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LLC distribution or special allocation question

Old 09-10-2015, 05:20 AM
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Default LLC distribution or special allocation question

Before we head off to the Accountant and Lawyers offices next week, I'm hoping to gain some insight here.

A partner and I are considering setting up an LLC for a new business. It will be a related entity for his existing business. He has the office space and clientele that purchase widgets in our market. I have expertise in renting out those widgets when the owners aren't using them. Typically these widgets get rented out 2-3 months per year.

We want to set up the LLC with 50-50 ownership, with my partner receiving only a percentage of top line revenue from commission generated by widget rental. The rest of the business would be allocated to me. The start up capital, small, would be contributed equally. Beyond that, he provides office space and is essentially a silent partner. Many people who rent widgets ultimately purchase, and would do so from my partner quite frequently.

Anyone have thoughts on this passing the special allocation test, or a better way to set this up?

Thanks in advance,

'Slot
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Old 09-10-2015, 05:36 AM
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Originally Posted by Airslot View Post
Before we head off to the Accountant and Lawyers offices next week, I'm hoping to gain some insight here.

A partner and I are considering setting up an LLC for a new business. It will be a related entity for his existing business. He has the office space and clientele that purchase widgets in our market. I have expertise in renting out those widgets when the owners aren't using them. Typically these widgets get rented out 2-3 months per year.

We want to set up the LLC with 50-50 ownership, with my partner receiving only a percentage of top line revenue from commission generated by widget rental. The rest of the business would be allocated to me. The start up capital, small, would be contributed equally. Beyond that, he provides office space and is essentially a silent partner. Many people who rent widgets ultimately purchase, and would do so from my partner quite frequently.

Anyone have thoughts on this passing the special allocation test, or a better way to set this up?

Thanks in advance,

'Slot
You know about special allocations already it seems so that is good. You can allocate any way you want as long as it has Substantial Economic Effect (SEE). As long as you go into it knowing what is going on (all parties), all is left is the lawyers to draw up the agreement with the right phrases and code sections in it and then the accountants will handle the rest.

I see most issues when one partner doesn't exactly know what is going on and then see minimum gain charge back or qualified income offset on their K1 and freak out.


EDIT: What I would be worried about is having to restore the deficit balance in your capital account. If your partner is being allocated only income and then has it distributed out as a commission, his capital account would be always positive. If the partnership as a whole loses money, your capital account would lower. When this thing dissolves, you must distribute out based on the positive capital account balances. If yours is negative, you would then have to restore it (if you haven't already been). So you would have to put in more money or have a qualified income offset. So your partner is bearing a lot less risk than you. I would want more than 50%. On the flip side, if it makes a lot of money you will get a larger slice, presuming your capital grows more through net income than his does by commission. Just some things to think about. Talk it through with the lawyers and CPAs. They will be able to present you with what it all could entail.

Last edited by Trollin4Tuna; 09-10-2015 at 05:54 AM.
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Old 09-10-2015, 05:49 AM
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Thanks for the feedback. It seems that we are "barking up the right tree." The operating agreement, rightfully so, seems to be the key to setting this up correctly. Ultimately we'd like for his share to be a distribution (passive income) vs. earned income and looking at SECA taxes.
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Old 09-10-2015, 06:00 AM
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Originally Posted by Airslot View Post
Thanks for the feedback. It seems that we are "barking up the right tree." The operating agreement, rightfully so, seems to be the key to setting this up correctly. Ultimately we'd like for his share to be a distribution (passive income) vs. earned income and looking at SECA taxes.
Hmmm...I would be worried about him being classified as a limited partner then. That would fail the SEE test since he can't be obligated to restore a negative capital account. I am not 100% on this though. I haven't dealt with this where one partner is not getting SE income from it. I would defer to a lawyer on this. (Which you are) Let me know what they say. I'm curious. §704 is very interesting and extremely difficult. Some say it is the hardest part of taxation.
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Old 09-10-2015, 06:03 AM
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Originally Posted by Airslot View Post
The operating agreement seems to be the key to setting this up correctly. .
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Old 09-10-2015, 06:17 AM
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I suppose we'll have to see if we can "freeze" one members capital account. Otherwise we'll have to write that into the agreement.
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Old 09-10-2015, 06:19 AM
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Originally Posted by triplenet View Post
You got that right.
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Old 09-10-2015, 06:22 AM
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Trollin,

I missed your edit above. That is exactly what we are trying to accomplish. I am taking on a greater share of both the risk and reward. The reason for ownership is that my business is essentially piggybacking his. If at some point in time he wishes to sell his original business, it has greater value with both together. The exit strategy is also being given great consideration.
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Old 09-10-2015, 06:24 AM
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you sound more like a broker in this business venture. Why not structure the transaction accordingly using a contract. This is very similar to RV rental brokerages where RV's are purchased, used only occasionally by the owner, then rented out through a broker.

OK, I see the future value here. I can already see the future purchase price valuation arguments.
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Old 09-10-2015, 06:34 AM
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Originally Posted by Airslot View Post
Trollin,

I missed your edit above. That is exactly what we are trying to accomplish. I am taking on a greater share of both the risk and reward. The reason for ownership is that my business is essentially piggybacking his. If at some point in time he wishes to sell his original business, it has greater value with both together. The exit strategy is also being given great consideration.
Why not a JV .... Set up your own LLC and have a JV Agreement with him ...

