phantom income problem). In such a case, your distributive share of the LLC’s income would have been $10,000 instead of $20,000 (as described above). Your tax distribution would also have been correspondingly smaller as well.
The fact that the highest distribution priority is given to the return of capital may be a signal that the capital contributors lack full confidence in the financial viability of the LLC. In that case, the capital contributors may be focused on recovering their capital as quickly as possible so that it can be invested elsewhere, as opposed to seeking a preferred return from the LLC. Such a priority also has the economic effect of spreading the LLC’s tax liability among all of the members, including those not otherwise receiving a regular cash distribution. In such cases it would not be surprising to see a “claw-back” provision because the capital contributors are intent on making certain that every dollar of invested capital is returned, including from members such as you who may resign with an excess of tax distributions over regular distributions. The fact that you were allocated a portion of the LLC’s income and paid tax on such income is less significant to such investors than the full return of their invested capital. Perhaps that should be a signal that the offer is not as valuable as you first thought, especially since you likely never considered having to potentially make a capital contribution at the time you resign or the LLC is liquidated.
One final point to consider concerns the tax ramifications of your $10,000 monthly salary. It is fairly common to think of yourself as an employee of the LLC. In that case, you would expect to have income tax and employment taxes withheld from your “paycheck.” Actually, that is not what occurs. The prevailing view is that a member cannot also be an employee of her LLC. In that case, your $10,000 monthly salary would generally be classified a “guaranteed payment” (because it is not based on the annual profitability of the LLC and therefore lacks entrepreneurial risk). As a member of the LLC, you are required to remit your estimated taxes on a quarterly basis, and the full amount of the guaranteed payment is subject to self-employment tax. You should not expect the LLC to provide you with a Form W-2 following year-end.
What started out as so promising an opportunity looks very different when you consider all of the hidden tax traps. There is the possibility that you will have to repay tax distributions or, at a minimum, extend the time line over when you can expect to start receiving regular cash distributions from the LLC. There is also the fact that you may not be comfortable with making quarterly estimated tax payments and paying self-employment tax. Sometimes, it is far simpler to be classified as an employee. This is especially true when, like in the case of the dress that some saw as blue and others as gold, how you view your membership interest in the LLC may be very different from how the organizers of the LLC view your participation. Being informed and well advised is the key to making a well informed and well advised decision to either accept or reject the offer of a profits interest in an LLC.