In a previous blog post, I talked about how Not Incorporating is Risky Business, which was directed at the sole proprietor and why they should consider incorporating their business. Suppose, however, you’re considering signing up as a partner into a pre-existing company, such as a partnership, limited liability corporation (or LLC), or S-Corporation? Is there anything to be concerned about?
Turns out, there is much to be careful about, when signing up as an equity partner to a pre-existing company, whether it’s a partnership, LLC or S-Corporation. These concerns are also shared by shareholders, members or partners leaving a company (either through retirement or for other reasons).
What you need to look out for before you sign
Do you know exactly what you’re getting into when you join a new partnership?
Congrats! You’ve been invited to become a member of an LLC, shareholder in a S-Corp, or partner in a partnership. This is prestigious, and you have much to be grateful for. However, be aware that as a partner or owner of a tightly held corporation, you immediately share the burdens, risks and liabilities of that company. Are you getting in over your head? Have all the risks been fully disclosed to you? Are you prepared to share in the liabilities?
Some questions you need to answer for yourself, BEFORE becoming an equity partner in any company, no matter how prestigious, successful, new or old the company is, are the following:
- Are there any outstanding judgments, lawsuits or liens on the company or the threat of such events to the company?
- Is the Operating Agreement or By-Laws fair and balanced, or are their inequities between partners or class of partners?
- Are the financials audited and/or is there adequate transparency to understand and evaluate the financial condition and health of the company?
- Is there an appropriate system of checks-and-balances, and operational segregation, to prevent “commingling of funds” between one or more partners and the company?
- Is the value of the company adequately protected against double-dealing, or disinterested or uninvolved partners?
- If you’re contributing capital (i.e. buying equity), is your money protected? Is the value for your money fair?
- Are you aware of the tax implications for yourself personally?
Each one of bullets above are ripe for an entire book, and therefore one blog article cannot go into sufficient depth to cover everything. I’ll go into more detail in subsequent blog articles. In the mean time, however, consider just some of the issues.
Judgments, lawsuits or liens
When you sign up to a new company, you are essentially becoming a part of that company. The value you place in that ownership is immediately at risk, when you sign up, if there are judgments, potential lawsuits or other risks facing the company. Worse, your personal wealth and assets are at risk, if the company is not managed well such that a plaintiff can “pierce-the-corporate-veil” and go after the personal assets of the shareholders, members or partners of a company. You need to make sure the company has fully disclosed these risks to you, or has agreed to indemnify and hold you harmless against such risks.
Operating Agreement or By-laws
Often, I see companies founded by individual entrepreneurs who have been slow to let go of the reigns and extend true ownership and power to their partners. As a consequence, the operating agreement or by-laws are written heavily in favor of one or two individuals, posing unfair risks to the other partners. Sure, this may be fine and dandy in the short-term, because everyone gets along and trusts the main partner. What happens, however, when the main partner dies or becomes incapacitated? Or, the main partner wants to sell the company and the remaining partners do not?
Make sure your new company is protected in case of a death or incapacity of an owner.
In a death or incapacitation situation, the operating agreement or by-laws are crucial. Will the family become your new partner, or worse, your new boss? Does the company have the right of first refusal, to buy up the main partner’s equity? Can the company afford to do so? It is my strong recommendation that the operating agreement, or by-laws, are written such that the company has the right of first refusal to purchase the equity from a deceased or incapacitated member, shareholder or partner. This gives the company (i.e. through a vote of the surviving partners) the ability to maintain control of the company, and increase everyone’s share in the company pro rata. Keyman, or Key Person, life insurance is one method to ensure the company has the cash available to purchase the shares, units or ownership percentage from the estate of the deceased’s membership or ownership in the company. Keyman life insurance is a form of life insurance, that a company can take out against each partner, so that the company can use the proceeds to buy out the estate should a member become deceased or incapacitated.
Don’t be too eager to sign up with a company as its newest shareholder or member, and don’t let them tell you it’s a “take it or leave it” proposition. Everything is negotiable, and remember, the worse case happens more times than you might think. If it didn’t, people wouldn’t need lawyers.
