ABA Business Law Section’s
2009 Annual Meeting, Chicago, IL
Reconsidering Private Equity and
Venture Capital Investments in
LLCs as Portfolio Companies
Sponsored by the Private Equity and Venture Capital Committee;
Partnerships, LLCs and Unincorporated Entities Committee;
and Taxation Committee of the
ABA Section of Business Law
August 1, 2009
2:30 – 4:30
Sheraton Ballroom II, Level Four
Warren P. Kean
K&L Gates LLP
Hearst Tower, 47th Floor
214 North Tryon Street
Charlotte, NC 28202
warren.kean@klgates.com
704.331-7413
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Exploring the Reasons Behind the Bias
of Private Equity and Venture Capital Firms
Investing in Corporations Rather Than
Limited Liability Companies – A Time to Reconsider
By: Warren P. Kean
K&L Gates LLP
Charlotte, NC
A.
Outside of the PE/VC Fund Portfolio Company Arena, LLCs Generally Are the
Choice of Entity – Why Have PE/VC Funds Been Reluctant to Invest in Them?
If C corporations are clearly the preferable entity choice for start-up and other
businesses, then –
1.
Why was it determined that the statutes and regulations listed below were
needed?



2.
The publicly-traded partnership rules under I.R.C. § 7704 to
prevent the “de-incorporation” of America.
LLC statutes adopted in all 50 states and the District of Columbia
(also LLP and LLLP amendments to general and limited
partnership statutes).
The “check-the-box” regulations under § 301.7701.
Why was it necessary or beneficial to devise and employ the techniques
listed below (and discussed later in this outline) to own interests in entities
classified as partnerships?


Use of “blocker” corporations.
Use of the UPREIT/barnesandnoble.com structure.
3.
Why over the past 15 years or so has there been an ever increasing number
of limited liability companies (“LLCs”) and other unincorporated entities
organized; in many states in numbers greater than the number of new
corporations?
4.
Why do law firms, accounting firms, and other professional service firms
of all sizes (including international firms with billions of dollars of
revenue) operate as LLCs or limited liability partnerships?
5.
Why do hedge, private equity, and venture capital firms and their related
investment funds operate as LLCs or limited partnerships, often utilizing
many unincorporated entities in their organizational and operational
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structure? The U.S. House of Representatives in 2008 passed H.R. 6275,
which, among other things, would add a new Section 710 to the Internal
Revenue Code to tax certain partnership carried income and loss as
ordinary income or loss.
6.
Why the popularity for the seemingly endless number of books,
periodicals, papers, and presentations on LLCs and other unincorporated
entities and on “choice of entity” (of which, the list below is only a small
sampling)?
ADVISING THE SMALL BUSINESS: CHOOSING THE RIGHT ENTITY TYPE & ISSUES
ARISING IN REPRESENTING ENTITIES presentation sponsored by the ABA General
Practice, Sole & Small Firm Division and the ABA Center for Continuing Legal
Education on March 11, 2009 and the related book by Jean L. Betman, Advising
the Small Business, Forms and Advice for the Legal Practitioner; Robert R.
Keatinge and Anne E. Conaway, KEATINGE AND CONAWAY ON CHOICE OF
BUSINESS ENTITY: SELECTING FORM AND STRUCTURE FOR A CLOSELY-HELD
BUSINESS, (West 2009 ed.); Laurence E. Crouch, Revival of the Choice of Entity
Analysis: Use of Limited Liability Companies for Start-Up Business, TAX
PLANNING FOR DOMESTIC & FOREIGN PARTNERSHIPS, LLCS, JOINT VENTURES &
OTHER STRATEGIC ALLIANCES, Practising Law Institute (2008); William P.
Streng, Choice of Entity, BNA Tax Management Portfolio 700-3rd; Victor
Fleischer, “The Rational Exuberance of Structuring Venture Capital Start-Ups,”
57 Tax L. Rev. 137 (2004); Steven G. Frost and Sheldon I. Banoff, “Square Peg,
Meet Black Hole; Uncertain Tax Consequences of Third Generation LLEs,” 100
J. Tax’n 326 (June 2004); C. Wells Hall and Jordan P. Rose, “Considerations in
Choice of Entity Revisited,” 62 NYU Inst. on Fed. Tax’n 15-1 (2004); Daniel S.
