How to value intellectual property capital contributions to LLC?
My LLC operating agreement details the cash and non-cash initial capital contribution of the members. One of them is contributing the source code of the program that will be basis of the company.
This member is going to get a very high ownership stake in exchange for that.
In addition, should the contribution be valued as a non-cash contribution and added to his capital account? Will it later create a tax problems for the member/LLC if this non-cash contribution is valued too highly/low?
Is (reasonable monthly salary of programmer) * (months to create sofware working full time) a reasonable measure of the value of the initial value of the software?
1 Answer
This situation is quite common in forming a new business where some members contribute cash, others property, and others Intellectual Property. The source code here is valuable Intellectual Property that can be contributed in exchange for the membership interest in the LLC exactly as you state. However, the other members are assuming that the IP is worth the fair value of the membership interest he gets back. As long as the board of directors certifies that the LLC has received adequate consideration for the membership interest, then there are no problems internally so long as you all agree on a price.
The main problem will come with the IRS if you value the IP too low. Take the following example:
Member...Contributes....Basis......FMV........Stock
A.............Cash...............30.........30.........30
B.............Property.........10.........30.........30
C.............IP....................0..........40.........40
In the above scenario, the founders take their membership interest with an initial capital account equal to their basis in the property. Self-created IP has a basis of zero because he did not pay anything for it. He'll pay for it in the end when he sells his membership interest.
The problem here is if the IP is value too low, the IRS can come back and revalue the IP saying that the FMV should have been 60 instead of 40. As a result, income can be attributed to the other founders and additional tax may have to be paid. However, there is a catch all that says if you didn't have tax avoidance as your principal motive generally the IRS will not do income shifting as above.
Note: The above information is not legal advice and does not create an attorney-client relationship.
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Very good answer. Thanks. I didn't entirely follow how other members can have income attributed to them if the IP is valued too low. I'm going to maintain separate capital accounts for each member, and with pass-through taxation, each member will pay tax only on allocated income. Ah ... I see now. Are you saying that the post-formation increase in company value due to revaluing the IP will be counted as "income" and *if* this value increase were allocated to the other members, it would case a tax problem for them? Valuing it high doesn't seem to hurt anybody. Thx! – User6451 13 years ago
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Sure, let's say that the FMV above represented cash values. Each person puts in the same amount of cash as they get back stock. Now let's say Member C puts in 60 cash and gets back 40 stock. How much cash is in the business now? 30 + 30 + 60 = $120. So if you hold a 30% interest in that stock or membership interest, it is now worth $120 * 30% or $36 instead of the $30 that you put in. So the IRS might come back and say you now owe tax on $6 because you just made money without doing anything. – Alex Naegele Lawyer 13 years ago
