Partnership with unequal contributions

[Avs19]

A client of mine opened a bar last year with his dad. The partnership agreement states that the son owns 49% of the partnership and the dad owns 51%. It doesn't mention anything about who contributed what and that any profits or losses will be divided according to the ownership percentage. 

The dad contributed around 150K during the year to get it up and running. He did not do any of the work. The son worked there all year and the balance sheet is showing that he distributed 12K throughout the year. He did not pay himself a salary. This could be treated as a guaranteed payment. The bar generated a 30K loss in 2022 and they're talking about shutting it down in 2023. 

I'm somewhat confused on what to do with the losses on the K1's being that the contributions don't come close to matching.

If we report the losses based on the ownership percentages, the son will not be able to deduct the 15K loss and probably won't be able to deduct anything in 2023, assuming there will most likely be losses in that year as well.

Is there a way to structure this so that the dad can eventually write off 100% of his investment if the bar goes under in 2023?

[Accountant-Man]

"He did not pay himself a salary. " Good; partners cannot have salary.

"This could be treated as a guaranteed payment." Possibly, since Partner Son is working and that is how a working partner gets paid. Guaranteed payments are deducted from net income and are part of total loss of $30,000.

"The partnership agreement states that the son owns 49% of the partnership and the dad owns 51%. It doesn't mention anything about who contributed what and that any profits or losses will be divided according to the ownership percentage. " How does it says ownership is 49/51 but doesn't say contributions or profits and losses?

"The dad contributed around 150K during the year to get it up and running. He did not do any of the work." Was this money contributions or loans?

Call the partners and their lawyer for more info.

[Avs19]

Thanks for the reply Accountant-Man!

"This could be treated as a guaranteed payment." Possibly, since Partner Son is working and that is how a working partner gets paid. Guaranteed payments are deducted from net income and are part of total loss of $30,000. That's right. I'm assuming he'll have to treat the 12K as a guaranteed payment regardless being that he never contributed anything. That will increase the loss to $42K.

"The partnership agreement states that the son owns 49% of the partnership and the dad owns 51%. It doesn't mention anything about who contributed what and that any profits or losses will be divided according to the ownership percentage. " How does it says ownership is 49/51 but doesn't say contributions or profits and losses? I guess the best answer to that is that they did it themselves on Legalzoom. They did not fill in the blank that asks about capital contributions.

"The dad contributed around 150K during the year to get it up and running. He did not do any of the work." Was this money contributions or loans? I think this is the main question. There is not a formal note and there is nothing that mentions what was contributed to capital.

What we're trying to determine is the best way to structure the 150K from dad? 

Please correct me if I'm wrong,

If it's capital, the son will have zero basis, the dad will have 150K in basis. The dad can deduct his 15K loss on his 1040 and the son cannot. I'm thinking the bar will go under this year so any 2022 and 2023 losses will be completely lost by the son. Can they amend the agreement to state that all losses will flow to the dad? Does this meed the definition of substantial economic effect?

If it's a loan, they would have to create a formal note between the partnership and the dad that makes them both personally liable to the dad. Would this create recouse debt and allow both of them to deduct the losses? If the bar goes under this year, would the dad be able to write off the remaining amount of the bad debt? Not sure if the recourse part of it would interfere?

Thanks

[TaxGuyBill]

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@Avs19 wrote:

I'm thinking the bar will go under this year so any 2022 and 2023 losses will be completely lost by the son.

Can they amend the agreement to state that all losses will flow to the dad? Does this meed the definition of substantial economic effect?

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I would first back up a bit.  If the bar goes out of business, will there be assets?  I they put $150,000 into the bar, there may be assets that will be sold, creating Basis for the son to deduct losses.

Amending an agreement might be more of a lawyer situation.  And I suspect you first need to figure out what was the original understanding/agreement?  I wouldn't think you can amend things just because you realized after-the-fact that it isn't an ideal setup.

