SMLLC to LLC allocation issue

Potential client came in and I think we have some issues. High level details in this post and relevant section of operating agreement in second post. I know there is a lot here....

2017: John started an LLC, wholly owned by him.
12/31/2017
Cash: 858
Payable: 3,433
Debt: 100,000
Loss: 102,575 (Sch C)

On 1/1/2018, the LLC became a partnership. Tim contributed 115k (owns 23.19%) and Bill contributed 150k (owns 21.74%). John now owns 55.07%
12/31/2018
Cash: 25,693
Asset purchase: 3,000
Payable: 8,117
Debt: 25,000 (the 100k was paid back after Tim and Bill contributed funds to the partnership. This 25k is a new member loan from Tim)
PY RE: 102,575
Contributions (Tim and Bill): 265,000
CY Loss: 166,849

2019 has profit of 40k. No other loans

Potential issues:
1) In 2018, the prior accountant allocated John 55.07% of the losses AND deducted them on his personal return. Thinking he shouldn't have been allocated losses and if he was, shouldn't have taken them.
2) John was relieved of his share of the 100k debt. Since he was relieved of 55% of the debt, and had no debt basis, cap gains?

Wanted to get some help with these areas:
1) Confirming my understanding of the safe harbor rules for 704b.
-It does not look like the agreement has SEE, since the partnership does not state to liquidate in accordance to positive capital accounts. It does have a QIO provision, which satisfies the alternative test for econ. effect.
-Do we have targeted allocations based on the statement at the bottom of the member schedule?

2) Should John have been allocated the loss in 2018?
-Since agreement doesn't have SEE, we must allocate with PIP, or to Tim and Bill based on their contributions.

3) Ways to address:
-Amend 2018?
-Apply QIO in 2019, allocate gross income to John for the amount of his allocate loss in 2018 (not subject to SE tax)
-Ignore and allocate 2019 income based on ownership.

Relevant sections in Agreement:

3.5. Negative Capital Accounts. In the event that any Member shall have a deficit balance in its Capital Account, such Member shall have no obligation, during the term of the Company or upon termination or liquidation thereof, to restore such negative balance or make any Capital Contributions to the Company by reason thereof, except as may be required by Applicable Law or in respect of any negative balance resulting from a withdrawal of capital or termination in contravention of this Agreement.

“Adjusted Capital Account Deficit” means, with respect to any Member, the deficit balance, if any, in such Member's Capital Account as of the end of the relevant Fiscal Year, after giving effect to the following adjustments: crediting to such Capital Account any amount that such Member is obligated to restore or is deemed to be obligated to restore pursuant to Treasury Regulations Sections 1.704-1(b)(2)(ii)(c), 1.704- 2(g)(1) and 1.704-2(i); and debiting to such Capital Account the items described in Treasury Regulations Section 1.704-1(b)(2)(ii)(d)(4), (5) and (6).

Maintenance of Capital Accounts. The Company shall establish and maintain for each Member a separate capital account (a “Capital Account”) on its books and records in accordance with this Section 3.3. Each Capital Account shall be established and maintained in accordance with the following provisions:

Each Member's Capital Account shall be increased by the amount of:

(i) such Member's Capital Contributions, including such Member's initial Capital Contribution and any additional Capital Contributions;
(ii) any Net Income or other item of income or gain allocated to such Member pursuant to Article 5; and
(iii) any liabilities of the Company that are assumed by such Member or secured by any property distributed to such Member.
(b) Each Member's Capital Account shall be decreased by:
(i) the cash amount or Book Value of any property distributed to such Member pursuant to Article 6 and Section 12.3(c);
(ii) the amount of any Net Loss or other item of loss or deduction allocated to such Member pursuant to Article 5; and
(iii) the amount of any liabilities of such Member assumed by the Company or that are secured by any property contributed by such Member to the Company.

ALLOCATIONS
5.1. Allocation of Net Income and Net Loss. For each Fiscal Year (or portion thereof), after giving effect to the special allocations set forth in Section 5.2, Net Income and Net Loss of the Company shall be allocated among the Members pro rata in accordance with their Membership Interests.