Goldberg, “Choice of Entity for a Venture Capital Start-Up; the Myth of
Incorporation,” 55 Tax Law, 923 (Summer 2002); Steven A. Waters, Choice of
Entity for Real Estate Deals CLE presentation sponsored by several state bar
associations; Choice of Entity/Current Structures/Tax Planning for LLCs Holding
Real Estate/Exit Strategies program presented at the Tenth Annual Real Estate
Tax Forum (2008; Norton L. Steuben, Choice of Entity for Real Estate After
Check-the-Box and the Entity Explosions, 37 R. Prop. Prob. & Trust J. (Spring
2002).
B.
Advantages of LLCs and Partnerships1
1.
No Entity Level Income Tax or (in most states) Franchise Tax.
Partnerships (and entities classified as partnerships for federal tax
1
For a more comprehensive discussion of the federal income tax treatment of partnerships and entities classified
as partnerships for federal tax purposes engaged in mergers and acquisitions, see Warren P. Kean, M&A
Transactions Involving Partnerships and LLCs, Including Conversions, Mergers and Divisions, TAX PLANNING FOR
DOMESTIC & FOREIGN PARTNERSHIPS, LLCS, JOINT VENTURES & OTHER STRATEGIC ALLIANCES, Practising Law
Institute (2008).
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purposes, e.g. LLCs)2 do not pay federal income taxes and generally do
not pay state income or franchise taxes. See e.g., I.R.C. § 701. But see
Bruce P. Ely, Noted Trends in the State Taxation of Pass-Through
Entities, TAX PLANNING FOR DOMESTIC & FOREIGN PARTNERSHIPS, LLCS,
JOINT VENTURES & OTHER STRATEGIC ALLIANCES, Practising Law
Institute (2008) for a general description of how each state taxes
partnerships and LLCs. See also taxes such as the California LLC
franchise tax fee discussed in the “Shop Talk” column in the March 2009
issue of the Journal of Taxation; “Thumbs Down on California LLC
Franchise Fee Again, Show Us the Money!” Quoting from this column:
A 2007 analysis was prepared by the California State
Senate Republican Fiscal Office illustrates the phenomenal
growth of LLCs and the amount of LLC taxes and fees paid
to the state. In fiscal 1994, 7,000 LLC returns were
received, generating total LLC taxes and fees to California
of $800,000. In 2001, 98,000 returns were field generating
total revenues of $243.3 million. Within four years, the
numbers had doubled – in 2005, 194,000 returns were
received, transmitting LLC taxes of $156.9 million and
LLC fees paid of $283.3 million, resulting in total revenues
to California of $440.2 million. (The numbers probably are
even larger for 2006 and onward.) [Emphasis added.]
2.
Flow-Through of Income and Losses/Deductions. Taxation of partnership
earnings and operations generally occurs at the owner level, with income
and losses/deductions, and the character of that income and
losses/deductions, passing through the entity to the owners. See e.g.,
I.R.C. §§ 702 and 703.
(a)
This treatment may allow losses/deductions to be utilized sooner than if,
as in the case of C corporations, they had to be carried forward to future
profitable years (subject to capital account (I.R.C. § 704(b)), basis (I.R.C.
§ 704(d)), at risk (I.R.C. § 465), and passive loss (I.R.C. § 469)
considerations and limitations). In this regard, it is important to note that,
unlike a loss on an investment in a C corporation that has gone bad that
(except for the case for corporations filing consolidated returns) may only
be recognized when the purchased shares of stock are sold or otherwise
disposed of in a taxable transaction (and then, except for § 1244 stock,
only as capital losses), the losses of flow-through entities generally are
recognized as ordinary or § 1231 deductions as the invested funds are
spent by the portfolio company (or recovered over applicable depreciation
or amortization periods or at the time, generally as § 1231 losses, that
2
This outline refers to limited liability companies (LLCs), partnerships, and other domestic unincorporated
entities interchangeably because under Treas. Reg. §§ 301.7701-2 and 301.7701-3 each is an eligible business entity,
which with two or more members will be deemed to be a partnership for federal tax purposes unless it files a Form
8832 to be classified as a corporation.
