Contribution of debt guarantee for capital interest in LLC

What do you do in that case?

It’s hard to say what the relevant provisions of the OA say, since you haven’t posted them.

On the one hand, your assigning a percentage to a capital interest is meaningless. I’m not sure if you’re doing that, if someone is telling you that, or if that’s actually what the OA says. If $10k is contributed for a 30% “capital” stake, it really isn’t a 30% capital interest. Rather, $10k divided by $110k = 9.09%. So if we have an immediate liquidation, the GP’s get their $10k back, or 9.09% (not 30%) and nothing more. Thus, stating that the GP’s have a 30% capital interest is inaccurate, since they don’t have such an interest.

Now, if we immediately liquidate and the GP’s really are to receive 30% of the invested capital, then they’d get $33k [30% of $110k = $33k]. In that case, there has indeed been a shift (from the LP’s to the GP’s). But that certainly doesn’t seem right, given that the LP’s have not agreed to give up any of their capital.

And I’m not sure if the OA uses targeted allocations or not.

And I’m not sure what the cap table looks like for sure, in terms of value contributed.

Finally got my hands on the operating agreement.

We have Class A and Class B units. The only difference is that Class A is voting and Class B is not.

Class B contributed all of the capital for a 70% interest. Class A did not contribute capital but received a 30% interest.

Distributions occur as follows:

1. First to Class B to cover the cumulative unpaid preferred return (8%) to-date;
2. Second, until capital contributions are repaid, 40% to Class A and 60% to Class B.
3. Third, after capital contributions are repaid and until total IRR is 17%, 50% to Class A and 50% to class B
4. After 17% IRR, 60% to Class A and 40% to Class B

Partner A who contributed the guarantee owns Class A units.

The only difference is that Class A is voting and Class B is not.

Quite clearly, that is not the case. These two classes have differing economic rights.

You continue to use phrases like “70% interest” and “30% interest.” Where are you getting that from? I’ll say more on this after you respond.

And can you post the allocation provisions?

And what about the cap table at the back wherein capital contributions are detailed out?

Allocation provisions are below.

Allocations of Profits and Losses. The Net Profits and Net Losses of the Company for each Fiscal Year will be allocated as follows:

(a) The Net Profits of the Company for each Fiscal Year will be apportioned as follows:

(i) First, an amount of Net Profits equal to the aggregate amount of all Net Losses previously allocated to the Members and Economic Interest Owners for prior fiscal years, less an amount equal to all Net Profits previously so allocated, shall be allocated among the Members and Economic Interest Owners in proportion to the Net Losses previously allocated to them.

(ii) Second, an amount of Net Profits equal to the cash distributed to the Members and Economic Interest Owners during the
fiscal year shall be allocated among the Members and Economic Interest Owners in proportion to the cash distributed to them.

(iii) Third, any additional Net Profits shall be allocated among the Members and Economic Interest Owners in proportion to the amount of cash each Member and Economic Interest Owners would be entitled to receive had cash in the amount of such additional Net Profits been distributed pursuant to Section 9.2(b).

(b) The Net Losses of the Company for each Fiscal Year shall be apportioned as follows:

(i) First, an amount of Net Losses equal to the aggregate amount of all Net Profits allocated to the Members and Economic
Interest Owners for prior fiscal years, less an amount equal to all Net Losses previously so allocated, shall be allocated among the Members and Economic Interest Owners in proportion to the Net Profits previously allocated to them.

(ii) next, until all Unreturned Capital Contributions to the Members and Economic Interest Owners have been reduced to zero (0), sixty percent (60%) to the Class A Members and Class A Economic Owners pro rata in proportion to such Class A Members’ and Class A Economic Owners’ Class A Prorata Percentage, and forty percent (40%) to the Class B Members and Class B Economic Owners pro rata in proportion to such Class B Members’ and Class B Economic Owners’ Class B Prorata Percentage;

(iii) next, after all Unreturned Capital Contributions to the Members and Economic Owners have been reduced to zero (0) and until the total distributions from the Company are sufficient to cause the aggregate distributions from the Company to yield a 17% IRR on all Capital Contributions (taking into account all distributions made pursuant to this Section 9.1 on or prior to the date of such distribution), sixty percent (60%) to the Class A Members and Class A Economic Owners pro rata in proportion to such Class A Members’ and Class A Economic Owners’ Class A Prorata Percentage, and forty percent (40%) to the Class B Members and Class B Economic Owners pro rata in proportion to such Class B Members’ and Class B Economic Owners Class B Prorata Percentage.

