New 1065 w/ Capital Contribution not Equal to Ownership %

Hi folks,

New guy here hoping to get some help and hoping to contribute!

I am looking for some guidance on how to properly complete a 1065/K1's for a new client. This guy called me on Friday (3/13) to ask me to do their taxes (lol). I filed an extension and told him I would get to it this week.

A little about my self:
I'm a CPA with 12 yrs background in corporate accounting, finance, and FP&A. I started my own consulting + outsourced controller and CFO a few years back, and started doing bookkeeping and taxes a couple years ago.

Here's the facts:

1. TX LLC setup 2019 to be taxed as Partnership (initial return)
2. The client that came up with the business idea was able to get a few partners through networking events and social connections. He and the partners agreed to a $1M valuation for the business.
3. There are 4 partners involved:
Partner A (ind) - (the guy that came up with the business idea) - contributed $100k capital, owns 81% equity
Partner B (ind) - contributed $20k, owns 2% equity ($1M valuation)
Partner C (ind) - did not contribute capital, is contributing "sweat equity", owns 16% equity
Partner D (S-Corp) - contributed $10k capital, owns 1% equity

I'm not sure how to properly setup their K1s to properly reflect ownership.

I have done several 1065s but all of them were partners that contributed capital that was inline with their ownership % and valuation.

The owner also tells me that there is a 2 year vesting period. I asked for a copy of their operating agreement, there is nothing in there about vesting.

Thanks!

There should be an award letter/agreement for Partner C. That may have vesting.
You absolutely need the OA. You get to look forward to special allocations, targeted capital, etc.

What else was contributed by A that made the value $1 million?

There should be an award letter/agreement for Partner C. That may have vesting.
You absolutely need the OA. You get to look forward to special allocations, targeted capital, etc.

What else was contributed by A that made the value $1 million?

I will ask about an award letter/agreement, but I'm doubtful that they have one.

Partner A's other contribution would essentially be his sweat equity and time.

I want to add that they only had 2 transactions totaling $11k during 2019. I figure I can get the initial filing setup correctly, and then get some education on how to continue filing properly between now and the next filing (TY2020).

With those non pro rata capital accounts you are probably looking at special allocations of income.

You really need to determine what Partner C received. This will drive much of the remainder.

Here's my guess, to play out an example....

Let's say Partner C received nothing but a profits interest. That is, if the entity liquidated on Jan 1, 2020, he would be entitled to no cash.
I'm also going to assume the 2 transactions you noted above are income transactions, loss would be different.
Profit percentages would be:
A= 81%
B= 2%
C=16%
D= 1%
Income of $22,000 is allocated:
A= 17,820
B= 440
C= 3,520
D= 220
Ending capital would be (on a 704(b) basis):
A= 887,820
B= 20,440
C= 3,520
D= 10,220
Capital percentages would be simply to find the ratio of the ending balances to the total. As you can quickly see, Ptr A's 704(b) capital is dramatically different than his tax capital and tax basis.
I've also not accounted for any 704(c) allocation, which would be very likely in this kind of setup.

One other scenario, is that Partner C received a grant of a "full capital" interest of 16%. This is much less friendly to him tax-wise.
In that case, there would be a guaranteed payment of $160,000 to him (16% of a $1M valuation) and this would be his starting capital account.

Search for 704(c)...there are some great discussions and other examples provided by Jeff-Ohio that can further illustrate the point.

I figure I can get the initial filing setup correctly

You’re not quite there yet. Everybody here is leading you in the right direction and you have to get this right from the beginning.

It might be that the operating agreement is insufficient…and is not adequately capturing the economic arrangement/understanding among the partners. Or, it might be that you overlooked something in the OA, like if there’s a second class of interest (Class B) that might be a profits interest. That point is specific to Partner C. Others have already said this. You’ll also have a 704c issue here (which gets disclosed on the K1’s). There’s a $1m valuation and not $1m of cash/identifiable property being contributed. Mr. A is contributing something more than Cash, it seems to me. Sounds like he’s the idea guy. Not sure if allocations in the OA are Targeted or something different.

You really need to determine what Partner C received. This will drive much of the remainder.