Tax implications
The tax implications are often overlooked, and present some serious issues for the new shareholder, member or partner. If you buy into a company, for the exact value it is worth, you have NO tax implications at first. However, if the value of the equity you receive is greater than what you pay for it, you DO have tax implications. In the simplest example, if you’re simply given equity without paying for it, you are receiving value. This is taxable, and it’s ordinary income at that. Just because it’s equity in a company, doesn’t mean it’s taxed as capital gains. You only pay capital gains on equity, when it increases in value and a triggering event occurs (i.e. you cash out). So, think about what this means: If you’re given equity in a company, that is worth $250,000, it is as though the company paid you $250,000 in that tax year. This means you will be responsible for paying the ordinary taxes on $250,000 worth of income, even though you received no cash. This is your risk: Will that $250,000 in equity really payoff for you, or are you paying taxes on money you will never see?
Vesting
The next biggest tax issue most people overlook, is one of vesting. In the same scenario above, what happens if that $250,000 in equity given to you vests over time? This is what the IRS calls “at risk,” and of course, the IRS has a rule on it. It’s called Rule 83. In particular, what every partner, shareholder or member needs to know, is Rule 83(b). If your equity is “at risk,” such that it can be taken from you (i.e. it doesn’t vest fully, because you may leave at some point; or you own all of it, but the company retains the right to buy some portion of it back from you for whatever reason), then the IRS makes you factor in the ordinary income of your equity as it vests — at the time it vests.
Taking IRS Rule 83 into account can save you a lot of money when it comes to paying taxes.
What does this mean? Well, suppose you’re given enough shares equivalent to $250,000 that vests monthly over two years. To keep this example simple, we’ll say each share is worth $1. At the end of year one, 1/2 of your grant has vested and therefore in the beginning, you’re expecting to pay ordinary taxes on $125,000 of income. However, suppose the fair market value of the shares have doubled in that year? Without filing an 83(b) exemption with the IRS (within 30 days of your grant), the IRS requires you pay the ordinary taxes for the equity you receive, at the time of grant, at their fair market value. This means, at the end of the first year, you are now paying the taxes on stock worth $2/share, not $1/share. It’s as though your stock grant has increased, although it has not. You are now paying a lot more taxes because the value of your shares has increased.
Filing an 83(b) exemption with the IRS within thirty (30) days of your grant of equity, however, gives you the option of paying your taxes at the fair market value at the time of grant, not the fair market value at the time of each vest (i.e. keeps the taxes on ordinary income at $250,000). The gamble is, will the value of your stock go up, or go down, over the vesting period?
Consult an expert before you sign
Each situation is very fact specific and complicated. It behooves you to consult with an accountant, tax adviser or CPA, before you accept equity and/or sign on the dotted-line.
Law 4 Small Business (L4SB). A little law now can save a lot later.
16 Comments
Considering that I’m in a process of joining an existing partnership I really find this to be on point ..very much of what I needed.
Larry, thank you so much for this posting! My fiancé was just offered a partnership and was very cavaliers about it. I flipped, understanding some of the benefits this should include (which weren’t mentioned), as well as many of the problems that one could incur. I sent him your posting and he’s now looking at it differently. Thanks again!
After 40 yrs in a 3 partner business retiring but still owes 50,000 in buyin partnership, does it get deducted from sale of business? How can I evade this debt? A lot of fraudulent claims in buyin, tax lien etc
Thanks
Hi, Ron.
If I’m understanding your question properly … if there is some “debt” owed by a departing partner, that debt should either adjust the capital account (if being properly maintained) or it can be deducted from whatever share of the assets would be owed to the departing partner.