(iv) next, the balance sixty percent (60%) to the Class A Members and Class A Economic Owners pro rata in proportion to such
Class A Members’ and Class A Economic Owners Class A Prorata Percentage, forty percent (40%) to the Class B Members and Class B Economic Owners pro rata in proportion to such Class B Members’ and Class B Economic Owners Class B Prorata Percentage.

9.2 Distributions.

(a) Subject to the restrictions of Section 9.3, the Company shall make a mandatory distribution (“Mandatory Distribution”) of Distributable Cash to the Members and Economic Interest Owners equal to the net income of the Company taxable to the Members and Economic Interest Owners as determined under the Code, multiplied by the top personal federal income tax rate in effect for the preceding fiscal year. Notwithstanding the foregoing, the Mandatory Distribution may be waived by the Managers. The Mandatory Distribution shall be made within ninety (90) days following the end of the Fiscal Year of the Company, or at such time as determined by the Managers.

(b) Notwithstanding the provisions of Section 9.2(a), the Managers, in their sole discretion, may authorize the funding of amounts the Manager deems necessary and desirable into the Reserves, and the Company shall make, other distributions of any Distributable Cash in excess of the Mandatory Distributions and such amounts funded into the Reserves, to the Members and the Economic Interest Owners, subject to the restrictions of Section 9.3 and in accordance with the
following priority:

(i) first, to the Class B Members and Class B Economic Owners until the Class B Members and Class B Economic Owners have
received an aggregate amount of distributions equal to the cumulative Preferred Return due but unpaid, which amounts shall be allocated among the Class B Members and Class B Economic Owners in proportion with each Class B Member’s and Class B Economic Owners’ unpaid Preferred Return;

(ii) next, until all Unreturned Capital Contributions to the Members have been reduced to zero (0), forty percent (40%) to the
Class A Members and Class A Economic Owners pro rata in proportion to such Class A Members’ and Class A Economic Owners’ Class A Prorata Percentage, and sixty percent (60%) to the Class B Members and Class B Economic Owners pro rata in proportion to such Class B Members’ and Class B Economic Owners’ Class B Prorata Percentage;

(iii) next, after all Unreturned Capital Contributions to the Members and Economic Owners have been reduced to zero (0) and until the total distributions from the Company are sufficient to cause the aggregate distributions from the Company to yield a 17% IRR on all Capital Contributions (taking into account all distributions made pursuant to this Section 9.2 on or prior to the date of such distribution), fifty percent (50%) to the Class A Members and Class A Economic Owners pro rata in proportion to such Class A Members’ and Class A Economic Owners’ Class A Prorata Percentage, and fifty percent (50%)
to the Class B Members and Class B Economic Owners pro rata in proportion to such Class B Members’ and Class B Economic Owners’ Class B Prorata Percentage.

(iv) next, the balance sixty percent (60%) to the Class A Members and Class A Economic Owners pro rata in proportion to such
Class A Members’ and Class A Economic Owners Class A Prorata Percentage, forty percent (40%) to the Class B Members and Class B Economic Owners pro rata in proportion to such Class B Members’ and Class B Economic Owners Class B Prorata Percentage.

(c) All amounts withheld pursuant to the Code or any provisions of state or local tax law with respect to any payment or distribution to the Members or Economic Interest Owners from the Company shall be treated as amounts distributed to the relevant Member or Economic Interest Owner pursuant to this Section 9.2(c).

9.3 Limitation Upon Distributions.

(a) No distributions or return of Capital Contributions shall be made and paid if, after the distribution or return of Capital Contribution is made, the Company would be insolvent or the net assets of the Company would be less than zero.

(b) The Managers may base a determination that a distribution or return of Capital Contribution may not be made as a result of Section 9.3(a) in good faith reliance upon a balance sheet and profit and loss statement of the Company represented to be correct by the Person having charge of its books of account or certified by an independent public or certified public accountant or firm of accountants to fairly reflect the financial condition of the Company.

