I’ve been working on LLC Operating Agreements for a variety of client types recently. Each poses its own challenges with risk and potential financial reward – sometimes connecting maximum flexibility with maximum uncertainty (in ways that established business clients might not appreciate).
Two Client Types, Two LLC Operating Agreement Needs:
1) The experienced business people, perhaps starting a new partnership in a familiar business field or leaving an employer to have their own small firm again. They may be happy with “the usual” buy-sell terms (redemption or cross-purchase on death, disability, termination of employment, certain other events) and allocation of profits and losses in accordance with percentage interests. Maybe, if they really want to be “equals” and choose one of the lawyer’s least favorite things – 50/50 voting, they’ll need a deadlock provision or a “shotgun” clause (layperson translation – I don’t like you anymore, buy me out or I’ll buy you out).
In some cases, while the mature business person presents more opportunities for tax, succession and estate planning due to the income they generate from their line of work, these clients may wish for more streamlined LLC tax treatment – just allocate that profit and loss ratably, make distributions for tax payments, and let us run with the business. They can turn to onshore and offshore investments and to their estate plans for tax savings or deferrals – or to attorney-structured small business or professional practice retirement and benefit plans – and may desire much more creativity in structuring a future transition of the business. Their risks may be less in the LLC’s day to day governance than in their field of expertise or market.
2) The startup, founded on technology or other idea capital, some cash, and high hopes for grant funding or later investors or market success. These founders may be much more interested (especially if they read startup and venture advice) in controlling near term equity vesting under something like the “4 years + cliff” concept (equity starts vesting after a 1 year wait, then 25% year) to avoid founders departing early and expecting to be paid for their equity. Though in all honesty, in a startup, what is that vested equity worth in years 2-4? It depends on book value, assets, EBITDA or another objective measure and it may not be as much as insiders think or hope.
These founders, if only one or two are cash contributors, may wish for more customized and technical partnership tax allocations, such as targeted allocations for early repayment to investors, or allocation of losses in accordance with capital contributions. Or maybe the higher income bracket parter wants losses first, and then profits to repay the losses, or something else custom-drafted. Their potential reward (starting from zero, or close to it) may be huge, and with it the risks of failing to launch, or scale. Different risks from the established going concern, and different desires for structural planning.
I spent some quality time with the 704 Regs yesterday (an activity that can lead one to wonder what cosmetic dentists and investment bankers do during the day), looking into evaluation of “substantial economic effect” of certain types of loss allocations to cash contributing founders. In layperson’s terms, looking at substantial economic effect asks “can we do this and not be in trouble with the IRS?”
The 704 Regs, or that part of federal Partnership Taxation that is to “simple LLC planning” what fugu is to sushi, govern how much creativity a tax planner may have in allocating items of profit and loss in (non-standard ways. The density of the Regs and difficulty of the material give attorneys and accountants just enough ability to be creative to open up audit land mines. No easy answers here, everything is fact and circumstance dependent.
What caught my eye, from one of the 704 Regs and the IRS audit techniques manual, was the discussion of transitory allocations (the IRS example is all losses to the higher income tax bracket partner, then all profits, in a highly speculative new startup with no guarantee of any profit). The winning fact and circumstance that gave the custom-crafted transitory allocation “substance” was the presence of sufficient levels of risk so that no prediction could be made on profits offsetting losses in the first 5 years. There might be nothing but losses. The business might not make it to year 5. There is a certain irony to offering the greatest ability to creatively plan for profit and loss allocation to the business that might benefit from it less (profits? what profits?). There is also a philosophical consistency with the Code’s and IRS’s desires to disallow tax avoidance.
In any case… each business is different and each stage is different. What flies for the founder putting $25,000 into a startup, and hoping not to lose it all (at least without getting some deduction or offset) may not fly for the experienced professional starting a new LLC, but not a new line of work. It’s all facts and circumstances, no easy answers here, but specialist know where to find the few answers or guideposts that exist.