I see this screwed up more than any other area in tax law. I don't know why attorneys don't understand it when they form LLCs or partnership, and it drives me nuts. Don't be that person.
It’s crucial to understand when contributions to a business are taxable, how to structure them strategically, and why working with a qualified tax attorney is essential.
When is Contributing Services for Equity Taxable?
Receiving an equity interest for cash or property is NOT taxable. Receiving an equity interest for services IS taxable. However, the tax treatment depends on the type of equity you receive:
Capital Interest: A capital interest represents a share of the LLC’s or partnership’s current value (or equity), including its assets and earnings. If you receive a capital interest, it’s generally taxable immediately as ordinary income. The value of the interest is measured by the present value of your share of the entity’s net assets.
Profits Interest: A profits interest represents a share of future profits and appreciation but has no current value. Under IRS guidelines, if certain conditions are met, receiving a profits interest can be structured as tax free upon receipt.
How to Work Around Taxable Service Contributions
To avoid the immediate taxation of a capital interest received in exchange for services, consider structuring the arrangement differently. Here’s how:
Use a Promissory Note: Instead of receiving equity immediately, the entity can issue a promissory note to compensate you for your services. The note can later be converted into equity or repaid based on agreed terms. This avoids the immediate tax consequences of receiving a capital interest. This also has to be structured properly under the tax code and regulations.
Grant a Profits Interest: Structuring the equity as a profits interest can defer taxation, as this type of interest is generally not taxable when issued if it meets IRS requirements:
The recipient only shares in future profits and appreciation.
The interest is not related to a substantially certain income stream.
The partnership does not redeem the interest within two years of issuance.
Draft Proper Agreements: These strategies require specific language in the partnership or operating agreement to ensure compliance with tax laws and to protect the interests of all parties. DO NOT SHOW A POSITIVE BALANCE IN THE RECIPIENTS CAPITAL ACCOUNT.
The Role of a Qualified Tax Attorney
Structuring service contributions for equity in an LLC or partnership is complex. A qualified tax attorney is essential to:
Draft the operating agreement or partnership agreement with the correct provisions for profits interests.
Ensure compliance with IRS safe harbor rules for profits interests.
Advise on the tax implications of promissory notes and equity conversion.
Protect the entity and its members from unintended tax consequences.
I have all the various clauses and forms ready on my desktop to help if you need it. Don't mess this up, just make the call.
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