Once An Employee, Now A Partner
by Cliff Ennico
www.creators.com
.
This article deals with the delicate subject of how to make an employee your business partner.
#147;I run a small hardware store in the Midwest. For years I have employed a young fellow as a clerk-slash-assistant manager. Last year I became suddenly ill, and couldn#146;t work for several months. My employee really took charge and ran every aspect of the business so well our profits actually increased during my absence! Needless to say, I#146;m very grateful to this employee, and I really want to marry the guy. We have agreed to form a limited liability company (LLC) for the business, and that we split everything 50-50 from day one. My accountant had a conniption, however, when I told him about our agreement. How can I do the right thing by this employee, to whom I owe an awful lot?#148;
Well, your accountant shouldn#146;t have freaked out, but I understand his concern. The problem is our wonderful Tax Code, which will require your employee-slash-partner to pay something for his 50% interest in the LLC with money he presumably does not have.
Let#146;s say your business is worth $100,000 right now. You form your LLC, contribute your $100,000 in assets to the LLC capital, and take back a 50% interest. That means your employee, in order to justify a 50% ownership stake, has to contribute $100,000 to the LLC capital as well. If he doesn#146;t, he will be considered to have received a $100,000 #147;gift#148; from you, and he will have to pay taxes on that. Unfortunately, the IRS puts a zero value on his past (admittedly wonderful) services to your business, since you already paid him for those when he was an employee. Likewise, his future services to the LLC won#146;t count towards the $100,000 value of his 50% stake.
There is a way to do what you want to do, if your employee is willing to go along. You can form the LLC, contribute your $100,000 in business assets to the LLC capital, and split the ownership 50/50 with your employee, but include a #147;preferred distribution#148; clause in your LLC Operating Agreement (that#146;s like a partnership agreement between you and the employee). A #147;preferred distribution#148; clause says that notwithstanding your agreement to split everything 50/50 with the employee, for a limited time you will be entitled to take out 75% or 80% of the LLC profits until such time as these #147;excess cash distributions#148; total $100,000 plus interest at a reasonable rate (5% or 6% per annum at the time this article is being written).
By doing this, you and the employee will be 50/50 owners from day one, and the employee will #147;buy#148; his way into the business by giving you the #147;preferred distributions#148;. Once your 25% or 30% #147;preferred distributions#148; total $100,000 plus interest, the #147;preferred distributions#148; will cease and each of you will be entitled to take 50% out of the business#146; profits each year. It#146;s the same as if you had loaned the employee $100,000 to buy his 50% of the business, and he is repaying the loan with interest out of his 50% share of the LLC profits.
Of course, you need to make sure your employee can live on the 20% to 25% of the LLC profits remaining after your #147;preferred distributions#148;. You should also check with your accountant to make sure each of you will be taxed on only the income you actually receive from the LLC -- in other words, that your employee will be taxed only on the 20% to 25% of the LLC profits he actually receives during the first few years, not the full 50% to which he is entitled under the LLC Operating Agreement. If that#146;s a problem, you will have to come up with a creative way to get money back into the employee#146;s hands so he can pay taxes on the #147;phantom income#148; (the difference between his 50% share and the 20% to 25% he actually receives).
Don#146;t forget to have your lawyer draw up a Buy-Sell Agreement between you and your new partner #150; this will protect both of you in the event one of you dies, becomes disabled, retires or otherwise ceases to become actively involved in the business at an inconvenient time. If you#146;re new partner is significantly younger than you (as I suspect from your e-mail), I would also take out a policy of life insurance on him, naming yourself as beneficiary. That way, if something bad happens to him, you can use the proceeds of the policy to buy back his 50% interest in the LLC without having to dip into the LLC#146;s operating capital.
Cliff Ennico (
cennico@legalcareer.com
) is a syndicated columnist, author and host of the PBS television series 'Money Hunt'. This column is no substitute for legal, tax or financial advice, which can be furnished only by a qualified professional licensed in your state. To find out more about Cliff Ennico and other Creators Syndicate writers and cartoonists, visit our Web page at
www.creators.com
. COPYRIGHT 2005 CLIFFORD R. ENNICO. DISTRIBUTED By: Creators Syndicate. Permission granted for use on DrLaura.com
