Are there tax consequences when admitting a new partner to an LLC?
Imagine that a friend from college calls you up with a great idea for a new business. Your friend asks you to join his business as the CEO and, although he can’t pay you for your services, you will be a 50% owner of the business. You probably need to know if this is a good deal for you and also whether there are any tax consequences.
In general, any time you receive something of value for your services you have earned income subject to income tax (IRC §61). So if your friend promised to pay you a monthly salary for your services as CEO you’d expect that salary to be subject to tax. Is it any different if you receive equity in a company instead of salary?
One difference between payment of a salary and your friend’s promise of equity is how easily it can be valued. It may be obvious, but in order to tax income the IRS needs to know what the value of the income is. Right now your friend has described a great business, but one that doesn’t yet generate income (profit) and which has substantial risk. It could be reasonable to say that 50% of the business isn’t worth anything yet and that you’ll wait to pay taxes when the business starts to generate profits.
But what if the facts are different and your friend has been running the business profitably for more than a year? On those facts you may need the services of a business valuation expert, and you may expect to pay taxes when you receive 50% of a going concern business.
Change the facts just slightly and you’ve got a third scenario: your friend has been running the business successfully for over a year and has generated small profits. He knows that growing the business will require a professional CEO and some capital invested in inventory. He asks that you invest $100,000 in exchange for 50% of the business and that you help him hire a CEO. You have to pay for your ownership interest and, although you will be entitled to 50% of the profits, the business will be paying the expense of a CEO salary. On these facts have you received income? You may or may not pay taxes depending upon whether the price you pay is a fair representation of the value you’re receiving.
As you can see, the tax consequences of becoming a partner in a business can quickly become complicated and difficult to calculate. It becomes even more complicated if one or more of the partners provide services and are promised reimbursement or a salary. It is always best to have one or several advisors to assist—a CPA, an attorney and a business valuation expert may all be needed to properly calculate the effect of changes when admitting a new partner. The most important thing to remember is that a taxable event can occur without the payment of cash, so be aware and look for tax consequences to avoid surprises and penalties.