5.2. Regulatory and Special Allocations. Notwithstanding the provisions of Section 5.1:

(a) If there is a net decrease in Company Minimum Gain (determined according to Treasury Regulations Section 1.704-2(d)(1)) during any Fiscal Year, each Member shall be specially allocated Net Income for such Fiscal Year (and, if necessary, subsequent Fiscal Years) in an amount equal to such Member's share of the net decrease in Company Minimum Gain, determined in accordance with Treasury Regulations Section 1.704-2(g). The items to be so allocated shall be determined in accordance with Treasury Regulations Sections 1.704-2(f)(6) and 1.704-2(j)(2). This Section 5.2 is intended to comply with the “minimum gain chargeback” requirement in Treasury Regulations Section 1.704-2(f) and shall be interpreted consistently therewith.

(b) Member Nonrecourse Deductions shall be allocated in the manner required by Treasury Regulations Section 1.704-2(i). Except as otherwise provided in Treasury Regulations Section 1.704- 2(i)(4), if there is a net decrease in Member Nonrecourse Debt Minimum Gain during any Fiscal Year, each Member that has a share of such Member Nonrecourse Debt Minimum Gain shall be specially allocated Net Income for such Fiscal Year (and, if necessary, subsequent Fiscal Years) in an amount equal to that Member's share of the net decrease in Member Nonrecourse Debt Minimum Gain. Items to be allocated pursuant to this paragraph shall be determined in accordance with Treasury Regulations Sections 1.704-2(i)(4) and 1.704- 2(j)(2). This Section 5.2(b) is intended to comply with the “minimum gain chargeback” requirement in Treasury Regulations Section 1.704-2(i)(4) and shall be interpreted consistently therewith.

(c) Nonrecourse Deductions shall be allocated to the Members in accordance with their Membership Interests.

(d) In the event any Member unexpectedly receives any adjustments, allocations, or distributions described in Treasury Regulations Section 1.704-1(b)(2)(ii)(d)(4), (5) or (6), Net Income shall be specially allocated to such Member in an amount and manner sufficient to eliminate the Adjusted Capital Account Deficit created by such adjustments, allocations, or distributions as quickly as possible. This Section 5.2(d) is intended to comply with the “qualified income offset” requirement in Treasury Regulations Section 1.704-1(b)(2)(ii)(d) and shall be interpreted consistently therewith.

(e) The allocations set forth in subsections (a), (b), (c), and (d) above (the “Regulatory Allocations”) are intended to comply with certain requirements of the Treasury Regulations under Code Section 704. Notwithstanding any other provisions of this Article 5 (other than the Regulatory Allocations), the Regulatory Allocations shall be taken into account in allocating Net Income and Net Losses among Members so that, to the extent possible, the net amount of such allocations of Net Income and Net Losses and other items and the Regulatory Allocations to each Member shall be equal to the net amount that would have
been allocated to such Member if the Regulatory Allocations had not occurred.

5.3. Tax Allocations.
(a) Subject to Section 5.3(b), Section 5.3(c), and Section 5.3(d), all income, gains, losses and deductions of the Company shall be allocated, for federal, state, and local income tax purposes, among the Members in accordance with the allocation of such income, gains, losses, and deductions pursuant to Section 5.1 and Section 5.2, except that if any such allocation for tax purposes is not permitted by the Code or other Applicable Law, the Company's subsequent income, gains, losses, and deductions shall be allocated among the Members for tax purposes, to the extent permitted by the Code and other Applicable Law, so as to reflect as nearly as possible the allocation set forth in Section 5.1 and Section 5.2.

(b) Items of Company taxable income, gain, loss, and deduction with respect to any property contributed to the capital of the Company shall be allocated among the Members in accordance with Code Section 704(c) and the traditional method with curative allocations of Treasury Regulations Section 1.704-3(c), so as to take account of any variation between the adjusted basis of such property to the Company for federal income tax purposes and its Book Value.

(c) If the Book Value of any Company asset is adjusted pursuant to Treasury Regulations Section 1.704-1(b)(2)(iv)(f) as provided in clause (c) of the definition of Book Value, subsequent allocations of items of taxable income, gain, loss, and deduction with respect to such asset shall take account of any variation between the adjusted basis of such asset for federal income tax purposes and its Book Value in the same manner as under Code Section 704(c).

