LIMITED LIABILITY COMPANIES – WHAT IS A QUALIFIED INCOME OFFSET?
Have you ever used a boilerplate LLC Operating Agreement for your business? Have you ever wondered about some of the drastic legal consequences that the boilerplate language in such operating agreements can have for your business? Consider the following hypothetical, which pertains to the economic structuring of an LLC. Most operating agreements have standard boilerplate language related to respective member allocations and distributions. Among those provisions, one often finds a clause pertaining to qualified income offsets. What is the meaning of this provision in the context of a two-member LLC? Lets examine how this scenario plays out in the following hypothetical.
Trump and Jim decide to form Top Real Estate Investors LLC, a Virginia-based member-managed limited liability company that provides cheap construction materials to real estate investors in Northern Virginia. They did not want to pay any attorneys or accountants to help them draft the operating agreement for their LLC, so Jim came up with a brilliant idea to cut and paste a standard form LLC operating agreement he had found on the internet.
No one understood the meaning of terms like “capital accounts,” “special allocations” and “qualified income offsets,” but they decided to go ahead and adopt the operating agreement for their LLC anyway. They both wanted to share profits equally, a “50-50 split,” as Trump put it. How hard could that be, right?
Since Jim had some money, he decides to contribute $100,000 to the LLC whereas Trump contributes no money. Instead, he promises to contribute his computer skills to help market the company over the internet.
Soon enough, the business venture turns out to be an absolute disaster and both Trump and Jim realize that this was a bad idea to begin with. So, they decide to sell the business for a measly sum of $ 20,000 (an $80K loss!). Who gets what upon the sale of the business?
Jim gets $20,000 whereas Trump gets nothing – zilch!
Although Jim was somewhat happy with this result, Trump was furious. “Where’s my $10K you thief?” he yelled at Jim. Sadly, as Trump later found out through his attorney, the “qualified income offset” provision in the operating agreement mandated this seemingly unfair result. Further, Trump’s attorney helped clarify some of the complex accounting language in the LLCs operating agreement.
First, the attorney explained that the operating agreement called for the creation of a separate “capital account” for each member, which keeps track of each member’s respective contributions to the company and all distributions made to such member by the company. Each member’s capital account is credited with the amount of his contributions to the LLC.
The difference between allocations and distributions, the attorney explained to a confused Trump, is that profits and losses of the LLC are allocated to the respective members capital accounts. If the operating agreement is silent on how profits and losses of the LLC are to be allocated, then the default provisions allocate profits and losses in proportion to the value of the contributions made by each member. Thus, each member’s capital account is increased by the member’s share of the LLCs profits and decreased by the member’s share of the LLCs losses. Distributions, on the other hand, are made from these capital accounts.
Since Jim had initially contributed $100K, his capital account balance was $100K. Similarly, Trump’s capital account was zero because he did not contribute anything to the LLC. When the business was sold for $20K for resulting in a loss of $80K, the qualified income offset provision kicked in, which allocated the entire $80K loss to Jim’s capital account for tax purposes. This reduced his capital account balance to $20K, whereas Trump’s balance was still zero.
When the LLC was finally liquidated, Jim got $20K and Trump got nothing.
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