How to get paid after a flip

19 Replies

I got wrapped into an informal partnership on a real estate flip project that we are about to sell after 3 months of rehab. We split the costs 50/50 and we are about to close soon. Since the partnership/deal wasn't under a LLC structure, I'm not sure what the proper way is to get paid from this deal. The property is under my partner's name and I technically don't have my name on anything. I paid my cut of the expenses directly from my personal account to his personal account. He wants to pay me directly upon close on the HUD and I'm not sure whether to take payment directly under my personal name or take payment using my existing LLC. I'm trying to mitigate my tax burden on this deal. Any advice?

The taxes will be the same, since the money passes thru the llc to your personal return.  You need to talk to your cpa, Flip profits are subject to self employment taxes, interest income is not.

@Navid A.

Normally you use the operating agreement to determine how to distribute proceeds on flips. As @Wayne Brooks mentioned there aren't too many ways to mitigate flip income. Your only tax burden mitigation would be to receive money on the deal as a gift since you are not a listed partner on this flip, this would force the tax burden on your partner both in SE and income taxes. You can potentially get assigned the property and wholesale it to make the agreed upon money from the deal also reducing your partner's sales price. Either way you structure it you are subject to SE and ordinary income tax. 

Sales price = 200k
partner's basis = 130k

You want to split profit 50/50, he assigns the house to you for 165k and you sell for 200k. He makes 35k and you make 35k profit on the deal and are both subject to SE taxes and ordinary gains just different ways it was derived. Then going forward you can set up a more formal agreement. You can adjust to recoup expenses paid into the business.

The other way is for your partner to gift you the proceeds you are owed for your participation. He calculates what the net income would be after tax and splits your after tax portion as a gift (up to $15,000 tax free) and he takes the taxable hit for the full ordinary gains. 

@Art P.

I'd be careful with the taking the "gifting" position.

A gift is a transaction in which full consideration is not received in return.  The "quid pro quo" here is the use of capital for a return on investment.  That'll bust the gift theory pretty quickly...

I think tax treatment will ultimately follow what the "partners" in this "informal partnership" agreed to... (hint hint)

Originally posted by @Navid A. :

I got wrapped into an informal partnership on a real estate flip project that we are about to sell after 3 months of rehab. We split the costs 50/50 and we are about to close soon. Since the partnership/deal wasn't under a LLC structure, I'm not sure what the proper way is to get paid from this deal. The property is under my partner's name and I technically don't have my name on anything. I paid my cut of the expenses directly from my personal account to his personal account. He wants to pay me directly upon close on the HUD and I'm not sure whether to take payment directly under my personal name or take payment using my existing LLC. I'm trying to mitigate my tax burden on this deal. Any advice?

Your CPA or other professional will file a partnership tax return and your share of income will flow to you. You will pick up the income in your personal return. Your friend’s contribution and your cash contribution will be properly documented in your respected capital accounts by your professional. 

If you were not actively involved, make sure you are listed as limited partner as it will save you 15.3 % partnership taxes. 

There is not much you can do now to save on taxes except might establish some tax deferred retirement account ,if possible/applicable. Have to be discussed in detail with your professional even if that is possible. 

 

I would also not go the gift route, for reasons already noted.

While there is no formal LLC agreement, the IRS will respect income allocations that reflect the resulting economic impact of the deal, so regardless of whose name it is in you can treat this as any other partnership and file a general partnership / limited partnership return which reflects the actual income and economic impact. Whose name it is in is more of a legal / asset protection problem than an IRS problem - they will just follow the money.

Thank you all for the reply, appreciate the feedback!

@Ashish Acharya and @Kory Reynolds ,

Based on your guidance, for clarification, I should take the entire balance (investment + profit) under my personal name and during tax time I would need to file as a limited partner on the deal? I would really like to avoid paying the Self-Employment Tax since I didn't have an "active" role in this flip. I was more of a silent partner who contributed capital in the deal. 

The main reason I thought taking the money through my LLC was the better route was because I have more deductions through the LLC than I do under my personal name. Since I have another few months until the year end, my LLC needs to buy a few assets that can be used as deductions for the tax year. Also, my reasoning is that if the LLC receives the money, it will help qualify the LLC for any future projects with lenders and help build credibility. I only have one rental property in that LLC currently.