(c) No distributions or return of Capital Contributions shall be made or paid if, at the time of the distribution or return of Capital Contribution, the Company is party to an agreement or agreements with third party lenders which prohibit the
making or payment of distributions or the return of Capital Contributions. If the Company is a party to an agreement with third party lenders which restricts the time or amount of distributions or return of Capital Contributions, any distributions or
return of Capital Contributions shall not be approved, made or paid in excess or in violation of such restrictions.

~~Cap Table~~

Class A units:
- Partner A = 5%; $0 contributed
- Partner B = 12.5%; $0 contributed
- Partner C = 12.5%; $0 contributed

Class B units:
- Partner D = 11.66%; $50k contributed
- Partner E = 11.67%; $50k contributed
- Partner F = 46.67%; $200k contributed

~~Definitions~~

1.8 Class A Members. “Class A Member” shall mean a Member who owns one or more Class A Membership Units.
1.9 Class A Membership Interests. “Class A Membership Interests” shall mean a Class A Member’s entire interest in the Company including such Class A Member’s Economic Interest and the right to participate in the management of the business and affairs of the Company, and the right to vote on, consent to, or otherwise participate in any decision or action of or by the Members granted pursuant to this Operating Agreement and the Act.
1.10 Class A Membership Unit. “Class A Membership Unit” shall mean one unit of Class A Membership Interests as set forth on the attached Exhibit A. Each Class A Membership Unit has equal governance rights with every other Class A Membership Unit and in matters subject to a vote of the Class A Members has one (1) vote. Subject to the provisions herein, each Class A
Membership Unit has equal rights with every other Class A Membership Unit with respect to sharing of profits and losses and with respect to distributions. A Class A Membership Unit may be diluted if the Company issues additional Class A Membership Units, or creates other classes of Membership Units.
1.11 Class B Member. “Class B Member” shall mean a Member who owns one or more Class B Membership Units.
1.12 Class B Membership Interests. “Class B Membership Interest” shall mean a Class B Member’s entire interest in the Company, including such Class B Member’s Economic Interest; provided that a Class B Membership Interest has no right to participate in the management of the business and affairs of the Company, and no right to vote on, consent to or otherwise participate in any decision or action of or by the Members.
1.13 Class B Membership Units. “Class B Membership Unit” shall mean one unit of Class B Membership Interests as set forth on the attached Exhibit A. Subject to the provisions herein, each Class B Membership Unit has equal rights with every other Class B Membership Unit with respect to sharing of profits and losses and with respect to distributions, and each Class B Membership Unit shall be entitled to a Preferred Return. A Class B Membership Unit may be diluted if the Company
issues additional Class B Membership Units, or creates other classes of Membership Units.
1.14 Class B Membership Unit. “Class B Membership Unit” shall mean one unit of Class B Membership Interests as set forth on the attached Exhibit A. Subject to the provisions herein, each Class B Membership Unit has equal rights with every other Class B Membership Unit with respect to sharing of profits and losses and with respect to distributions, and each Class B Membership Unit shall be entitled to a Preferred Return. A Class B Membership Unit may be diluted if the Company
issues additional Class B Membership Units, or creates other classes of Membership Units.
1.15 Class A Prorata Percentage. “Class A Prorata Percentage” shall mean the number of Class A Membership Units owned by a Class A Member or Class A Economic Interest Owner divided by the total number of Class A Membership Units outstanding.
1.16 Class B Prorata Percentage. “Class B Prorata Percentage” shall mean the number of Class B Membership Units owned by a Class B Member or Class A Economic Interest Owner divided by the total number of Class B Membership Units outstanding.

The cap table reveals that the guarantor partner is getting no capital account credit for his guarantee. Likewise, the other Class A members aren’t getting any capital account credit because they didn’t contribute anything, as you mentioned. (As to the amounts the Class A members paid towards property closing costs, those should be booked up as loans).