(d) Allocations of tax credit, tax credit recapture, and any items related thereto shall be allocated to the Members according to their interests in such items as determined by the Manager taking into account the principles of Treasury Regulations Section 1.704-1(b)(4)(ii).

(e) Allocations pursuant to this Section 5.3 are solely for purposes of federal, state, and taxes and shall not affect, or in any way be taken into account in computing, any Member's Capital Account or share of Net Income, Net Losses, distributions, or other items pursuant to any provisions of this Agreement.

Distributions:
6.1. General.
(a) Subject to Section 6.2, distributions of available cash shall be made to the Members when and in such amounts as determined by the Manager. Distributions determined to be made by the Manager pursuant to this Section 6.1(a) shall be paid to the Members in accordance with their respective Membership Interest.

(b) Notwithstanding any provision to the contrary contained in this Agreement, the Company shall not make any distribution to the Members if such distribution would violate § 101.206 of the BOC or other Applicable Law.

The member schedule at the back of the agreement states:
John shall only receive profits after all other members have been paid back their investments into the Company in full.

Bump. I know this is a complicated one.

1) In 2018, the prior accountant allocated John 55.07% of the losses AND deducted them on his personal return. Thinking he shouldn't have been allocated losses and if he was, shouldn't have taken them.

I don’t follow your logic here. It seems that this provision creates a preferred return of capital:

The member schedule at the back of the agreement states:

John shall only receive profits after all other members have been paid back their investments into the Company in full.

If that is the case, then shouldn’t 100% of the 2018 loss been allocated to John (but we need to work through the 704c issued referenced below)?

-It does not look like the agreement has SEE

There seem to be some inconsistent provisions in the OA. We have the boilerplate/original language which talks about allocating, and distributing, based on percentage interests. But then we have the added preferred return clause at the end.

Also, when we run the Balance Sheet out to account for the cash capital contributions by Tim and Bill, it’s a little screwy, if you will. These capital contributions came in at the same time, but the respective interests Tim and Bill received were not proportionate. If we take Tim’s $115k and divide it by 23.19%, we get $495,903. If we take Bill’s $150k and divide it by 21.74%, we get $689,972. If we go with Bill’s $150k as setting the enterprise value, then Tim got an extra $45k of value. I’m not sure why that is. I’d bet John could tell you.

Related to this is the self-evident idea that we have 704c at play.

My logic: since the agreement doesn't have substantial economic effect, the losses should follow the PIP rules, which would've allocated the loss to Tim and Bill because they have basis.

Regarding the preferred return clause: if the company issues distributions, do they go to Tim and Bill first? If there is profit (2019), do we allocate to Tim and Bill according to ownership.

704c: do we book some kind of enterprise value into the books? We like to keep tax basis financials. Since it was cash being contributed, I didn't think of 704c since there isn't a different between FMV and tax basis for the asset being contributed.

Excuse my ignorance with the preferred return clauses. Not something I see often.

My logic: since the agreement doesn't have substantial economic effect, the losses should follow the PIP rules, which would've allocated the loss to Tim and Bill because they have basis.

The PIP rules don’t specifically say that. But they don’t specifically say what I’m saying either. The PIP rules are unclear as to what “basis” we use for determining PIP percentage interests – tax basis or 704(b) book basis.

Regarding the preferred return clause: if the company issues distributions, do they go to Tim and Bill first?

That is what my reading of the preferred return clause dictates. And my reading is how one would read the intent of the clause:

John shall only receive profits after all other members have been paid back their investments into the Company in full.

When the clause says “receive profits,” it’s a bit unclear. But I think the intent is that the guys that contributed cash get their cash back first before John is distributed anything. So, I’m reading this clause as if it were worded properly, so that the wording mirrors intent. Once we’re there, and if we are taking this clause as the operative provision, then it seems Tim and Bill shouldn’t be allocated any losses because doing so would diminish their capital accounts below their contributions. If that happens, I don’t see how Tim and Bill could get their cash back first. (I also made a comment about the $45k extra accruing to Tim. I still don’t understand why that is).

Since it was cash being contributed, I didn't think of 704c since there isn't a different between FMV and tax basis for the asset being contributed (cash).

John contributed something whose tax basis differs from its FMV.