[Avs19]

I would first back up a bit.  If the bar goes out of business, will there be assets?  I they put $150,000 into the bar, there may be assets that will be sold, creating Basis for the son to deduct losses. I don't think they'll get much for the assets. Most of the 150K was for goodwill. I think they're starting to realize that they overpaid. But you're right, there could be some basis based on what they sell but I think the overall loss for the year will negate that.

Amending an agreement might be more of a lawyer situation.  And I suspect you first need to figure out what was the original understanding/agreement?  I wouldn't think you can amend things just because you realized after-the-fact that it isn't an ideal setup. To be honest, I don't think there was much of an agreement. The dad was just trying to help out his son start up a bar and forked over 150K. It's obvious that they didn't put much thought into it. They're not going to spend money on an attorney. 

[qbteachmt]

"To be honest, I don't think there was much of an agreement."

You stated, "they did it themselves on Legalzoom." Did what? You cannot state there is not much of an agreement, then pull up the Secretary of State website where they filed the LLC paperwork and are running this under an entity.

That's why the reference to a lawyer keeps coming up. They can't make an initial mess, then try to walk away to their tax benefit, and expect either process to be the right legal process.

And you mention goodwill. That implies someone sold something, they bought that something, and everyone is supposed to agree on what was purchased and by value. So that other party also has some evidence that something was in fact in place and is much of an agreement.

[Avs19]

You stated, "they did it themselves on Legalzoom." Did what? You cannot state there is not much of an agreement, then pull up the Secretary of State website where they filed the LLC paperwork and are running this under an entity. I probably should have stated that there wasn't much of an agreement as to how the 150K was going to be labled and when and how it will be paid back. There is a legal partnership agreement, it's just vague. It does not state who contributed what nor does it state how the losses should be divided.

That's why the reference to a lawyer keeps coming up. They can't make an initial mess, then try to walk away to their tax benefit, and expect either process to be the right legal process.  I'm not sure what a lawyer will do at this point. I don't think the dad is overly concerned about getting paid back. If they made a mistake by not stating who gets to report the losses then that's on them and they might not get the full benefit. I'm just trying to figure out what they can legally do?

And you mention goodwill. That implies someone sold something, they bought that something, and everyone is supposed to agree on what was purchased and by value. So that other party also has some evidence that something was in fact in place and is much of an agreement. Correct, there is a purchase contract between the old owner and the partnership. Sorry, I'm not sure what you're implying? 

[qbteachmt · Accepted solution]

"I'm just trying to figure out what they can legally do?"

Right here: "I'm not sure what a lawyer will do at this point."

You answered your own question.

"there is a purchase contract between the old owner and the partnership. Sorry, I'm not sure what you're implying?"

I'm not implying. I stated that a buy/sell means there is in fact a formal explanation that included valuations for whatever was bought. Then, Bill brought up these considerations: "If the bar goes out of business, will there be assets? I they put $150,000 into the bar, there may be assets that will be sold, creating Basis for the son to deduct losses.

Amending an agreement might be more of a lawyer situation. And I suspect you first need to figure out what was the original understanding/agreement? I wouldn't think you can amend things just because you realized after-the-fact that it isn't an ideal setup."

So far, you are asking to allocate the operating loss, which is a very small part of this entire picture. And he mentioned backing up to the original document, get it to a lawyer with the right experience, to figure out how or if they have the right info for basis, ownership, contributions, etc.

You cannot keep asking the Internet. We cannot look at all of the paperwork to tell you what they did, and we don't know the local laws, requirements, regulations, to tell you what they did not do. You keep stating both assumptions, and requests, but you need to work off of facts.

For all you/we know, their purchase included real estate that has increased 4 fold due to the pandemic and/or equipment that is not being made due to material shortages and is more valuable now than the valuation assigned in the buy/sell. We don't know anything about anything in this scenario, but it is not as simple as you stated.

[Avs19]

I appreciate you're input.

I realize the many aspects of the situation and didn't expect a concrete answer. You've given me a lot to think about.

I think the difficult part of this is that the partners didn't put a lot of planning into this and have no idea as to what they want in the end.

I'll stress again the importance of a lawyer and go from there.

Thanks again!