So, Class A made no capital contributions, yet the distribution provision (Part 2) says:

(ii) next, until all Unreturned Capital Contributions to the Members have been reduced to zero (0), forty percent (40%) to the Class A Members and Class A Economic Owners pro rata in proportion to such Class A Members’ and Class A Economic Owners’ Class A Prorata Percentage, and sixty percent (60%) to the Class B Members and Class B Economic Owners pro rata in proportion to such Class B Members’ and Class B Economic Owners’ Class B Prorata Percentage;

Here’s the quirk with that provision: The unreturned capital for the Class A members is $0 right off the bat. The provision implies that, nonetheless, if distributions are made, Class A should get 40% of them. I say that because the provision states, “until all Unreturned Capital Contributions to the Members.” The Members are Class A and Class B. Although Class A has $0 unreturned capital off the bat, all members, which would include Class B, do not. Thus, it seems, if distributions are made, Class A shares in them, even though Class A already has $0 unreturned capital. But, it could be that the provision is intended to be read like this: Since Class A has $0 unreturned capital already, if distributions are made, they all go (i.e. 100%) to Class B, until Class B’s unreturned capital goes to $0.

What I’m trying to figure out here is if there’s a capital shift from B to A. In other words, if the partnership were liquidated right after it started, for whatever reason, who would get what? Would Class A get something or not? In other words, how do we interpret the above distribution provision?

Seems to me to be a question for the drafting attorney. I suspect a shift wasn’t intended, but I’m not so sure the OA language above produces that result.

Thanks, I’m on the same wavelength. Assume no shift occurs (if the OA is amended to clearly explain that), there’s no tax implication for Class A receiving a % ownership until they receive distributions/profits at some later point, right?

On the flip, if a shift was intended, what would the tax implications be? If the partnership liquidated and Class A did receive a distribution, they’d pay tax on that. So does that mean that such amount would be immediately taxable upon raising the capital and operating this entity?

Assume no shift occurs (if the OA is amended to clearly explain that), there’s no tax implication for Class A receiving a % ownership until they receive distributions/profits at some later point, right?

Right. Remember, what might be taxable up front is if a partner receives a capital interest for services rendered, be they current services or future services. The Class A guys are the service providers here. If there is no up-front shift, then any “ownership” the Class A gets up front isn’t a capital interest. Specifically, if the OA says that distributions first go to those members that contributed capital (i.e. the Class B members), then the Class B members haven’t “given up” any of their capital in favor of the Class A members. No shift. The only capital interests are those of Class B, which Class B retained in full. This concept is spelled out in Reg. Sec. 1.721-1(b)(1). There have been a few cases which have concluded otherwise (Finkelman and Mark IV Pictures), but those decisions are kind of mind-boggling. Here’s what the court said in Finkelman, for example:

While petitioner argues that he received only an interest in profits and losses, the partnership returns indicate that he had a percentage capital interest as well. Further, petitioner testified that he would share in any appreciation in value of partnership property, subject only to the right of the partners to first receive back their cash contributions. Thus, he did have an interest in partnership capital, in addition to profits and losses.

That makes no sense to me, given that post-formation appreciation, if realized, comes in the form of profits. I would understand the court’s logic if a partnership interest was granted to a service provider after unrealized appreciation had already occurred and some of the appreciation would inure to the benefit of the recipient of the granted partnership interest. But usually you don’t see that. Usually, if there is existing appreciation and a partnership interest is granted, the grant is labeled a “profits interest” (in the first place) and it comes with a “distribution threshold” attached to it so that it isn’t treated as a capital interest. For example, if a partnership is worth $1m and a 10% interest is granted to a service provider, the agreement will state that the recipient partner gets no distributions with respect to the first $1m of distributions. The recipient partner only shares in subsequent/additional appreciation/distributions. In other words, existing appreciation gets allocated to existing partners.

So does that mean that such amount would be immediately taxable upon raising the capital and operating this entity?

Yes. Look at your cap table – $300k of capital contributed by Class B. If the agreement really is to be read that Class A gets 40% of the distributions (until capital has been recovered by ALL members), you’d have an immediate shift of $120k from the Class B to the Class A. I can’t believe that’s what was intended. The Class B members wouldn’t be too happy about it.

Also, your OA is a little odd in that Class A is shown, on the cap table, at 30%, but its sharing ratio starts at 40%. Usually in these deals, and as I mentioned somewhere above, capital contributions are pro-rata between Class A and Class B. In your case, it would be $120k contributed by Class A and $180k contributed by Class B. At that point, most of the OA would make better sense, since capital contributions would be aligned with the pre-flip percentages in the OA (40% and 60%).