I’m not sure what you mean by “fraudulent claims.” That could be a factor in negotiating a settlement, although the word “fraudulent” is a very strong word to mean obtaining something for value through intentional (or criminal) deception. If such a thing is a factor, and intentional deception is at play, you generally have three options depending on the circumstances and what’s at stake: (1) The departing member can simply take what is offered, and try to leave the business and its liabilities and issues behind him or her, (2) The departing member can try to find the true value by auditing the books, look at the tax filings, etc, leveraging an appropriate accountant to help, which could help at least negotiate a better offer, or (3) Sue the other partners, which may be necessary if they are not providing access to the books and underlying information, such as the bank statements, receipts, tax documents, etc.
Litigation should always be viewed as a last resort, because it’s expensive, time consuming and uncertain. In such instances, you will almost always need one or more expert witnesses to examine and testify regarding the financials or other aspects of the business.
I hope this helps, and I wish you the best of luck. If you need representation, please call us. We’d be happy to talk to you, or refer you to the right attorney to help (depending on your circumstances and which jurisdiction you and your business are located).
Larry.
Hello I want to join my friends in their business adventure in the media field. They run a Sound recording studio and I am a freelance videographer. I figure teaming with them would help alleviate some tax burden from me, since I don’t really charge my clients much. Should I still look at this like joining a frat party with good times to be had or should I just get a sole proprietor?
Hi, Andrea.
You should always be careful with whom you are considering joining a partnership with. I definitely wouldn’t treat it as a “party,” given you could be subject to the harms / damages / liabilities committed or incurred by your partners. Even if you think you’re a “sole proprietor,” if you’re “working together,” it could be viewed as a partnership and expose you to the liability (and even debts) of the others.
Larry.
Hi Larry,
My friend has recently incorporated her start-up as an LLC in the US and I am thinking of joining her e-commerce business venture. As we have been traveling in the last 4-weeks, we have been working remotely and haven’t discussed the terms of the partnership yet. We were thinking of using the next few months as a “try out” to see how the partnership will work. I would like to get your advice on the best way to approach this partnership if we are to go ahead. Will it be better to ask for inclusion as a partner / member of the LLC? Or can I negotiate equity and other terms without registering myself in the LLC? Thanks!
Hi, Cecilia.
Thank you for your inquiry. Just to be clear, having equity in a LLC means you’re a partner / member of the LLC. This permits you to have some level of control (or vote), depending on what’s stated in the Operating Agreement, as well as participate in profits (again, as permitted in the Operating Agreement).
Therefore, I advise you negotiate as appropriate on what this looks like, and then put the proper paperwork in place to make sure you have the level of control and remuneration that you are expecting. Oftentimes, this will include a revision to the Operating Agreement (if one exists). In my opinion, if this is a game of chess and we’re thinking strategically, waiting only benefits the existing members of the LLC and disadvantages you. Your hand is strongest, no matter how good you are and what you do in these next few months.
Larry.
My friend has a Ltd company that has been operating for about 5yrs, I’m developing a product which I want to launch through his company, while negotiating for a partnership, can I use this product to buy my shares and what happens if the market response is +/_ to the granted equity?
Hi, there.
This is a great question. The short answer is that you can use whatever “consideration” (i.e. whether money, promise of services, intellectual property, product, etc) you and your friend decide is appropriate for your partnership. When you negotiate for equity, both you and your friend need to make some decisions on what you think is fair for your contribution (i.e. the product) in return for his contribution (i.e. the equity).
It is possible to put a deal together, where the % equity changes, depending on “market response” (however you define that), but it does create some problems. The first problem is, if I were your friend, my willingness to “contribute” to the success of the product would be directly proportional to my long-term gain. What you can potentially create, is a lose-lose situation for your friend, in that if your product tanks, he’s lost whatever effort/money he’s put into your product. If your product goes through the roof, you take a bunch of equity (and therefore long-term gain) from him.
