Clients frequently seek legal advice when they are considering the start-up of a new venture or investing in an existing business. Challenging aspects of these deals include the tax issues that arise by virtue of different investors contributing different mixes of resources to the venture.

Consider that some clients are the idea people who hold a patent or copyright or perhaps just have an idea in the conceptual stage. Others will provide tangible capital needed for the new business in the form of cash, real estate, equipment, etc. Others may contribute knowledge or other assets, such as a customer base, industry know-how and experience, a great “Rolodex” of contacts, or even an existing business with goodwill value. Then there are the service providers–those who contribute no property or capital but who will bring the “sweat equity” needed to convert tangible and intangible property into profits.

All of these clients could incur tax burdens differently, depending somewhat on the form of entity being created in order to conduct the venture. Selections include different types of corporations, limited liability companies, limited partnerships, or perhaps no entity at all in certain situations. In planning the formation of the entity, each participant must be careful not to trigger immediate income tax liabilities when contributing the property or services.

Federal tax law contains many intricate and detailed provisions governing the tax treatment of receiving an ownership interest in a new venture. The rules differ somewhat depending on whether the venture is in the form of a corporation or an entity taxed as a partnership (which includes limited liability companies). However, certain general principles apply to both.

For example, if an investor is awarded an ownership interest by contributing only services to the venture (whether the services were already performed or are to be performed in the future), that person will probably have to include the value of the ownership interest in taxable income. This is rarely a desired result. This treatment differs dramatically from that of a person who contributes property to the venture, whether that property is tangible (real estate, equipment, cash) or intangible (intellectual property, patents, copyrights). Generally a contribution of property to a new venture, in exchange for an ownership interest, is a non-taxable event.

There are, of course, exceptions to these general rules, including a couple of common techniques for the “service partner” to avoid suffering immediate taxation on the receipt of the ownership interest. One way is to subject the ownership interest to a “substantial risk of forfeiture.” For example, the shareholder or partner in the venture may have to wait for a period of years until free control of the interest is granted. The ownership interest might be contingent on continued employment or the venture achieving certain profitability goals. If the contingencies are not met, the ownership interest might be subject to partial or total forfeiture. Until that restriction is lifted, the holder of the interest is not taxed on the value of the interest.

Another method to avoid immediate taxation applies to members of LLCs and partners of partnerships. The owner could receive a “profits interest” in the venture, rather than a full ownership interest. Immediate income taxation is avoided when receiving a profits-only interest. However, there is a trade-off in that the holder of the profits interest will not fully participate in distributions upon a capital event such as the complete sale of the business or liquidation of the venture.

Even further complications must be addressed when a restricted ownership interest is granted to a participant in the joint venture that is taxed as a flow-through entity (such as an S corporation or a partnership). During the restriction period, there is an issue of who is allocated income on the IRS Form K-1 from the venture. A recent U.S. Tax Court case addressed this issue where an individual executive received a 2% interest in a joint venture, conditioned on continued employment in the venture. The tax advisors of the venture prepared the partnership tax return for the first two years and issued a Form K-1 to the executive, causing him to pay personal income tax on 2% of the profits of the venture. He later contested this result, arguing that as a restricted owner he should not be allocated any profits during that period. The Tax Court agreed with the executive and concluded that, under federal tax law, he was not to be treated as a partner of the partnership for income tax purposes during the period when he could forfeit the ownership interest.

This discussion touches the surface of the types of tax issues that participants will face in the formation stage of a joint venture. There are more in-depth issues that will need analysis to ensure that each participant does not receive an unpleasant surprise when it comes time to report the tax results of the business ownership.