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.
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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.
Cliff Ennico is host of the PBS TV series MoneyHunt
and a leading expert on managing growing companies. His advice
for small businesses regularly appears on the "Protecting Your
Business" channel on Small Business Television Network. E-mail him at
cennico@legalcareer.com. This
column is no substitute for legal, tax or financial advice, which
can be furnished only by a qualified professional licensed in your
state. Copyright 2003 Clifford R. Ennico. Distributed by Creators
Syndicate Inc.