In the world premiere of Toni Talks, Toni Covey, Anderson’s Director of Professional Services and an enrolled agent (EA), invites special guests Aaron Soffer, Esq. and Jeff Webb, CPA to discuss the ins and outs of taking on investors in your business.
Updated September 16, 2020
Investors and small business owners know that not every investor can self-fund every deal every time. Sometimes, investors need to bring in others to take down bigger deals. There are different ways to structure deals with multiple involved parties, so let’s look at some of the ways this can play out.
Broadly speaking, a joint venture (JV) is an agreement between two or more parties with a common goal. There are two sides to consider with joint ventures: the legal liability side and the tax side. There are different ways to structure and organize a joint venture, so it’s important that you speak with a qualified professional when starting any JV.
Let’s use real estate as an example. One common JV scenario involves one party to the JV as the real estate developer and one party (or more) as the funder. The developer may find the deal, but may not have the means by themselves to complete the project, so others are brought in. In a traditional JV arrangement, the developer takes title to that property into their own entity.
Other times, however, we see clients going into legal contracts without legal entities intact. A partnership can be formed without an entity; however, it’s far from advisable. Without a legal entity or a JV operating agreement, the JV is likely headed for disputes and is exposed to liability.
When bringing in additional funders, it’s critical that you think things through fully and draw up an operating agreement that clearly outlines your arrangement. Your JV operating agreement should answer questions like: how will profits and losses be shared? What will the JV look like? Who will have control?
Sometimes, we’ll see JV operating agreements that have the two unrelated parties listed as 50/50 partners, but then one partner has put in $100,000 (for example) and another has contributed sweat equity. This is basically a profit partner and, when you do this, you have to look at the fair market value of the services performed. If that partner chooses to recognize the income in the year the services were actually performed, then that partner will have a basis in the partnership. This, in turn, affects the allocation of losses and profits.
Partnerships and S-corporations are a lot alike. Both are flow-through entities and both are divided based on ownership. One difference, however, is that partnerships offer more flexibility in how income and capital is divided. It does not have to be pro-rata. For instance, you could form a partnership wherein one partner takes 100% of the profits and the other takes 100% of the losses.
Ultimately, it’s essential that any JV has a clear JV operating agreement. Disputes will almost undoubtedly arise, and the operating agreement will dictate how these disputes are resolved.
If an investor wants to take down a bigger deal and bring in more than a couple of partners, that’s when we’re thinking about syndications. The main differences between joint ventures and syndications are the amount of money coming in and who contributes funds. Ultimately, the difference comes down to the scale of the deal.
Ideally, syndications will involve unrelated parties with whom you do not have a previous relationship. At this point, you’re selling securities, so the Securities & Exchange Commission (SEC) is in charge. There are strict rules that must be followed as set by the SEC.
At Anderson, we are more than happy to help set up a JV LLC to own the syndication; however, we’ll always recommend you talk to an SEC attorney to actually set up your syndication to ensure you follow the letter of the law.
There are two different types of syndications: those that involve accredited investors and those that involved unaccredited investors. There are tests to determine whether an investor is accredited or not. When you see syndications with unaccredited investors, that’s usually when family or friends are involved. My advice on this is: if someone’s asking you to invest in their syndication and they don’t ask for an accreditation letter, steer clear. You probably don’t want to invest in that deal.
There are two main structures for syndications: limited partnerships (LPs) and LLCs. When it comes to taxation of syndications, there isn’t a whole lot of difference between syndications and other partnerships. As the administrator of a syndication, you’ll share the income just like the other involved investors, but you’ll be able to take a portion of the income for administering the syndication. As the sponsor, your income from the syndication would be considered active, whereas the investors’ income is passive.
Overall, working with other investors can open up more possibilities for your deals. With that being said, it is critical that you work with a competent professional when creating any type of partnership, joint venture, or syndication. This is not an area where you want to do-it-yourself.
As always, take advantage of our free educational content and every other Tuesday we have Toby’s Tax Tuesday, a great educational series. Our Structure Implementation Series answers your questions about how to structure your business entities to protect you and your assets.
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