One side effect of the growing use of LLCs in startup companies is the general unfamiliarity of most first-time founders with the quirky side-effects of partnership taxation of LLCs. The most annoying of these for companies is usually that members, no matter how small their equity stake, can not be employees of the LLC. This rule complicates things because people are used to the idea that they can use salary as a mechanism to differentiate among types or amounts of work between different founders. (The tax differences for employees who hold equity require further tweaking of the system as well).
Models for differentiated compensation
There are a few different models that people use to compensate a working founder. (NB: these apply to any reason for differential compensation, but let’s solve one problem at a time!)
In most cases, the founder wants to treat the payments like a salary, which is what the normal model would be in a corporation. In that case, a traditional guaranteed payment, option A, is the first structure the team would examine.
A. Guaranteed payment
This term of art means a distribution that is made to a member without regard to the profits or losses of the company; it is treated as an operating expense for the purpose of determining profits and losses. The receiving member includes the distribution in that member’s tax filings as appropriate. These additional distributions do not affect the equity stakes of the various members, but they do affect capital accounts. So, allocations of profits and losses are unchanged.
B. Minimum payment
This approach sets a floating cap for the amount of the guaranteed payment. Here’s the IRS example:
Under a partnership agreement, Divya is to receive 30% of the partnership income, but not less than $8,000. The partnership has net income of $20,000. Divya’s share, without regard to the minimum guarantee, is $6,000 (30% × $20,000). The guaranteed payment that can be deducted by the partnership is $2,000 ($8,000 − $6,000). Divya’s income from the partnership is $8,000, and the remaining $12,000 of partnership income will be reported by the other partners in proportion to their shares under the partnership agreement.
If the partnership net income had been $30,000, there would have been no guaranteed payment since her share, without regard to the guarantee, would have been greater than the guarantee.
The next two options are not guaranteed payments. They are changes to the distribution of cash. Guaranteed payments are treated by the company as expenses, meaning that they are distributed first, and then the company’s profits available for allocation are calculated, and so on with the distributions. In other words, they take money off the table before it flows into the typical distribution waterfall provision. The following options instead simply change the way in which cash is distributed, as a way of changing the economic returns of a member, even if the overall ownership percentage isn’t changed.
C. Priority Distribution
This approach works like a minimum payment, except that it means that once an amount of distributable cash is determined, that cash is not simply distributed pro rata but that some percentage or amount goes first to the member providing services and then the remainder is distributed as agreed. So, if only a small amount of cash is distributed, it goes to the priority member first, and the other members may get no distribution. Their capital accounts will increase as a result of the allocation of profits, and they will pay tax on that income; they will later be able to receive a distribution of that profit tax-free. Typical structures include:
1. a fixed amount, similar to Option B
2. a percentage of an investment (functioning like a 6% dividend)
3. a percentage of the distributable cash.
This approach is sometimes tied to a similar allocation so that members do not suffer a disparate tax effect: no one likes to pay cash taxes on non-cash income. In that case, it becomes Option D.
D. Preferential distribution
This term means that before the other members get a distribution, the member providing services gets an additional distribution.
The difference between Options C and D is that C is intended to change only the order of distributions and not the final amount to which a member is entitled; D is intended to change the amount of total distributions. This question – order vs amount – is helpful in determining the intent of the parties.
Option A, a guaranteed payment, is the option that is most like a salary, and the one that best compensates members providing services as compared to those who do not (for example, if the company has an investor, that person would not typically get a guaranteed payment because she wouldn’t be working in the business on a daily basis).
Keep in mind, too, that these techniques are used in other situations to create differential cash flows among members of an LLC, including between members and investors. For example, Option D, the Preferential Distribution, is the way we implement a standard liquidation preference.
One final illustration, with two founders, Alice and Bob:
Assume guaranteed payments of $100k per year, a 50–50 split on profits, $200k profits each year, all cash distributed, and a sales price after two years of $2m.
At the end of year 1, Alice will have received a $100k guaranteed payment, and each of Alice and Bob will have been allocated $100k of profits, with $100k of profits distributed to each. Total for Alice is $200k and Bob $100k. Alice’s capital account will be ($100k) and Bob’s will be $0. (These capital account figures will typically affect their final tax situations at sale, which is a topic well beyond this post. Suffice it to say that the IRS will keep track that Alice got the extra $100k and find a way to tax it at some point.)
At the end of year 2, Alice will receive a $100k guaranteed payment distribution, and each of Alice and Bob will have been allocated $100k of profits, with $100k of profits distributed to each. Total for Alice is $200k and Bob $100k. The company’s proceeds of $2m are allocated 50–50, with $1m of income allocated to each of them and $1m of profits distributed to each of them.