Need help figuring out how my business partner will be taxed.

9 Replies

Hi,

I have a business partner who has provided money to my LLC, which I will use to invest in real estate. The agreement is that I will do the work and give them a percentage of the profits. I'm trying to figure out how they are going to be taxed.

When I give them money, are they just going to pay basic income tax? Will they be subject to self employment tax? I may be engaging in seller financing. If this is the case, they will be receiving monthly payments from my LLC. Would this money be subject to capital gains tax?

@Bob Jones

Have you asked a CPA? Better yet, your business partner should be doing the asking.

@Bob Jones

"I have a business partner who has provided money to my LLC, which I will use to invest in real estate. The agreement is that I will do the work and give them a percentage of the profits. I'm trying to figure out how they are going to be taxed."

For all intents and purposes you've created a general partnership.  A partnership is when two or more individuals/entities come together with a profit motive.  Your friend is a capital partner and you are the managing partner.

The general partnership should file a 1065 (and possible state tax returns), and issue K-1s to your SMLLC and to your friend.

"When I give them money, are they just going to pay basic income tax? Will they be subject to self employment tax? I may be engaging in seller financing. If this is the case, they will be receiving monthly payments from my LLC. Would this money be subject to capital gains tax?"

These are all really good questions for your CPA.

Generally speaking all partners in a general partnership are subject to SE taxes on their distributive share of ordinary business income. If you want to reap the benefits of IRC Sec 1402(a)(13) you may want to look into forming an LP or an LLC, with specific language in the operating agreement for the latter. Again, a tax CPA/EA who understands your facts, circumstances, and goals will be able to help out here.

@Bob Jones

I am not sure that you formed a partnership, unless your "business partner" agreed to share losses with you. If he did agree that, should your real estate investments lose money, he will then lose some of his money - than yes, it is a partnership which needs to be formalized. As @Eamonn McElroy suggested, it's best to form an LLC for the two of you (or make him a member of yours). And then get professional help, especially on the legal side. Joint deals between a money partner and a sweat partner are awfully prone to legal problems.

Otherwise, he is not your business partner but rather your lender. I actually recommend that you structure it this way if not too late.

As a lender, he will be receiving interest from you, which is not subject to self-employment tax. 

Seller-financing can create complications, depending on the arrangement between the two of you. If he is still a lender with respect to your ow-fin deals - then your payments to him are interest,

@Michael Plaks

Disagree.

A loan has distinguishing features.  Interest rate or discount, repayment terms, amortization schedule.  None of those exist here.

"The agreement is that I will do the work and give them a percentage of the profits."

Coming together with the intention to share profits = partnership.

If business partner wanted a loan and loan treatment, that should have been discussed, and OP/business partner's tax pros should have been roped in.

@Eamonn McElroy

1. See this snippet:

https://www.irs.gov/businesses/small-businesses-self-employed/partnerships

A partnership is the relationship existing between two or more persons who join to carry on a trade or business. Each person contributes money, property, labor or skill, and expects to share in the profits and losses of the business.

Are you saying that you can have a partnership where the partners share the profits but do not share the losses? 

2. Can you show me a legal requirement where a loan must have a predetermined interest rate and repayment terms and where conditional compensation such as % of profits would not qualify as interest?

@Michael Plaks

For #1, I'm saying merely not mentioning losses when they agreed to this venture does not negate partnership treatment.  Most first or second time joint ventures do not mention losses.  After all, who would enter into a venture if it's expected to lose money?

The IRS link while helpful to provide general information is not authoritative as I'm sure you're aware, and should be read in this context.

The statutory guidance on what constitutes a partnership is vague.  Instead we have to look to court precedence.

The courts have found that whether a venture is a partnership and subject to Subchapter K is "essentially a question of fact".

The Culbertson (49-1 USTC ¶9323) and Tower (46-1 USTC ¶9189) cases are the most frequently referenced here.

For #2, I'm not an attorney so I can't point to any law or statue regarding what's required in loan docs.

I think you'll have an uphill battle arguing the money is debt and not equity.  They intended to share in the profits of this new property.  What you're describing is some kind of perpetual, non-callable debt that doesn't have a stated interest or discount, doesn't obligate the debtor to make payments, and allows the debtee to share an agreed upon percentage in the profits of the property.  That sure sounds a lot like equity doesn't it?  : )

@Eamonn McElroy

Which is why I recommend that it is structured as a loan - i.e. @Bob Jones is obligated to return the money no matter what, whether or not the deal makes money. It allows him to keep control of the deal and greatly simplifies taxes and legal.

If their arrangement is true sharing, which includes both profits and losses, then indeed it's a partnership which opens a Pandora's box of tax, legal and purely operational complexity. New investors usually have no desire to deal with such complexity, resulting in a tax and legal mess.

Originally posted by @Eamonn McElroy :

@Michael Plaks

Disagree.

A loan has distinguishing features.  Interest rate or discount, repayment terms, amortization schedule.  None of those exist here.

"The agreement is that I will do the work and give them a percentage of the profits."

Coming together with the intention to share profits = partnership.

I agree with Eamonn on this. The payment to the other partner is the Percentage of the profit. If there is no profit, there is no payment. This is not debt. (I am sure he would say it was a debt, it really way). 

I despise these half pregnant deals. 

If you're sharing profits, you're in business together and the partners have risk and you've got some type of partnership or joint venture.

If you're lending money, then there should be a stated interest rate and payment terms and the income to the lender is defined interest, not a share of profits.

This lending with a share of profits - what the **** does that even mean?  Is the lender guaranteed their principal back?  Then it's a loan and for Pete's sake, paper up a promissory note and call it a loan (and don't forget to 1099-INT that thing or 1098 in the other direction)

Is the lender not guaranteed their principal back?  Then it's an investment.

I just worked through this with some clients and everybody is stuck on this Lending aspect and nobody wants a 1099MISC because now we've got SE Tax when it was "just a loan". But you're sharing the profits of a for-profit enterprise that is ordinary income. And the 1099 MISC is the best half-pregnant solution I could come up with because really everybody should be reporting percentage of financials as a JV or getting a K1 as an investor.

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