Agreements Matter

I have been summoned to a meeting.

I was helping a developer client with a sticky problem.  Once of the LLC’s was showing unequal capital accounts and I was tasked with trying to figure out why and then work with the LLC’s tax advisor on getting it straight.  Now the members wanted to discuss the impact of the plan to correct the problem their not following the operating agreement created.

The capital accounts were all out of sorts with a low of about $4K and a high of $50K.  Now, it is important to realize that the LLC was owned equally, 20% each for five members.  Distributions were all over the place.  All distributions happened on the same day but for entirely different amounts.  There were no instructions in the operating agreement to allow for disparate distributions.

The LLC’s CPA and I set up a meeting to review what had been happening and why.  The concern is that at least one capital account will go negative in 2019 and there is a plan to sell the project in 2020.  Not surprisingly, there is no claw-back or capital restoration provision in the LLC operating agreement.  So, someone was getting a bunch of money upfront with no requirement to take less than their 20% of the net proceeds upon sale.

The stuff of lawsuits.

Here is the frustrating part.  The tax advisor knew what they were doing was going to cause a problem but what could he do?  It was why he had his team set up the first layer of reallocations – to try and address the shifting of cash without the shifting of income.  Clearly it wasn’t enough.

I give him credit, he had tried to address this matter repeatedly over the previous 3 years.  He shared with me all his emails and memos to the manager and members.  To the members, it wasn’t a problem, until it was; capital accounts are edging towards negative territory.  His efforts to get the Members to see reason wasn’t working and it was now becoming a serious problem as almost 20 individuals were involved in this LLC.

The basic issues:

82% of the space is occupied by tenants controlled by the members.  Each of these tenants pays the same lease rate / square foot.   This is so even though they do not occupy the same amount of space.  Tenant 1, which is controlled by Member A occupies 25% of the total SF while tenant 5, controlled by Member E occupies less than 8%.

This isn’t as irrational as it sounds.  I agree that the goal should be to charge market rates for the space being occupied.  The 5 controlled tenants are paying $32.00 / SF.  It is a class A office building in downtown.  Each of the controlled tenants is occupying and using all the space they are paying for.  Is $32/SF reasonable?

Or perhaps that is the wrong question.  If we determined that the rent was overpaid, wasn’t it logical to offer a rent rebate back to the tenant?  After all, the tenant is the one who paid the rent, not the member.  The ownership of the LLC members was not the same as the tenant.  And remember, none of the members actually leased space; their businesses did.

What the CPA and I agreed to was that none of the tenants were overpaying rent, even though they are controlled by a member.  A business with 20 employees (tenant A to a tee) would occupy 5,500 SF of class A space.  They would pay anywhere between $20 and $40 / SF.  A business with 6 employees (tenant E) would pay between $24 and $48 / SF.

What we want is the members to accept that certain tenants (the affiliated tenants) are occupying the space and paying the rate / SF they are, due to the superior negotiating strength of the respective Member.  In short, Tenant 1 management was convinced to pay fair rent in this building for the space occupied.  Neither tenant nor member used a leasing agent.  Tenant was unable to negotiate a lower rate due to the control.  If this is true, couldn’t the argument be that the Member who put the tenant into place should get the benefit of the premium paid to the LLC for the additional rents paid and costs avoided?

Naturally being accountant’s we had to make it a little more complex but we ran it by counsel and the lawyer felt it was reasonable.  We had economic substance – a rational reason to reallocate cash flows and we had a model which supported the calculation.  Our reasoning that larger spaces could command a discount is sound and the fact that the controlled tenant didn’t (or couldn’t) request lower rents was because of the control of the Member.

The calculation actually allowed us to document almost all the distributions.  Three tenants had been overdistributed during the prior 4 years and two received less than they should have.  The largest over distribution is about $37K and the Member with the largest deficit was only $27K.  These can be corrected in the last distribution of 2018.

The downfall of this plan is that we would be creating specific allocations of the revenue.  The only way to do this fairly was to treat the payments as guaranteed payments.  That means that the Members could potentially see a tax hit for the payments.  Naturally, no one is happy about that and this is the reason for the meeting next week.  Also, no one wants to amend the prior returns as the sheer number of returns involved amounts to almost 200 separate amended returns.

Since I don’t know the tax situation of any of the individual members I can’t say with certainty what the net effect would be when passed through to all the various owners.  My gut instinct is almost zero; which means the concern is overblown.  But people fear what they have been conditioned to fear; in this case, each Member has a different tax advisor who has considerable influence over the client and each tax advisor has a different take on taxes.  Me personally?  I think that taxes are an ordinary cost of being in business: Make money – pay taxes.  But like any business cost, there is no need to pay more than you should.

I happen to agree with the LLC’s tax advisor.  the net cash flow from the rents after debt service should be distributed only in relationship to the Members ownership, i.e. 20% each.  If they wanted it another way, the structure should have been different – that is, perhaps the tenants should have purchased their space similar to a condominium arrangement and then they could have redistributed the net back to the owners.  But, that isn’t the structure they wanted.  They wanted to keep it simple.

While I understand the argument from the Members, it doesn’t stand scrutiny.  The rents charged were within an expected range.  Yes, Member A has a point; in comparison to smaller spaces for the other tenants, his company is overpaying.  But in relationship to the rest of the market, the lease rate was reasonable.  I can see where the Member could say he was being forced to shift income and cash flow to the other members if they didn’t reallocate; so what? This could have been easily avoided by the Member owning a smaller building and leasing it to his business as the sole tenant.  That isn’t what they wanted.

All this simplicity created enormous complications.  So, it is extremely important to think through your organization and how you want to generate revenues and distribute profits because in many cases your options are limited by the structure of your agreement.   Agreements matter and trying to smash a complex arrangement into a simple business agreement will cause nothing but headaches.

 

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