Here's my guess, to play out an example....

Let's say Partner C received nothing but a profits interest. That is, if the entity liquidated on Jan 1, 2020, he would be entitled to no cash.
I'm also going to assume the 2 transactions you noted above are income transactions, loss would be different.
Profit percentages would be:
A= 81%
B= 2%
C=16%
D= 1%
Income of $22,000 is allocated:
A= 17,820
B= 440
C= 3,520
D= 220
Ending capital would be (on a 704(b) basis):
A= 887,820
B= 20,440
C= 3,520
D= 10,220
Capital percentages would be simply to find the ratio of the ending balances to the total. As you can quickly see, Ptr A's 704(b) capital is dramatically different than his tax capital and tax basis.
I've also not accounted for any 704(c) allocation, which would be very likely in this kind of setup.

One other scenario, is that Partner C received a grant of a "full capital" interest of 16%. This is much less friendly to him tax-wise.
In that case, there would be a guaranteed payment of $160,000 to him (16% of a $1M valuation) and this would be his starting capital account.

Search for 704(c)...there are some great discussions and other examples provided by Jeff-Ohio that can further illustrate the point.

Thank you for walking through that example.
The transactions that took place were actually expenses, so they incurred a loss for 2019.

I'm assuming it's different in loss because the non-capital contributing partner's basis can't go below 0, correct?

In terms of basis in the example above, if I'm reading that correctly their starting basis would be $900K (Total $922k final basis less the $22k profit). Basis for B,C,D makes sense, but I am not clear on A's starting basis of $870k - if you could please walk me through that?

I figure I can get the initial filing setup correctly

You’re not quite there yet. Everybody here is leading you in the right direction and you have to get this right from the beginning.

It might be that the operating agreement is insufficient…and is not adequately capturing the economic arrangement/understanding among the partners. Or, it might be that you overlooked something in the OA, like if there’s a second class of interest (Class B) that might be a profits interest. That point is specific to Partner C. Others have already said this. You’ll also have a 704c issue here (which gets disclosed on the K1’s). There’s a $1m valuation and not $1m of cash/identifiable property being contributed. Mr. A is contributing something more than Cash, it seems to me. Sounds like he’s the idea guy. Not sure if allocations in the OA are Targeted or something different.

You're right... I feel like a toddler among giants in this topic.

I will take another look at the OA, but I think it's very basic and I think actually stale. Infact, their contributions and agreed upon % are even different from the OA.

I will ask about a specific agreement for partner C and look into more 704(c) examples to further my understanding.

What I meant is that at this point I just need to be able to get their initial 1065/K1s right and then I have time to delve deeper into the details of 704(c)... but I might still be thinking it's simpler than it really is.

Until you figure everything out I don't see how the initial K-1s will be correct, even with a loss.

Until you figure everything out I don't see how the initial K-1s will be correct, even with a loss.

Agreed
As Jeff noted above, this first k1 sets the stage for every other one

Will do. I'll get them to clarify ownership and provide documentation matching what they've agreed upon. Will update as soon as I know. Thanks all!

Hi all, I wanted to follow up now that I've got confirmation on a couple things:

Partner A is idea guy. Parters B/D are just money. Partner C is sweat equity by building out their online platform.

For Partner C he's considered a capital partner from Day 0 - so if they sold tomorrow at $1M, he would get $160k. His profit/loss interest vests monthly over 2 years to reach 16% at the end of year 2 (Increase 0.7%/mo over 24 months).

From what I'm reading this would be the setup:

Partner A - Starting Capital $810K (built in gain of $710k) - capital 81%
Partner B - Starting Capital $20k (no built in gain) - capital 2%
Partner C - Starting Capital $160k ($160k built in gain) - capital 16%
Partner D - Starting capital $10k (no built in gain) - capital 1%

Partner A - Starting Profit/Loss 96.43% @ 11/1 -> 95.14% @ 12/31 => avg 95.79%
Partner B - Starting Profit/Loss 2.38% @ 11/1 -> 2.35% @ 12/31 => avg 2.35%
Partner C - Starting Profit/Loss 0% @ 11/1 - > 1.33% @12/31 (partner was in for 2 months) => avg 0.67%
Partner D - Starting Profit/Loss 1.19% @11/1 -> 1.17% @ 12/31 => avg 1.18%

