Please help me resolve this mess I made for myself at work.
September 29, 2007 2:31 PM   Subscribe

Please help me resolve this mess I made for myself at work.

Short version (for a much longer version, see below):

From 2002-2006 I worked doing Java web development with someone who became a close friend. I was paid below market rates with a vague verbal agreement that I would be taken care of once the software started turning a profit. Now we're trying to make an agreement. He's offering me 5% of his LLC web consultancy. I have a number of questions that I'm hoping people can help me answer:

1. Who should I speak with to help me find the potential advantages/disadvantages of this agreement? A lawyer? An accountant? Both? Someone else? Any specific recommendations? I'm in NYC.

2. Here's a specific question I have: I'm under the impression that as a 5% member of an LLC I would be responsible for 5% of the tax liability of the business. Is it possible I could pay taxes without receiving any cash if the business decides to reinvest the profits? What if the business then folds?

3. What other questions should I be asking of my friend before signing any agreements?

4. Any other advice? What questions do I need to consider before moving forward?

Private advice can be sent to

Long version:

I would like to preface the story below by stating that I understand that I was incredibly foolish/naive in my actions below. I also am under the impression that were this to go to court, I likely would have difficulty in receiving any compensation. Luckily, both my friend and myself are attempting to do "what's right" and come to a resolution we can both feel good about.

From 2002 to 2006 I worked doing web development with someone who quickly became a good friend. He and his father are the only two members of a web consultancy LLC. He does most (95%) of the work, with his father participating in some of the IT management.

I built several Java-based web sites as a subcontractor for the LLC which drew from a unified code base I created. He participated in design discussions and limited code development. I was paid under a flat fee arrangement. The projects all took much longer than anticipated and it was recognized that I was very much underpaid. Over the course of three years I received just over $30K in payment in total. This was my primary source of income and I was able to subsist on savings from previous work. We verbally agreed that the company would attempt to compensate me for my efforts. It was agreed that since I wasn't being paid market rates, this wasn't "Work for Hire" but something else. It was our vision/hope that we were one step away from having a turnkey solution and we would be reaping the rewards for our efforts to continue to refine the codebase to be flexible for many different client needs.

While it was clear at the time that we needed to make the nature of this future compensation agreement explicit, we never did. Eventually, we agreed to move to an hourly compensation arrangement because while it seemed that we were just one step away from really turning a profit, I needed to start making some real money. The project went over time and he eventually had to ask me to stop work since he could no longer afford me. This essentially put an end, or at least a hold that has persisted through today, on our working relationship.

It was at this point that we began to get explicit as to what each of us understood would be appropriate compensation for my past effort. That was about a year ago. We have had very many difficult discussions and have disagreed as to what appropriate means. After many discussions, we were narrowing in on a solution that looked like the following:

- For the next 10 years, I would receive 5% of revenue derived from licenses and upgrades sold for software that derived from code that I built.
- In the event of a sale of the company within 10 years, I would receive 5% of the portion of the sale whose value could be attributed to the software that I built.

The problem with this solution is that it seemed open to different interpretations (especially concerning the sale of the company) and thus ripe for dispute. In an effort to address these issues, my friend proposed a new solution that seems a bit less prone to subjectivity:

- 5% ownership of the LLC, as a silent member.

While 5% of profits is obviously a lot less than 5% of revenue, they're two very different pies. Currently, no additional licenses have been sold of the software we built and there's no guarantee there will be. Alternatively, he just won a $30K hosting agreement. I find it appealing in that it seems cleaner and more transparent.

Any advice you have in answering the questions listed above would be greatly appreciated.
posted by anonymous to Work & Money (5 answers total)
1. A lawyer, certainly. I don't know if an accountant is necessary, but the lawyer will know.

2. It's complicated. An LLC can elect to be taxed as a C corporation, a partnership, or (possibly) an S corporation (which will result in treatment similar to a partnership).

If it elects to be taxed as a C corporation, the LLC is subject to an entity-level tax that it pays itself.

If it elects to be taxed as a partnership, though, the LLC's "tax attributes" are recognized proportionately by the members. So, as a member of an LLC that is taxed as a partnership, you would recognize a proportionate share of the LLC's income, loss, etc. on your own tax return.

This happens irrespective of whether any distributions of cash are made to the members, so it's quite possible for a member to be taxed on the LLC income without receiving any cash with which to pay the taxes.

Actual distributions, in turn, are tax free up to the member's "tax basis" in his interest in the LLC. I'm not going to delve into the details of determining the member's basis here, but if, as a member, you only receive distributions out of profits that you already paid taxes on, they should be tax free.

One way of dealing with this is to have the operating agreement stipulate that the LLC will distribute cash sufficient to cover the tax obligations of the members arising from LLC income.

If the LLC goes out of business, its assets will be liquidated, creditors paid, and if there's anything left, it will be distributed proportionately among the members.

3 & 4. How will you get your money out? Will there be guaranteed distributions, if the LLC has a profit? Does the operating agreement require distributions to be proportionate among member? (You don't want him to be able to distribute cash to himself and not you.) Can you force him to buy you out at any point, and how will the price be determined? Can you sell your interest to someone else?
posted by Mr. President Dr. Steve Elvis America at 3:36 PM on September 29, 2007

Definitely talk to a lawyer.

My first thought is that you may already be operating as a partnership, though the terms of your partnership agreement are not entirely clear. A lawyer will be able to help you work through the facts to find out where you stand, and to compare it against the current proposal.

Apart from anything else, all future negotiations should be done through, or at least in consultation with, your lawyer.

An accountant will be necessary to look at the financials, and given your concerns about the potential tax implications, I think it's probably worth meeting one.
posted by robcorr at 4:39 PM on September 29, 2007

I think Mr. President and Robcorr have given you excellent advice on the information you've given. I'll just add a softer reply to your fourth question.

If the code you wrote and the business you wrote it for are at all promising (and be as objective about that as you can), the 5% ownership offer on the table is reasonably likely to at least keep you from feeling bitter about working under market rate as a subcontractor. Possibly, 5% of the Next Big Thing winds up feeling like the best agreement you ever made.

If the business flops and produces insignificant revenue, you're still less screwed than your entrepreneureal friend is -- you slaved away on this project, invested savings, and wound up with little compensation to show, but didn't invest more than life-support savings (you weren't investing capital) and you walked away from further risk of uncompensated labor after only three years (I agree with Mr. President that, under most likely scenarios, the ownership liability risk for you would turn out to be minimal). However, life will go on, and you'll think of ways to make the experience into the best of hard knocks stories as you redefine yourself -- "savvy, experienced startup programmer seeks exciting partnership" -- in the future.

You're being offered a deal with what seems to be a fairly small and finite downside compared to what the business could achieve with your participation. The present offer defines that at 5% and silent. If you agree to that, will you relationship still be trusting and friendly enough that you might consider a larger and more active role in the future?
posted by gum at 11:42 PM on September 29, 2007

Ask for 60%.
posted by Ironmouth at 1:16 AM on September 30, 2007

This is what always kills me on these types of projects, all of which I eventually drop. How much of their project depends exclusively on your code? 5% feels light, but maybe if they're looking at having to give away significant percentages to outside investors it's not.
posted by maxwelton at 12:07 PM on September 30, 2007

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