Really appreciate any help on this as we close on the house this Thursday. Thanks

What myself and Ashish were getting at is that you should apply for an EIN / file a partnership return that reports you as a limited partner, and reports all the activity and allocations between partners accordingly. Joint ventures/limited partnership/ whatever you want to call this are required to file partnership returns. The partnership return will record all of the expenses paid by both partners, any cash or property contributed, etc.

From there, whether the partnership passes the income to you directly or to your LLC via a K-1, the tax impact will be the same.

@Navid A. @Kory Reynolds

OP appears to have created a general partnership for tax purposes.  There are no limited partners in a general partnership, only general partners.  Therefore, OP generally doesn't avoid and has exposure to SE taxes.

Sec 1402 is distinct and separate from Sec 469.  The two contain no cross references to one another.  Therefore, it would be a mistake to attempt to apply the material participation and active participation standards of the passive activity loss rules (Sec 469) to make a self-employment tax exposure determination, which is codified under Sec 1402 and makes no reference to those terms.

Proper entity structuring might have allowed OP to avoid SE tax exposure.  It may not be too late to rectify if it's still early in the flip process.

One reason why tax planning needs to happen early in the game and not retrospectively...

Originally posted by @Eamonn McElroy :

@Navid A. @Kory Reynolds

OP appears to have created a general partnership for tax purposes.  There are no limited partners in a general partnership, only general partners.  Therefore, OP generally doesn't avoid and has exposure to SE taxes.

Sec 1402 is distinct and separate from Sec 469.  The two contain no cross references to one another.  Therefore, it would be a mistake to attempt to apply the material participation and active participation standards of the passive activity loss rules (Sec 469) to make a self-employment tax exposure determination, which is codified under Sec 1402 and makes no reference to those terms.

Proper entity structuring might have allowed OP to avoid SE tax exposure.  It may not be too late to rectify if it's still early in the flip process.

One reason why tax planning needs to happen early in the game and not retrospectively...

 I agree the claim to be a truly "limited partner" is not an easy climb with no agreement, and it is the only important one as passive/non passive does not apply to the SE tax question. It was the facts of this case that in my mind create an argument that this was a limited partnership, where no management duties were taken, and with no personal liability on the property or loan, he does appear meet a definition of a limited partner in action, even if not in document execution. If all he did was contribute capital and was at risk for that capital, there is standing to say he is a limited partner, therefore no SE tax under 1402(a)(13). Certainly if this agreement was documented it would be much more supportable.

@Kory Reynolds can you provide a citation for a code section, regulation, rev proc, rev ruling, or court case that supports the position that OP is a limited partner based on a facts and circumstances analysis that only takes into consideration the partnership agreement and dynamics between the partners?

I contend OP is a general partner in a general partnership.  Prop reg §1.1402(a)-2(h)(2) lists three scenarios that will cause an individual to not be classified as a limited partner.  The two relevant ones in OPs situation are (1) the individual has personal liability for the debts of or claims against the partnership by reason of being a partner based on the law of the jurisdiction in which the partnership is formed, or (2) the individual has authority under the law of the jurisdiction in which the partnership is formed to contract on behalf of the partnership.

Those are pretty objective standards.  Let's examine the North Carolina Uniform Partnership Act:

Except as provided by subsections (a1) and (b) of this section, all partners are jointly and severally liable for the acts and obligations of the partnership. [§59-45(a)]

Subsections (a1) and (b) relate to partners in a LLP (i.e. a legal entity) and are not applicable to OPs fact pattern.

That alone confirms OP is a general partner based on prop reg §1.1402(a)-2(h)(2) above and therefore subject to SE taxes on his distributive share under IRC §1402.

SE tax exposure analysis for partners is mainly based on jurisdictional law and not the dynamics or agreed upon dynamics between the partners. Facts and circumstances do get dragged in if we're talking about LLC members exposure to SE taxes (and there are some good court cases about that), but again that is not applicable to OP's fact pattern.