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assets of the portfolio company are sold) or, at the latest, when the
investment is disposed). In most cases, this will be a better answer than
that for a shareholder of a C corporation, even an individual owner of
Section 1244 stock [who is able to deduct the loss recognized on that stock
as an ordinary loss instead of as a capital loss if certain requirements are
satisfied (such as the 50% active income requirement and the small
business corporation requirement limiting capital contributions to
$1,000,000) and subject to certain limitations (such as not being able to
treat more than $50,000 ($100,000 for married couples filing joint returns)
of such losses as ordinary losses in any taxable year)]. There are no such
limitations and restrictions to a direct or indirect partner recognizing
suspended (such as by the application of the passive loss rules) ordinary
losses when an investment is disposed.
(b)
This treatment may allow losses/deductions to be utilized when they might
otherwise be lost or delayed because of the application of the loss
disallowance rules of I.R.C. §§ 382 and 384. But see the somewhat
comparable rules preventing the “trafficking of losses” of partnerships
having “substantial built-in losses” of I.R.C. §§ 743(b)(2) and 743(d)
discussed in Parts B.9 and C.7 below.
(c)
Because of the flow through of the character of partnership losses,
investors are able to report their share of the partnership’s ordinary and
§ 1231 losses instead of being limited to recognizing only capital losses
when one’s investment is disposed, as is the case with stock issued by a C
corporation. Capital losses are far less attractive than ordinary losses
because they generally may be used only to shelter capital gains.3 Thus,
except for the annual $3,000 ($1,500 in the case of married individuals
filing separate returns) exception under I.R.C. § 1211(b), capital losses
may be used by individuals only to offset income that generally would
otherwise be taxed at a 15% federal income tax rate instead of the
maximum ordinary federal income tax rate of 35%.
3.
Flexible Exit. Perhaps most importantly in the PE/VC Fund (“Fund”)
context, given the limited time horizon of their investments and most of
the gain on sale of a portfolio company usually being attributable to
goodwill, going concern, and similar intangible assets, the buyer is able to
purchase assets (or, if the parties prefer, equity interests that under Rev.
Rul. 99-6, 1999-1 C.B. 432 or, generally speaking, I.R.C. §§ 743(b), 754,
and 755, allow for the adjusted tax bases of the entity’s assets to be
stepped up to their fair market values for, i.e., the amount paid for them
by, the buyer) usually with little or no additional tax to the seller or its
owners, except with respect to preserving the ordinary income character of
3
Individuals, however, may apply in each taxable year up to $3,000 ($1,500 in the case of married individuals
filing a separate return) of their excess capital losses (the amount by which their capital losses exceed their capital
gains for the year) to offset ordinary income. I.R.C. §§ 1211(a) and (b).
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inventory, recapture items and other “unrealized receivables” such as
under the collapsible partnership rules of I.R.C. § 751(a). This ability of
the purchaser to buy (or otherwise push down the purchase price for the
target company into the tax bases of) the target company’s assets generally
enables the purchaser to recover (i.e., deduct) the price paid for the
company over an average of (roughly speaking) 15 years (meaning for
each $15 million of purchase price, an average of $1 million per year of
sanctioned tax shelter is created, resulting in an annual average net cash
flow benefit of $400,000 to $450,000 of annual federal and state income
tax savings). See, I.R.C. § 197(a)
4.
Outsized Returns Have Become Harder to Come By. Generally, with the
growth in number of financial buyers and the increased sophistication of
the owners of prospective portfolio companies, opportunities for realizing
above-market returns have become increasingly challenging to develop;
thus, financial buyers increasingly need to squeeze out returns from nontraditional sources. These economic pressures also may cause the
organizers of a Fund to become more targeted not only in the type of
industries or geographic areas in which the Fund invests but also defining
their “space” to include the type of investor that they would like to attract.
5.