Thinking he shouldn't have been allocated losses and if he was, shouldn't have taken them.

One thing I’ve having trouble with here is understanding the economic arrangement among these three guys. Based on the italicized wording above, I think you’re understanding is that John’s contribution is being valued at $0. This means we’d only have capital contributions from Tim and Bill. And then, Tim and Bill would get back the cash funds they contributed. And then, things would be shared 55.07%, 23.19% and 21.74%. Prior to this sharing, there is no capital return/distribution to John, since John is deemed to contribute nothing of agreed-upon value. In this case, we’d have to work through various annual scenarios (i.e. losses, profits, etc.) to model out in-balance/pro-rata capital accounts. This isn’t necessarily so simple…if we have annual losses, then profits, then profits, then distributions, then losses, etc. with the end game being capital accounts that are 55/23/22. We also have to deal with the 2018 situation.

The alternative, which is where I was going with this, is that we’d have a revaluation/book-up. If Bill’s $150k is the benchmark (not sure), it implies an enterprise value of $689,973. Bill’s book and tax would be the same. Tim’s would roughly be the same (still don’t understand the $45k, however). And John would have a big book capital account and something much less (or negative) on the tax basis. (A reverse 704c contribution by John). If Bill and Tim’s contributed capital is returned to them first, then we wonder what happens next, given that John has a book capital account. Does he get that back next and only thereafter we start sharing in the agreed upon ratios? That seems kind of doubtful to me.

It seems to me that the first paragraph above, which is based on your understanding, is likely what the partners had in mind – that Tim and Bill are the only capital contributors – and they get back what they put in, and in an ideal world, the slate gets wiped clean with everyone at $0 (or more than $0, but in proportion) and then we start sharing 55/23/22. So I see where you’re coming from. If that is the situation we’re dealing with (no revaluation/book-up), then care should be taken that we don’t have a capital shift. But I think the preference would prevent any shift from taking place.

Sometimes, when you see these types of arrangements, especially involving start-ups or some speculative enterprise that doesn’t involve hard assets (like real estate), wherein the “idea” guy’s contribution is valued at zero, all partners will make pro-rata capital contributions with the excess cash being booked as loans.

What type of business is this anyway?

First of all, thanks for taking the time to provide the above!

The business is very simple. Trash pickup. They hire contractors to go around to apartment complexes and pickup trash. The only assets are a bank account and a 3k truck. When the partnership was created (1/1/18) the only asset was the bank account and it was a whopping $850.

FWIW, John deducted about $100k on Sch C on his 2017 return, which was funded by a loan that was subsequently paid back in 2018, when Tim and Bill entered the game. Another thing I'm worried about, debt reduction = cap gain?

This one is rough because the economics, agreement and value all say something different. There is a lot to answer but the answer from the client might just be 'they put it what they could or want to.' I haven't seen a cap schedule or value/share. Their intent in 2020 is to potentially sell to a national 'brand.' A competitor of theirs had about 5k doors they serviced and sold for 3-5M. These guys service 10K+ doors...

Do we look at the distribution provision and allocate based on liquidation?

The business is very simple. Trash pickup.

Ok. I figured this was some type of service business.

I think you ought to talk to these guys to get an understanding of the economic arrangement. These percentages they came up with weren’t pulled out of thin air (nor were the dollars). They imply a valuation in the $700k range. But I don’t know their thought process.

Since Tim and Bill put in cash, and negotiated a preferred return of that capital, it’s almost like John’s capital interest is $0 and Tim/Bill are collectively at 100%. All allocations go to Tim/Bill. When Tim/Bill get repaid, the slate is wiped clean with $0 capital across the board (or pro-rata capital across the board) and we start sharing in the agreed-upon ratios. Effectively, what John has is a carried (profits) interest.

We’d have something different if we’re saying John made a capital contribution and we’re valuing it at something.

Another thing I'm worried about, debt reduction = cap gain?

Either that or a disguised sale (non-qualified liabilities).

This one is rough because the economics, agreement and value all say something different.

That’s why you need to talk to these guys. It is very common for partners only to think in terms of profits and profit sharing. You need to pose some hypotheticals to them (one of which is reality though…the 2018 loss). Ask them who bears the economic burden of that.

I'll reach out to them and report back.