Originally posted by @Eamonn McElroy :

@Kory Reynolds can you provide a citation for a code section, regulation, rev proc, rev ruling, or court case that supports the position that OP is a limited partner based on a facts and circumstances analysis that only takes into consideration the partnership agreement and dynamics between the partners?

I contend OP is a general partner in a general partnership.  Prop reg §1.1402(a)-2(h)(2) lists three scenarios that will cause an individual to not be classified as a limited partner.  The two relevant ones in OPs situation are (1) the individual has personal liability for the debts of or claims against the partnership by reason of being a partner based on the law of the jurisdiction in which the partnership is formed, or (2) the individual has authority under the law of the jurisdiction in which the partnership is formed to contract on behalf of the partnership.

Those are pretty objective standards.  Let's examine the North Carolina Uniform Partnership Act:

Except as provided by subsections (a1) and (b) of this section, all partners are jointly and severally liable for the acts and obligations of the partnership. [§59-45(a)]

Subsections (a1) and (b) relate to partners in a LLP (i.e. a legal entity) and are not applicable to OPs fact pattern.

That alone confirms OP is a general partner based on prop reg §1.1402(a)-2(h)(2) above and therefore subject to SE taxes on his distributive share under IRC §1402.

SE tax exposure analysis for partners is mainly based on jurisdictional law and not the dynamics or agreed upon dynamics between the partners. Facts and circumstances do get dragged in if we're talking about LLC members exposure to SE taxes (and there are some good court cases about that), but again that is not applicable to OP's fact pattern.

 Eamonn - I completely agree that it is a steep hill to climb to call this a limited partnership. I will note that while the proposed reg that you cited is helpful guidance, it doesn't provide the force of law. Therefore contextually the term "limited partner" has yet to be truly defined by the regs, and we don't have to rely on this definition, so we get the benefit of looking at case law. 

In several cases regarding self employment tax where someone is tossed out because it is not a limited partnership AND the partners do not resemble limited partners -  136 TC No. 137. From that same case "the insight provided reveals that the intent of 1402a13 was to ensure that individuals who merely invested in a partnership and were not actively participating in operations (the archetype of limited partners at the time) would not receive credits towards social security coverage."

Cited in IRS Chief Counsel Advice 201640014 it is noted that "1402a13 was intended to apply to those who 'merely invested' rather than those who actively participate" - this is also based on the above case

Cited in the counsel memo above - Riether 919F Supp 2d 1140 "Limited partners are those who lack management powers but enjoy immunity from liability and debts of the partnership".

As noted - OP still has a steep hill to climb. No management participation, no liability or risk other than capital. The loan on the house is recourse to the other partner, but future lawsuits/ other issues/ if the house went under? If all debts week recourse to the other member that would support a position that OP is immune, but of course the future unknown liabilities have not been discussed. That would depend on the agreement (handshake in this case, extremely difficult to substantiate) between the members.

It would be an aggressive path to pursue without a doubt, but I think there is a narrow window IF all the facts line up.

One other item of note, while I am certainly not an attorney, the rules outlines in the uniform partnership acts of nearly all states are there to govern when no agreement exists. If there was a handshake deal, it can be enforceable as is even though it is incredibly difficult to do so. The existence of other documents also would help support - IE OPs partner's name on all the documents. Optimal? Yeah not at all ha.

@Kory Reynolds

I'm sure you're aware that Chief Counsel Advice is not authoritative guidance either. : )

That Renkemeyer case is a good find.  However in Renkemeyer the individuals formed an LLP and participated in the day to day of the business and the case was geared toward an analysis of that fact pattern although there are some good nuggets in there. A more applicable court case would be Methvin (U.S. Court of Appeals, Tenth Circuit; 15-9005, June 24, 2016) in which the individual was a partner in a GP and claimed he was a passive investor and therefore not subject to SE taxes.  

Really a deeper conversation is needed to dial everything in and I encourage OP to consult his CPA.  We are only considering, based on his posts, 50-75% of what we need to be considering.

Here's the thing: if OP had formed an LLC with his partner and wrote himself into the operating agreement as the functional equivalent of a limited partner, I'm onboard all day every day with the position that his distributive share isn't subject to SE taxes.