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Old 09-10-2015, 06:35 AM
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Originally Posted by Airslot View Post
Trollin,

I missed your edit above. That is exactly what we are trying to accomplish. I am taking on a greater share of both the risk and reward. The reason for ownership is that my business is essentially piggybacking his. If at some point in time he wishes to sell his original business, it has greater value with both together. The exit strategy is also being given great consideration.
Hmmmm....There are a million and one ways to structure a partnership. If it were me, I would probably just pay him a guaranteed payment for the commission and negotiate another capital split other than 50/50. Then not worry about special allocations at all.
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Old 09-10-2015, 06:40 AM
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Originally Posted by Trollin4Tuna View Post
Hmmmm....There are a million and one ways to structure a partnership. If it were me, I would probably just pay him a guaranteed payment for the commission and negotiate another capital split other than 50/50. Then not worry about special allocations at all.
Thanks for the idea, will chase it down and see what happens.
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Old 09-10-2015, 06:43 AM
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Originally Posted by triplenet View Post
Why not a JV .... Set up your own LLC and have a JV Agreement with him ...

Yes a joint venture makes the most sense, operating under a singular jv ownership entity/LLC. Each partner should set up its own LLC.

Contributions and distributions are outlined in the jv operating agreement.
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Old 09-10-2015, 06:43 AM
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Backto, Triple,

Thanks for the ideas. No bad ones presented and everything is on the table at this point.

13 posts deep and this thread hasn't been derailed. Is that a new THT record?
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Old 09-10-2015, 07:07 AM
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Originally Posted by Airslot View Post
We want to set up the LLC with 50-50 ownership, with my partner receiving only a percentage of top line revenue from commission generated by widget rental. The rest of the business would be allocated to me. The start up capital, small, would be contributed equally. Beyond that, he provides office space and is essentially a silent partner. Many people who rent widgets ultimately purchase, and would do so from my partner quite frequently.
Like mentioned, there are many ways to set up a partnership or a JV.

Some of my thoughts:
- If I'm your partner, why do I pay 50% up front, give you the space (free lease), already have the relationships with the widget owners (free inventory), and only take a percentage when you're renting them out?

- If I'm you, why would I be okay with a partner that gets 50% of the business, and money off the top line revenue? He'd be getting paid first in a scenario that could leave me open to an operating loss.

- Why does he want 50% ownership? As I understand it, LLCs have members and the percentage can be adjusted it isn't necessarily fixed in the same way shares in Corps are. LLCs can have members that are other business entities also. But I'm not the expert on this, I just recall that from discussions with my CPA and previous LLCs

Let's think Shark tank for a minute.

You have a business idea, but it requires renting the product from someone (not your partner, his clients), and renting a space (from your partner). You have a prospect list of clients, that are also from the person you're renting the space from and he's the seller of the widgets (presumably not manufacturer) to your prospects. You need an investor for 50% startup capital.

Shark answer: I'll give you 50% startup capital, a line of credit for office space and to finance your list rental cost, in exchange for 50% ownership of your business and X% royalty in perpetuity.

Another idea: Set up your own business - S Corp, or LLC, whatever you think is better for you, have the 50% startup cost be a loan from your investor, paid at X% over some time period, including the lease value of the space, and a marketing agreement giving you access to his list. In exchange you'll pay X% commission on each rental, a percentage of which will go to payoff the loan so he gets his investment back first, and then a smaller % once that is recouped.

Of if you want a straight 50-50, then why not have his percentage come out of gross profits? He's providing you value (lease, customer list) you're doing the work.

How much start up costs are you talking? Can you / would you have the confidence to pay it all on your own? If so, you can reverse the deal. You sign an exclusive agreement with him to rent his customer list and in exchange for office space and the list, you will pay X% to him on every deal you close - no ownership due to no costs for him.

Just some random thoughts.
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Old 09-10-2015, 07:16 AM
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Much appreciated Crazybeard,

He's got the location, the name, and a customer base. He doesn't have the skill or bandwidth to do this himself. I've got the skill, bandwidth, and industry connections. I could do this 100% on my own, but would have a much better entry point and quicker path to profitability using this partner. He wants a stake in the endgame since he has the location, the name, and the reputation. He's only getting a small piece of the pie on an ongoing basis. It's a deal that we are both comfortable with. It also will help him expand his business.

Startup costs are insignificant. Either of us could do this out of pocket if we chose to. For him, it would take time / focus off of his primary business. Makes no sense. He's an expert in his field as I am in mine.

I'll update this as we get more proper advice.
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Old 09-10-2015, 08:27 AM
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Originally Posted by Airslot View Post
Much appreciated Crazybeard,

He's got the location, the name, and a customer base. He doesn't have the skill or bandwidth to do this himself. I've got the skill, bandwidth, and industry connections. I could do this 100% on my own, but would have a much better entry point and quicker path to profitability using this partner. He wants a stake in the endgame since he has the location, the name, and the reputation. He's only getting a small piece of the pie on an ongoing basis. It's a deal that we are both comfortable with. It also will help him expand his business.

Startup costs are insignificant. Either of us could do this out of pocket if we chose to. For him, it would take time / focus off of his primary business. Makes no sense. He's an expert in his field as I am in mine.

I'll update this as we get more proper advice.

So essentially, you'd be marketing it all under the umbrella of his existing business?
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Old 09-10-2015, 10:07 AM
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50:50 is never a good idea.
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