Partnership - % net income vs. guaranteed payments

Technical topics regarding tax preparation.
#1
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I have an LLC currently taxed as a partnership, equal ownership percentages among three owners. But, the partners take distributions based on their relative percentage of respective revenue generation, which results in some partners receiving more than they should and others receiving less when compared to ownership percentages.

First, trying to get them to grasp that a business with multiple owners is ultimately based on the combined efforts (service and capital inflows) of the owners, and not only the relative revenue they each generate, is like pulling teeth. In other words, without all three owners being involved, the business would not be able to produce nearly the revenue and profits it is currently generating, and thus, none of the owners would realize the same overall cashflows from the partnership. They want to continue handling cash outflows to partners based on their percentages of revenue generation vs. ownership percentages. I realize this is fine for partnerships to have different distribution ratios, but it is resulting in one partner already having negative basis/ending capital balances, and in 2021, forecast is that Partner #3 would end up in that same boat.

I first thought guaranteed payments might help, but in thinking it through and doing calculations, I cannot find a balance.

I welcome any ideas on how to approach this such that negative basis can be restored ASAP and yet partners still feel like they are obtaining fair share of cash flows. But, like I said, they feel fair approach is ratio of revenue generation with no regard for actual ownership percentages on top of the fact they are in business TOGETHER. Capital contributions are a moot point, minimal to date and also equal.
 

#2
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Why not just allocate income consistent with the distribution of cash?
These folks already have a method of distributing cash that they all agree upon. I would suggest you have well underallocated income to the fellow having a negative capital account and OVER allocated to the others.
Have them modify their operating agreement to state: Taxable income will be allocated consistent with the distribution of cash. In the "distributions" section of the operating agreement: Distributions of operating cash flow to owners will reflect the proportionate generation of revenue by each partner.

This is one of the reasons I love partnerships. Accounting and taxation are very flexible and can line up well with the economics of their deal.
~Captcook
 

#3
Nilodop  
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Not to mention the disputes that will arise if when one of them leaves or they sell or close the business. They need to amend the agreement to show what they decide is the real allocation.
 

#4
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Correct, and they have already made amendments to partnership agreement (this topic is NOT one of the amendments), but more will be necessary if they do not wish to adhere to ownership ratios. I am trying to avoid partners having a negative capital balance in case they have a year of losses, which could very well occur based on other factors that may arise this year but very likely in 2022, including increased expenses stemming from 2021 that will not be paid UNTIL 2022 (cash basis). Plus, potential of bringing in additional partners or existing partners moving on.

I am not fond of seeing negative capital for a partner, which is why we are debating this subject and how to address and prevent going forward. S-Corp election is on table for 2022 with valid circumstances, but I fear they will violate S-Corp taxation if they do not get into the habit of allocating net income based on ownership ratios and appropriately utilize guaranteed payments as a partnership or salaries under an S-Corp to make cash flow to each partner as equitable as possible.

These three individuals are not closed minded, but they are certainly overwhelmed with running a business. And that is why they brought me on, but it is proving a challenge to communicate why certain things can be an issue and the potential resolutions.
Last edited by CornerstoneCPA on 7-Jun-2021 10:26pm, edited 1 time in total.
 

#5
sjrcpa  
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CornerstoneCPA wrote:trying to avoid partners having a negative basis

There's no such thing as negative basis. There is negative capital.
As CaptCook said, the income allocations in prior years were probably incorrect since they did not follow the money.
 

#6
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sjrcpa wrote:There's no such thing as negative basis. There is negative capital.
As CaptCook said, the income allocations in prior years were probably incorrect since they did not follow the money.


Yes, I am referring to capital. I realize negative basis cannot technically go below zero.

There are other factors I did not discuss that originally led to guaranteed payment discussion with client, but in looking at everything and the forecasts they provided me, I am agreeing best approach is to have them amend partnership agreement with language along the lines of what CaptCook posted.
 

#7
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CornerstoneCPA wrote:I have an LLC currently taxed as a partnership, equal ownership percentages among three owners.

I first thought guaranteed payments might help, but in thinking it through and doing calculations, I cannot find a balance.
l.


I don't understand why GPs would not work. That seems to me the most equitable way to handle SE income and capital accounts.

The partners in the CPA firm I first worked for adopted a similar method while I was with them. The idea was you reap what you sow.

The arrangement did create other issues.
 

#8
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Have them modify their operating agreement to state: Taxable income will be allocated consistent with the distribution of cash. In the "distributions" section of the operating agreement: Distributions of operating cash flow to owners will reflect the proportionate generation of revenue by each partner.


Capt -- what if the distribution of cash doesn't perfectly line up with the income recognition? e.g. cash basis income $600k, distributions $400k. One partner takes $300k of distributions and therefore gets allocated $450k of income (75% of each).

What if you have income recognition and cash distributions that lag year over year? E.g. one partner generates $1M of income in Year 1 but doesn't take the $1M of cash out until Year 2. Could you wind up with the same situation of income allocation in Year 1 not lining up with actual cash received in Year 2 when there's less income to allocate?
 

#9
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Permanently-Diff wrote:
Have them modify their operating agreement to state: Taxable income will be allocated consistent with the distribution of cash. In the "distributions" section of the operating agreement: Distributions of operating cash flow to owners will reflect the proportionate generation of revenue by each partner.


Capt -- what if the distribution of cash doesn't perfectly line up with the income recognition? e.g. cash basis income $600k, distributions $400k. One partner takes $300k of distributions and therefore gets allocated $450k of income (75% of each).

