You aren't my CPA. I need to understand profit sharing accounting.

August 18, 2015 9:25 AM

A few years ago I invested in a start up brewery. It finally opened this year, about a year behind schedule. So far, things are going very well. According to the pro forma we (the investors ) saw, it should take 2 to 3 years to make back my money from profit sharing. How do I account for the profit sharing until that time? I would think that monies received up to the amount of my investment would be considered a return of principal and therefore reportable but not taxable. Is my thinking on the right track?
posted by jtexman1 to Work & Money (5 answers total)

You need an accountant, but your underlying assumption is incorrect. They would not constitute a return of capital.
posted by JPD at 10:32 AM on August 18, 2015 [1 favorite]

That doesnt necessarily mean you need to pay tax on it though. A lot depends on how it's structured and other complications.
posted by JPD at 10:35 AM on August 18, 2015 [1 favorite]

Yeah, sorry, you need to go to an accountant. The answer depends, among other things, on whether the investment was structured as a partnership or a corporation. If it was a corporation, on whether there were different share classes and if so what their characteristics are. On whether the term "profit sharing" is being used in a technical legal sense (i.e., the monies distributed are in fact legal "profits" of the partnership/corporation that will be reported by them to the IRS) or whether it's a wishy-washy use of the term actually fulfilled by some sort of distributions that cause the amounts to not technically be reported "profits."

As JPD points out, none of the information you provided supports your assumption that the initial amounts would constitute a "return of principal." That may or may not be true depending on the structure but I certainly wouldn't assume it, and in practice I've never seen an investment set up that way. In fact my default assumption would be rather the opposite - that if you are receiving true profit disbursements, these may well be treated as ordinary income for you and not even "capital gains," and, if they are substantial enough (and depending on other personal circumstances), you may even be obligated to make quarterly estimated payments and not just wait until April to cut the IRS a check.

Go to an accountant!
posted by Joey Buttafoucault at 12:20 PM on August 18, 2015

It depends entirely on the nature of your investment. To explain veeeeeeery broadly... Equity investment, where you own a fractional share of the business? Then, no. You're thinking about this like you loaned them money, but if you loaned them money there would have to be a stated interest rate and you'd have to be reporting the interest income. You didn't loan them money, I'm guessing, you bought in. That means that when you've gotten that first year's money, you don't have 1/3 of your money back... you have all of your initial investment in the brewery AND cash. That's why it's probably income. Now, just how that income is calculated and taxed depends very much on how this investment is structured, and that's why you need an accountant. But the broad principle of why this is so is that you still own something after the end of those first three years, and you've gotten all that money besides. If you've bettered your financial position, then it's income.

If your investment was for some reason going to become valueless after they paid the money back, that's the only way that the profit sharing MIGHT not be income. So, at this point the question is how much it's going to be and how it has to be handled, and once you've gotten to the point where you're making investments like this, you really need a CPA.
posted by Sequence at 12:53 PM on August 18, 2015 [1 favorite]

To put it even more simply if your logic were correct it would mean dividends on an S&P 500 company's shares would be tax free until you recouped your entire investment
posted by JPD at 1:00 PM on August 18, 2015