Partnership Items (expenses) result in $11,000 loss

It feels like I would just allocate the loss across all the capital accounts straight forward, ie:
Partner A - ($10,536)
Partner B - ($259)
Partner C - ($73)
Partner D - ($130)

The examples I looked at were all related to property contributed to partnerships that had built in gains or losses once they disposed of the property. It wouldn't apply here, but the tax basis vs book basis has to be right for the day when they do eventually sell. I also looked at examples of of how depreciation would be allocated, but depreciation doesn't apply here.

I guess - is the above the right way to allocate the loss, or should I be allocating against the built in gain first?
I suppose it depends on what allocation method they're electing under 704c?

Thanks in advance

Partner A is idea guy.
Partners B/D are just money.

Ok...no problem there. Figured that much.

Partner C is sweat equity by building out their online platform.

For Partner C he's considered a capital partner from Day 0 - so if they sold tomorrow at $1M, he would get $160k. His profit/loss interest vests monthly over 2 years to reach 16% at the end of year 2 (Increase 0.7%/mo over 24 months).

I'm going to stop there. If you sell at $1M, that's one thing. What if things liquidate (instead of sale) and capital goes back to money guys? What would happen then for C?
Additionally, you mention his interest vests 0.7%/month, but that he would receive 16% of a sale tomorrow. That is inconsistent.

In liquidation he'd get $0.
If sold today @ $1M he'd get $160k
His profit/loss interest vests at 0.7%/month up to 16%

The client (Partner A) keeps calling it ownership, but what he's describing is like a bonus if it sold before Partner C was fully vested.

I still feel that's inconsistent.
What's the point of the vesting, if C gets full 16% profit in a hypothetical sale now?
That doesn't sound like vesting.

Is he being paid a GP of $80k/yr in cash currently?

No cash/guaranteed payment being paid out currently to Partner C.
They don't think a sale is going to happen before the vesting period but if it did Partner A would be generous to Partner C and pay him out $160k on a $1M sale.

No cash/guaranteed payment being paid out currently to Partner C.
They don't think a sale is going to happen before the vesting period but if it did Partner A would be generous to Partner C and pay him out $160k on a $1M sale.

Ok, I think that is helpful. There is no legal obligation of the partnership to pay C $160K currently before vesting, but he might...At that point.

So, I would interpret that as a "profits only" interest to C which increases over the vesting period.

Go back to the figures in post #12 and recast that except C has no capital account and is allocated no loss ("profits only interest"). Remember, he has no basis to be allocated a loss anyway.
I usually advise my clients to have a provision in their operating agreement to allocate the first profits (after losses) back to the partners who received the losses and make them "whole" before allocating profits to any other partner.

No cash/guaranteed payment being paid out currently to Partner C.
They don't think a sale is going to happen before the vesting period but if it did Partner A would be generous to Partner C and pay him out $160k on a $1M sale.

Ok, I think that is helpful. There is no legal obligation of the partnership to pay C $160K currently before vesting, but he might...At that point.

So, I would interpret that as a "profits only" interest to C which increases over the vesting period.

Go back to the figures in post #12 and recast that except C has no capital account and is allocated no loss ("profits only interest"). Remember, he has no basis to be allocated a loss anyway.
I usually advise my clients to have a provision in their operating agreement to allocate the first profits (after losses) back to the partners who received the losses and make them "whole" before allocating profits to any other partner.

Thank you. Makes sense.

It’s a little hard to follow, since I’m not sure what specific paperwork/provisions exist and since you’ve been somewhat inconsistent in your comments, as pointed out by Captain.

Normally, the Profits Interests for the SP’s (service providers) are established as a second class of interest in the Operating Agreement (Class B, for example). They are granted and unvested. To ensure they meet the requirements of a profits interest and do not represent capital interests, a Distribution Threshold is set. If we have a $1m value, that would be the threshold. Profit Interest holders don’t get a thing until value rises above $1m. 83b elections are made, protective or otherwise.

It's really hard to say if your guy has a restricted capital interest or a profits interest.