More Tax-Efficient Equity Incentive. Profits interest awards in entities
taxed as partnerships generally are more flexible and favorable than their
corporate counterparts of restricted stock and qualified and nonqualified
stock options. That is because, unlike incentive stock options, the entity
does not give up its deductions (or the equivalent of allocating income or
gain to members of management and, therefore, away from the investors)
for members of management to have their equity incentive awards taxed at
capital gains rates. Also, for the appreciation in value of ISOs to be taxed
at favorable capital gain rates, many hurdles have to be overcome,
including, for example, when the option must be exercised and the stock
acquired by the exercise of those options may be sold, the recipient not
being a 10% shareholder, and the $100,000 annual limitation. I.R.C.
§ 422. Even if those and other hurdles are overcome, the spread between
the exercise price and the fair market value of the stock on the date of
exercise is subject to the alternative minimum tax. I.R.C.§§ 422 and
56(b)(3). In the case of nonqualified options that do not have a “readily
ascertainable fair market value” on the date of grant, the spread between
the exercise price and the value of the underlying stock generally is taxed
as ordinary, compensation income when the option is exercised or sold.
Treas. Reg. § 1.83-7.
Restricted stock presents the recipient with the dilemma of having to
recognize the value of that stock as compensation income either on the
date of grant (by filing a Section 83(b) election) or on the date on which it
becomes vested (i.e., no longer subject to a substantial risk of forfeiture).
I.R.C. § 83. Another consideration to bear in mind is the manner in which
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the deferred compensation rules of I.R.C. § 409A and the Treasury
Regulations promulgated thereunder (particularly Treas. Reg. § 1.409A1(b) and the rules applicable to stock options, stock appreciation rights and
other equity-based compensation arrangements under Treas. Reg.
§ 1.409A-1(b)(5)) may apply to different compensation arrangements that
a portfolio company may want to adopt. In that regard, it is important to
note that the IRS currently generally exempts partnership profits interests
from the application of Section 409A. See Linda Z. Swartz, Section 83(b),
Section 409A and Subchapter K, TAX PLANNING FOR DOMESTIC &
FOREIGN PARTNERSHIPS, LLCS, JOINT VENTURES & OTHER STRATEGIC
ALLIANCES (2008).
6.
Ability to Make Tax-Free Distributions. A corporation generally may not
distribute built-in gain property to its owners without triggering one (if it
is an S corporation) or two (if it is a C corporation) levels of tax. I.R.C.
§ 311(b)(1). In addition, the shareholders of a C corporation generally
must pay tax on the cash dividends and other distributions (e.g.,
recapitalization proceeds) paid to them. See I.R.C. §§ 301 and 302.
Shareholders of an S corporation with accumulated earnings and profits
must pay tax on the cash dividends and other distributions (e.g.,
recapitalization proceeds) paid to them to the extent that those
distributions exceed the S corporation’s accumulated adjustments account
balance until the corporation’s accumulated Subchapter C earnings and
profits have been exhausted, then again (as is the case for S corporations
that never had any accumulated Subchapter C earnings and profits) as
capital gains, to the extent that the distributions made to them exceed the
adjusted basis in their stock (which basis, unlike the rule for partners in a
partnership, is not increased by a shareholder’s share of the corporation’s
liabilities). Compare I.R.C. §§ 1367(a) and 1367(b)(2) to I.R.C. § 752(a).
An entity that is classified as a partnership for federal tax purposes, on the
other hand, generally (except as otherwise provided by (i) I.R.C. § 751(b)
with respect to the deemed exchange by a partner of that partner’s interest
in certain “hot” assets of substantially appreciated inventory and
unrealized receivables (including depreciation recapture) and that
partner’s interest in the partnership’s other assets or (ii) the I.R.C. §
707(a)(2)(B) disguised sale of assets and partnership interests rules) may
distribute built-in gain property to its owners without triggering income or
gain to the partnership or its members, and may distribute money to its
owners without them having to recognize gain except to the extent that the
amount of the money (including marketable securities under I.R.C. §
731(c) and reduction in a partner’s share of the partnership’s liabilities
under I.R.C. § 751(b)) paid to a member exceeds the adjusted basis of that
member’s partnership or membership interest (which is increased by the
member’s share of the company’s liabilities). I.R.C. §§ 731 and 752(a).
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7.
