Is there any advantage to owning equity in a company compared to a royalty agreement?

Question

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.

My take-home:
$ 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?

Answer 1

Each way you go is a little bit of a gamble.

Owning equity in the company is best in situations where you can trade and sell that equity, or where the dilution of your royalty product would affect your returns, or if you can maintain a certain equity stake without working at the company or if you can hold out on taking equity to reinvest profits for the purposes of growth.

The royalty is best in situations where you're getting a portion of the gross, since you get paid as a creditor, no matter how the company is performing, or if you intend to collect royalties after you leave the company.

Now for your situation: if your royalties are fluctuating with profit instead of gross and your equity is tied to your continued partnership and not subject to potential growth... then they're pretty much both workarounds for the same thing, you've removed the particular advantages for each way of receiving payment. If the company ever does buy out or go public, how much of your additional X earning a month would you have to then re-invest to get an equity stake? And for royalties, if another developer came aboard, or your company bought another company, how much would this dilute your IP contribution?

So, aside from the gambling nature of the issue, I'm not sure your tax calculation is right. You can take equity profit as dividend, as long as you're collecting a sufficient salary (this prevents a business from declaring all profits as a dividend). This would put those profits into a different tax bracket, 15% capital gains. Or if all profits are equitably split, you could take part as salary, part as dividend. As well, as someone who's making active income off of their IP, not passive income, you're supposed to file a Schedule C, not a Schedule E, so your royalties would include your self employment taxes. The schedule E is for royalties where the author isn't actively in the field or actually self employed in that area, or if you own royalties on something you didn't create. Should you keep the royalties then go to another job field or retire then your royalties could go on a Schedule E. Now, a tax advantage may exist on a Schedule C if you can write off certain health and business expenses reducing your income that you can't on a Schedule E, though it'd probably be difficult to write off more than the adjusted self employment cost savings of a Schedule E.