There is a much-longer-answer here, and frankly beyond my ability to type something in a blog article. I would encourage you to hire a business attorney to talk through your options. For example, when you say you want to “launch through his company,” what does that mean specifically? What expectations do you have on your friend’s company? To finance some marketing? To co-sign on some merchant accounts? Some of these things may be easy in practice, but still demand some level of money, effort or to extend credit (i.e. therefore some risk to the business). You need to properly define expectations, commit to a piece of paper, along with the “edge-cases” (i.e. how does one or the other get out, sell out, leave, or take action if the other partner breaches or otherwise doesn’t perform). Also, I assume your product represents some form of intellectual property. Typically, when you “run a product through a company,” what that really means is the company will own the IP. You have a lot of issues just around that, such as what happens to the IP if the partnership dissolves? Are “derivative works” (i.e. new versions) owned by the company or you? The list of issues can be quite extensive.
I hope this has helped, and I wish you the best of luck on your product!
Larry.
Hi! I own a retail store that’s been open right at one year. I have recently considered having a partner due to wanting to expand the business. I would Ofcourse make her a partner & would want her to get 50% of all profits. Would you say the new partner would need to invest a certain percentage up front to “buy in” or how is this normally handled? Thanks!
Hi, Lynn.
If your company “has value” and generating revenue, then it would be totally appropriate for a partner to “buy in” for an amount representing the 50% of the value of the business.
Note there are many ways to address this, depending on a number of factors. For example:
There are no right or wrong answers to the questions above, but they certainly have an impact on how much the “buy-in” should be.
Whatever you decide and negotiate with your future partner, please make sure you have a very good partnership agreement drafted to represent all the edge-cases to partnership.
One good mechanism for a partnership is a LLC. The Operating Agreement to the LLC acts as your “partnership agreement,” although PLEASE DO NOT assume whatever Operating Agreement you get (even from us) covers everything you need. You should review the Operating Agreement you get carefully, and make sure it covers everything that you need for your business.
We provide low-cost, flat-rate pricing for LLC’s and the pricing includes a good Operating Agreement (learn more). But, as I said, you should review our Operating Agreement to make sure it covers everything needed for your partnership.
Good luck to you. Larry.
Hey, Larry. Finding all the other comments helpful, but nothing is exactly what I’m looking for…
I’ve been in a service business for a little over 3 years. The business has been growing quickly and is doing well, but I have a potential partner with a different skill set than mine who has contacts that would be helpful for expansion. I want to bring him into the business as a smaller percentage owner (say 12.5-20% ownership) with incentives that will give him more ownership as he brings new business in.
The numbers are pretty basic. I’ll do about $250 in business this year. My take-home is around 100K.
I want to bring on this partner with a $25,000 buy-in for 12.5-20% ownership. Does this seem reasonable?
Have you don’t other deals like this? It’s very difficult finding info on this type of agreement online.
Thanks for any insight you can provide.
Hi, David.
This sounds like a very standard and typical deal, but I would caution you from trying to find an agreement on the Internet to handle this.
There are a LOT of potential pitfalls, and I would strongly encourage you to hire a local business lawyer to help you with this deal and come up with the right document for you. It will cost a lot more than downloading something free (or low-cost) from the Internet, but its money well-spent. Let me explain why.
This new partner is as important and “tied to you” as a spouse. If you were going to get married, you’d be well-advised to have some sort of prenup that would prevent the company from becoming part of the marital estate. That way, if the marriage failed, your business wouldn’t be negatively impacted.
The same goes for this partner. You need a very strong partnership agreement, and two important aspects of this agreement would include “disclosures” and “edge cases” in case the relationship were to breakdown some day. Issues include, in no particular order:
The list goes on and on and on. Disclosures are important, because you want to make it crystal clear he (or his family or estate) cannot later say “you promised X or Y or Z,” and make some claim for fraud or negligent misrepresentation. Furthermore, if you want to restrict him from doing something with his ownership, you need some restrictions put in place in the partnership agreement, and you want to make sure this is disclosed as a “restricted security.”
Good luck to you. Larry.
To be clear, I was only looking for an EXAMPLE on the internet, not looking to use it as my official document. I have no idea how these kinds of things are usually structured and was hoping to get an idea for initial discussions with the prospective partner.
Thanks for your response!
David
Hi, David.
I’m sorry, but I’m not sure where you could find an example of such a document.
Larry.