What if you have income recognition and cash distributions that lag year over year? E.g. one partner generates $1M of income in Year 1 but doesn't take the $1M of cash out until Year 2. Could you wind up with the same situation of income allocation in Year 1 not lining up with actual cash received in Year 2 when there's less income to allocate?


For scenario 1, that's generally how this works. Cash distributed almost never lines up perfectly with income to allocate so you use the proportions as you outlined. This is much more reflective of reality than the method it appears you've been using in the past.

For scenario 2, you have them put the modification to the allocation in the OA in writing and allocate consistent with their modification. As long as this it put in writing prior to March 15th, you can rely upon it. If they pay out distributions one month in arrears, then the OA could state that the income allocation for December (or any month) would be determined by the distribution of cash in the subsequent month. This is easier to determine.

Bottom line, to have an equitable allocation of income requires a conversation with them about these scenarios and how they want to handle them.
~Captcook
 

#10
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The three partners take checks each time a client payment arrives. Since these are higher dollar payments, they end up receiving only 2-3 checks per month, and it is always based on their accrued hours or budgeted hours for any particular contract. Since they are cash basis, it is not an issue when payment arrives in a different period.

I ditched the GP idea because I could not get it to work the way I was hoping vs. their desires, and they were simply having too hard of a time grasping guaranteed payments relative to the payout structure they are adamant in keeping. So, after contemplating CaptCook's suggestion, I cited IRC and suggested the amendment as the best way to handle this.
 

#11
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If they pay out distributions one month in arrears, then the OA could state that the income allocation for December (or any month) would be determined by the distribution of cash in the subsequent month.


Capt -- could the OA require the partners to take distributions? If Partner 1 decided to forego distributions for two years, how would that work in the OA? Theoretically you could take cash in down years and leave cash in up years to shift income recognition back and forth between Partner 1 and the other partners.
 

#12
Nilodop  
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Lacking in substantial economic effect.
 

#13
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That sounds like your describing what's called a "transitory" allocation, which isn't allowed.
~Captcook
 

#14
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I'm trying to wrap my mind around this. So if the OA called for allocations based on distributed cash, and one of the partners tried to do this:
Theoretically you could take cash in down years and leave cash in up years to shift income recognition back and forth between Partner 1 and the other partners.

then how would the tax preparer allocate income in one of those years? PIP? Ask the client?
 

#15
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Permanently-Diff wrote:PIP? Ask the client?

Yes.

The transitory allocation is when a partner says, I'm going to have income allocated to me next year instead of this year because it suits me better. However, when the distribution of cash is the driver, these allocations should have economic substance at all times. Remember, the distribution of cash isn't affecting the amount of income to allocate, only the proportion. To the extent one partner takes "less" in one year to lessen his tax burden, he's just borrowing from the following year when he'll have a greater share. His capital account will still be affected in roughly the same manner, which is the whole point to ensure his capital account doesn't end up inappropriately negative.
~Captcook
 

#16
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His capital account will still be affected in roughly the same manner, which is the whole point to ensure his capital account doesn't end up inappropriately negative.

Say in Year 1, Partner 1 generates $1M of income, Partner 2 generates $0. Partner 1 takes $0 distribution, Partner 2 takes $100k. Pretend there are no lagging distributions the following 1/2/3 month period, so the OA dictates you allocate all $1M income to Partner 2 and zero income to Partner 1.

Year 2, Partner 1 generates $0 and Partner 2 generates $500k. Partner 1 takes $1M of distributions, Partner 2 takes $0 of distributions. Pretend there are no lagging distributions the following 1/2/3 month period, so the OA dictates you allocate all $500k of income to Partner 1 and zero to Partner 2.

EOY 2 -- Partner 1 has ending capital of ($500k). Partner 2 has ending capital of $900k. Total income was $1.5M less total distributions of $1.1M equals total ending capital of $400k. You've allocated income based on the OA, but because of the lag in income recognition vs. cash distributions you wind up with capital not matching the economics..?

Is this result acceptable or would you need to allocate based on PIP? What would you need in the OA to correct this assuming you wanted the OA to have cash distributions based allocations?
 

#17
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The capital account DOES match the economics, though. It won't take long until P2 ends up with income recognition through distributions in excess of basis, which is an extension of the economic result.

More importantly, why would P1 agree to this? That dynamic serves as a bit of a backstop to this scenario.
In a liquidation, P2 would have a large amount of gain and P1 would have very little. Again, this is an extension of the economics.

I still wonder what else is going on to compel P1 to be agreeable to the scenario you illustrate.
~Captcook
 

#18
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I appreciate that I triggered a discussion, but it is giving me a headache.

Given my clients have difficulty grasping suggestions, I told them to read my proposed course of action twice, sit on it for a day or two, read it again, and then contact me next week with questions or to arrange a call. I like the idea, it suits their desires, and I am not quite sure why my mind did not pick up on such a simple solution in the first place. So, thanks to CaptCook for pointing out an obvious and simple solution for the scenario I described.
 

#19
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I still wonder what else is going on to compel P1 to be agreeable to the scenario you illustrate.

I think you flipped P1 & P2. Either way, I think that is the point. P2 wouldn't agree to an OA that allocates income based on cash distributions because it allows P1 to defer recognition of the income they created by leaving the cash within the partnership. P2 would want to make sure that P1 recognizes the income they generated and eventually intend to pull out of the partnership. P1 has incentive to leave cash in partnership because it defers their recognition of partnership income. P2 would also be better off.

Wouldn't an OA that allocates income based on the income each partner generates work better as it eliminates the potential lag between income recognition and cash distributions? P1 would be more inclined to take distributions with this arrangement.
 


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