WHEN “WORKER BEE” PARTNERS GET STUNG WITH TAXES - by Cliff Ennico
Posted by permission of Cliff Ennico – author of The eBay Seller’s Tax and Legal Answer Book – Get your copy at www.TaxandLegalBook.com
WHEN “WORKER BEE” PARTNERS GET STUNG WITH TAXES
By Cliff Ennico
“Two friends and I are forming a limited liability company (LLC). Two of us are putting in $50,000 each to get the business off the ground. The third friend doesn’t have any money, but will be the one who works in the business every day. We call her the ‘worker bee’. We want to be equal partners, because we’re friends after all. We thought that by valuing the ‘worker bee’s’ labor at $100 an hour, she will have earned a full one-third interest in the LLC after she works 500 hours worth $50,000. But our accountant tells us it doesn’t work that way. How can we set up this company in a way that’s fair to all three of us?”
What you have proposed is eminently reasonable and fair. Unfortunately, it’s not the law.
By putting in $50,000 each as capital to the LLC in exchange for a one-third interest each, you and your “rich” friend have established the value of the LLC as $150,000 ($50,000 x 3 partners). Your worker bee partner would have to put in $50,000 also in order to justify a full one-third interest at this time.
Since labor has no value under the federal Tax Code, giving the worker bee a one-third interest in the LLC today is giving her “compensation” equal to $50,000 (in the IRS view, giving her something worth $50,000 for nothing is the same as giving her $50,000 in cash). Unfortunately, the IRS won’t accept anything but cold, hard cash when it comes time to pay your taxes.
Whenever somebody has to pay taxes on income she didn’t actually receive in the form of cash, the income is called “phantom income”. In this case, you have socked the worker bee with a $17,500 phantom income tax bill (assuming she is in the top 35% federal income tax bracket) without giving her anything to pay those taxes with. The worker bee won’t be happy about that, will she?
There are a couple of ways you can deal with this from a tax perspective:
Option # 1: You can give the worker bee a small LLC interest (say, one percent) today, and give her – in addition to a cash salary — an additional 1% for each X hours that she works until she has worked her way up a full one-third interest. That way she can “earn” her way into the company over a long period of time. She will still have to pay taxes on the 1% “equity kickers” she receives, but as you are paying her cash on top of that while she works she will have the money to pay the taxes with when April 15 rolls around. Also, instead of her having to pay tax on the “phantom income” in one lump installment, you are spreading the pain out over several years, which will make the amounts much easier for her to handle.
You can sweeten this approach even more by agreeing to “gross up” the worker bee’s compensation each year: the LLC would pay the worker bee an amount each year equal to the federal and state taxes she is required to pay on the “phantom income” she receives each year (the amount is called a “gross-up payment”). This way the worker bee can earn her way up to a full one-third interest without having to pay the taxes on it out of her own pocket. Keep in mind, though, that the gross-up payment itself would be considered “compensation” to the worker bee, and she would have to pay taxes on THAT amount next year. Of course, you could agree to “gross up” that payment as well, and the next, and the next . . .
Option # 2: The three of you could each put in a small amount of money (say, $10) as capital. Then, you and your “rich” friend could make loans to the LLC of $50,000 each, with interest at a reasonable rate (say, 6% per annum), payable over the next few years. That way, the three of you would be equal partners from Day One without any adverse tax consequences to the worker bee. Of course, the $100,000 in loans would have to be paid off, with interest, over time. You and your “rich” friend would have to pay taxes on the interest you receive on those loans each year, but not on any repayments of the principal.
If you select Option # 2, make sure the loans can be prepaid at any time “in whole or in part, without premium or penalty,” and then devote any excess cash flow from the business to paying off the loans. Once the loans are paid off, all three of you will be truly equal partners, without any “phantom income” for the worker bee, and nobody will be “as angry as a wet hornet”.
Cliff Ennico (cennico@legalcareer.com ) is a syndicated columnist, author and host of the PBS television series ‘Money Hunt’. His latest books are ‘Small Business Survival Guide’ (Adams Media, $12.95) and ‘The eBay Seller’s Tax and Legal Answer Book’ (AMACOM, $19.95). This column is no substitute for legal, tax or financial advice, which can be furnished only by a qualified professional licensed in your state. To find out more about
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