Ability to Convert to or Merge with Other Entities Tax Free. Depending
on whether a corporation is a C corporation or an S corporation, one or
two levels of tax must be recognized when the corporation liquidates or
converts or merges into or with a domestic entity that is not classified as a
corporation for federal tax purposes. See Part VII.A of Warren P. Kean,
M&A Transactions Involving Partnerships and LLCs, Including
Conversions, Mergers and Divisions, TAX PLANNING FOR DOMESTIC &
FOREIGN PARTNERSHIPS, LLCS, JOINT VENTURES & OTHER STRATEGIC
ALLIANCES, Practising Law Institute (2008). On the other hand, usually
little or no tax gain need be recognized when an entity that is classified as
a partnership for federal tax purposes merges into another entity that is
classified as a partnership for federal tax purposes or converts into or
merges with a corporation and the 80% “control” test of I.R.C. §§ 351(a)
and 368(c) is satisfied. Id., Parts IV and VII.B.
8.
Ability to Divide (Spin-Offs, etc.). A corporation’s ability to divide taxfree is significantly limited by the many formidable requirements of I.R.C.
§ 355, which do not apply to partnerships. Id., Parts II.D and V.
9.
Ability to Avoid Special Adverse Tax Provisions That Apply to
Corporations. Some provisions of the Code treat corporations more
harshly than partnerships (which, in the case of partnerships, that
treatment generally flows through to the partnership’s corporate members
but not its individual members). For example, Section 163 imposes
restrictions on the ability of a corporation to deduct certain interest
expenses. See, e.g., applicable high yield discount obligations issued by
corporations (I.R.C. §§ 163(e)(5) and 163(i)), disqualified interest paid or
accrued by a C corporation (I.R.C. § 163(j) re: earnings stripping), interest
on disqualified debt instruments issued by corporations (I.R.C. § 163(l)).
See also, the imputation of dividend payments on certain corporate stock
and convertible debt instruments under I.R.C. § 305 and the limitation on
a corporation’s ability to deduct net operating loss carryovers after there
has been an ownership change under I.R.C. § 382. However, after the
American Jobs Creation Act of 2004, partners now have their own
limitation from being able to sell built-in partnership losses, for I.R.C.
§§ 743(b)(2) and 743(d) now requires the inside basis of a partnership’s
assets to be stepped down to fair market value (regardless of whether a
Section 754 election is in effect) with respect to the purchaser or other
transferee of a partnership interest if the combined adjusted bases of the
partnership’s assets exceed the combined fair market value of those assets
by more than $250,000.
10.
Flexibility.
Perhaps the biggest advantage of partnerships over
corporations is the flexibility afforded partnerships under both tax law and
the unincorporated entity statutes of most states. See, for example, the
stated public policy of Delaware “to give the maximum effect to the
principles of freedom of contract and to the enforceability of limited
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liability company agreements.” 6 Del. Code Ann. § 18-1101(b) (for
Delaware LLCs) and comparable language in 6 Del. Code Ann. § 171101(c) (for Delaware limited partnerships). See also Warren P. Kean,
M&A Transactions Involving Partnerships and LLCs, Including
Conversions, Mergers and Divisions, TAX PLANNING FOR DOMESTIC &
FOREIGN PARTNERSHIPS, LLCS, JOINT VENTURES & OTHER STRATEGIC
ALLIANCES, Practising Law Institute (2008) for a discussion of the
flexibility that owners have to move assets in and out of a partnership; to
determine and alter the manner in which the partnership’s income and
losses (including items of gross income, gain, deduction and loss) is to be
shared by the partners, and to determine the extent to which they may
share and include the partnership’s liabilities in the amount of the basis in
their partnership interests thereby, allowing the deferral of the recognition
of income that they otherwise would be required to recognize upon
receiving cash distributions from the partnership that exceed the amount of
cash and the basis of other property that they have invested in the
partnership; and to otherwise structure transactions involving the
partnership in tax-advantageous ways.
11.
Flexibility and Proposed Legislation to Tax Certain Carried Interests as
Compensation Income and a General Change in the Regulatory
Environment. In 2008, the U.S. House of Representatives passed H.R.
