Loan to partnership or equity contribution?

Question

I'm trying to understand how to account for the following scenario.

Three partners purchase a somewhat dilapidated income property for $600K, each partner contributing one third. It requires significant work to prepare for leasing, totaling $120k.

One of the three partners contributes an additional $120k to the partnership, and expects to be repaid from the income stream after the property is leased. The $120k goes towards capital improvements that raise the value of the property to $720k. I see two ways of accounting for this:

1. The $120k is a loan, and the first partner is made whole after withdrawing the entire $120k. Effectively the other two partners end up paying the entire cost of the upgrade.
2. The cost of the upgrade represents a capital contribution and must be shared equally between the partners, so each partner's share is $40k. The first partner is made whole after being repaid $80k.

Which of these is correct?

If it's a loan, as if the partnership went to a bank, then each partner would end up having paid $40k out of income. The bank would walk away with a zero balance.

However, in the second case partner 1 walks away with a zero balance PLUS an extra $40k in equity, which the bank wouldn't get. Effectively the other two partners paid $60k each.

Answer 1

Effectively the other two partners end up paying the entire cost of the upgrade.

That's wrong. Regarding the first 120 of income, say there were NO repairs made:

• each partner would get 40k

Now, say you loaned the 120 from a bank. Regarding the first 120 of income:

• each partner would get nothing. Each partner misses out on 40k

Now, say you loaned the 120 from partner Fred. Regarding the first 120 of income:

• each partner would get nothing. Each partner misses out on 40k

It makes no difference who you loan the 120 from.

Your example 2 is totally wrong :) However, if you can get away with example 2, do that :)

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An important point:

(Fred) contributes an additional $120k to the partnership

that language is totally wrong. Fred is simply making a loan of money to the business. (It's common that founders may make a loan to a business, for some reason.)

Fred is not contributing to the partnership.

If Fred WAS contributing to the partnership, ie, it WAS NOT a loan, then, your ownership would now be in the ratio 200:200:320, not 200:200:200.

Answer 2

It depends who pays the partner back.

At the start, each person owns 1/3 of a 600k property.

Then, each owns 1/3 of a business that has a 600k property, 120k in cash, and a 120k debt. No difference.

Later, each owns 1/3 of a business that has a 720k property and a 120k debt. Still no difference.

As the company manages to accumulate cash, let's say there's a 750k property, 120k in cash, and 120k debt. You each still own 1/3 of this.

The company pays the debt back and now you own 1/3 of a 750k property. This is a great thing and you have not really paid anything to achieve it, much less paid too much. This is your scenario 1.

However there is a another way to look at it, call it scenario 1A. In this scenario there is no business debt. Instead, each partner is supposed to put in a further 40k to fund the improvements, but two of you don't have it. This isn't a loan, it's more investing, and since you are all going to invest the same amount, your ownership shares won't change. The third partner lends each partner (not the company) 40k, at which point you all put it into the business. (This means 120 goes from the first partner to the business, as before, but the loans are different: the business isn't borrowing anything.) Now you all own 1/3 of "600k property, 120k in cash" and in addition, two partners each owe the other partner 40k personally.

As before you use the money to improve the property, and eventually it gets to "750k property, 120k in cash". If you like, the business can now pay the people 40k each. Two of you have to immediately repay 40k in personal loans to the one who put up the money. This looks a lot like that partner getting the whole 120, but there are tax things here about income and such that don't apply in the first case where it was a loan.

This is NOT your scenario 2. Any time the company issues dividends or the like, it should do the same amount for everyone. It's not fair to issue 40k to just 2 of the 3 partners, regardless of what they intend to do with it. It issues 40k to 3 of 3, two of whom divert it to the person who lent it to them personally. Both scenarios work out the same.

Your scenario 2 is wildly unfair. It issues a dividend to just 2 of the 3 partners, and leaves out the one who lent the company money, presumably at a time when banks would not.