I'm involved with an LLC company that is looking give me a financial-interest in their company to keep me around and ensure my loyalty.
Ordinarily they would simply grant me de-jure equity so I outright own a percentage share of the company, which would also entitle me to a proportionate share of the profits whenever a distribution is made, which is typically monthly. I understand this income is subject to federal income tax and self-employment taxes, so supposing I'm in the 28% IRS tax bracket already then this means an effective 43.4% tax on this income (as I'm still below the SSI income limit).
My take-home and my partners' take-home:
$ 10,000 - profit in a given month
/ 10 - There are ten partners involved, including myself, all with 10% equity
$ 1,000 - my gross drawing, same as the other partners
* 0.566 - 28% + 15.4% taxes (income and self-employment tax)
$ 566 - my take-home
Another option is a royalty agreement. For this to be bona-fide it means that I need to own and control a significant amount of copyrighted material that I license to the company. This is not a problem as I work in software so I can retain copyright of my software and grant the company an exclusive license in exchange for royalties. The IRS treatment of royalties means they are not subject to self-employment or FICA taxes - so the tax would be just 28%, and because it's a royalty on monthly profits it means my payment is guaranteed even if the other company owners decide not to take a drawing for themselves in a given month - and as my royalty would be an expense for the company instead of a drawing it's pre-tax for them.
$ 10,000 - initial profit in a given month
$ 1,000 - my 10% royalty on profits
* 0.72 - 28% income tax
$ 720 - my take-home
The other partners' take-home:
$ 9,000 - left-over profit for the other 9 partners after my royalty
$ 1,000 - 11.1% profit for each partner
$ 566 - each partner's gross drawing after taxes
In the latter case I wouldn't be gaining an equity in the company - but I don't consider the equity to be particularly valuable to me as the company is not publicly traded, and the company said they would be happy to give me the right to buy equity for a nominal/token amount (i.e. a Call Option) - or automatically granting it to me in the event of a buyout or incapacitation of the other owners.
It sounds simple: I get to keep more money instead of Uncle Sam with the royalty option without any risk of losing access to equity thanks to the Call Option.
Are there any possible downsides? Are there any advantages of being an equity partner over receiving royalties?