I don't think you have enough reasonable basis with the position that a GP in a general partnership with no partnership agreement avoids SE taxes.  Just my 2 cents.

@Kory Reynolds @Eamonn McElroy

So we established a new LLC and completed a quid claim deed transfer from my partner's name to the new LLC. So now the house in question is no longer under his name (except for the mortgage), and is deeded to the LLC. Upon closing, the plan for now is to receive the proceeds of the sale into the new bank account under the LLC. From there, we will distribute the net proceeds to one another. As for the original cost basis (i.e. my contribution to the flip expense), since I originally wired that money directly to his personal account, would it be okay if he just wired that money back through personal channels once he receives funds from the sale? We definitely realize how we should've done this, but due to timing of the deal and rapid partnership, we simply didn't have the time to structure this deal the "right way". In hindsight, I should've issued him a promissory note and "loaned" the money to him rather than a simple a wire transfer. Once again, appreciate the support guys.

@Navid A.

My colleagues did a spectacular job over-complicating a common situation that had a simple solution: report the entire deal as your partner's and have him issue a 1099 to you (or to your LLC). Yeah, I know - the letter of the law, blah blah blah. I enjoy academic discussions, too, but still prefer pragmatic ones. But alas, you already formed an LLC and deeded your property into it. Can't wait for @Eamonn McElroy and @Kory Reynolds to debate the fine points of partnership basis under the circumstances. :)

Meanwhile, I want to bring up two other issues you raised: 

"I have more deductions through the LLC than I do under my personal name." No, you don't. The deductions are exactly the same.

"I would really like to avoid paying the Self-Employment Tax since I didn't have an "active" role in this flip. I was more of a silent partner who contributed capital in the deal." Can't eat your cake and have it too. You either have active income against which you buy assets and use business deductions - and it costs you SE tax. Or you have passive income not subject to SE tax, but your ability to take business deductions against such income is limited, as well as your credit building.

@Michael Plaks Haha, I find that to be part of fun - I enjoy the technical discussions.  In the end it is great to have what is technically correct/possible, as that is what allows us to then have the pragmatic/simple approach that gives the same result.  In the end issuing the 1099 is a simple way to tackle this.  Technically correct? No. Will the IRS care?  Nope, because they will get everything that is due to them.  If he wants to explore the path of supporting no SE tax, the only way to do it is through a technical analysis. In the end the number of times I have had clients where we have a "simple" approach, and then an approach where we explore the technical nuance, often you can get a better result with the nuance. In the end since this is the internet and I am not wasting someones money by  getting into nuance they don't want to pay for I find it to be a great brain exercise. Wait until we get into the finer points of 163(j) and tax shelters!  

@Account Closed The gifting issue steps into one where maybe technically you can do it - but mixing gifting and business transactions can get messy.  If the property is partially gifted to OP, what would that make the payments made to his partner - are they business expenses or also a gift?  Is it really a gift if the only reason they are getting it is them paying the other partner to do repairs to the property?  A gift of this level would require a gift tax return as it exceeds the annual exclusion.  In the end I am far from a gifting expert - I just know enough to get a little dangerous and when to call in the experts at the firm.  The one other issue to consider would be transfer taxes - sometimes just moving real estate around can result in taxes and other legal fees, which is this applies to your state obviously you would like to avoid.  My state (NH) is a prime example - 0.75% paid by the transferree, another 0.75% paid by the transferor.

@Eamonn McElroy I was aware the IRS memo doesn't hold the force of law, but the memo did cite some great cases that do - I definitely get your point though ha, as I did not make it clear.  In the end I agree with you - more information is needed, and this could have been set up properly to avoid SE tax from day one.  Not an easy path to get there, and very likely we can't get there.  This whole case outlines why it is great to spend a little on legal fees up front and get an agreement in writing which supports the desired result.

@Navid A. It would be acceptable to move the money through back channels/personally to make it all work.  On the partnership return it could simply be displayed as contributions/distributions to make the balance sheet work (if one is even presented). Just provide all this information to your tax accountant in an organized manner (who put what into the project) and they'll be able to work through it so basis/distributions/contributions work.