6275 to, among other things, tax a partner’s income attributable to an
“investment services partnership interest” as compensation income. The
clear target of this proposal were the carried interests of investment fund
managers. The proposal, however, defines an “investment services
partnership interest” as one issued to a partner in exchange for that partner
providing certain services with respect to “specified assets,” which are
defined as certain securities under I.R.C. § 475(c)(2), real estate,
commodities (as defined in Section 475(c)(2)), or options or derivative
contracts with respect to such securities, real estate or commodities. In the
case of PE/VC Funds, the “specified assets” that most likely will be
applicable [although, given the potentially broad application of this
proposed legislation, one could inadvertently step into being deemed to
provide management, financing, etc. services with respect to one or more
of the other “specified assets”] are “securities” under I.R.C. § 475(c)(2),
which includes, among other securities, capital stock issued by a
corporation (regardless of whether it is publicly traded) and partnership
interests in a “widely held or publicly traded partnership.” Thus, the last
draft of the proposed legislation suggests that it might be possible to push
down a Fund manager’s promoted interest to the portfolio company level,
which would be more easily accomplished if those portfolio companies
were partnerships or LLCs classified as partnerships for federal tax
purposes. (See, generally, the placement of a partnership (a blocker
subsidiary or “B Sub” in the diagrams in Part D below) beneath blocker
corporations to allow the PE/VC firm to receive its carry on a pre-tax basis
with respect to the Fund’s investments in unincorporated portfolio
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companies for a structure, with appropriate modifications, that might be
utilized for this purpose). Bottom line, no one knows what tax or other
legislation and regulations might be enacted that could affect the type of
entity structure that is favored or required by a Fund for its portfolio
companies. That uncertainty may cause PE/VC firms and their advisors to
consider selecting the entity type that offers the greatest flexibility and
ease for converting into some other type of entity should the financial,
market, tax, or legal environment change in favor of operating under a
different entity shell or format.
C.
Disadvantages of Partnerships and Other Reasons Why a PE/VC Fund May Decline
to Invest in Entities Taxed as Partnerships.
1.
UBTI. The two biggest reasons given for why PE/VC Funds do not invest
in entities taxed as partnerships is because their Fund documents either
preclude or substantially limit them from engaging in activities that may
generate “unrelated business taxable income” (UBTI) or income
effectively connected with the conduct of a trade or business within the
United States (“ECI”). Fund advisors believe that such restrictions are
necessary to attract investment in the Funds they manage by pension
plans, endowments, and other tax-exempt investors and by foreign
investors. Some Funds are able to attract the investment of large amounts
of capital by these types of investors. Many Funds, however, are less
successful. In the latter case, is it sensible for a Fund and its other
investors to allow one investor, or a minor group of investors, to dictate
terms that disadvantage the majority, in many cases the overwhelming
majority, of the other investors?
For purposes of discussion, UBTI comes in two forms, (i) income from an
“unrelated trade or business” and (ii) “unrelated debt-finance income.”
Unrelated trade or business income is income from a trade or business that
is “not substantially related (aside from the need of such organization for
income or funds or the use it makes of the profits derived) to the exercise
or performance by” that organization of its tax-exempt purpose. I.R.C.
§ 513. This type of income does not include passive income such as
dividends, interest, certain royalties and rental income and, more
importantly for PE/VC Funds, gains from the sale of non-dealer\noninventory property (except to the extent of I.R.C. § 1245 or 1250
depreciation recapture) when the investment is not made, or deemed to be
made, with borrowed funds (the rules applicable to unrelated debt-finance
income are discussed below). I.R.C. §§ 512(b) and 514(b)(1)(B) and
Treas. Reg. §§ 1245-6(b) and 1.1250-1(c)(2). In the case of partnerships,
the aggregate theory of partnerships is applied in that the activities of the
partnership are treated as if they are undertaken by its members for this
purpose. I.R.C. §§ 512(c).
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An otherwise tax-exempt entity must pay corporate income taxes at the
graduated rates of I.R.C. § 11 on the net UBTI recognized for a particular
year. I.R.C. § 511. Thus, a tax-exempt entity is subject to the same tax
rates on UBTI as any non-tax-exempt, corporate investor. Moreover, a
direct (or indirect, through tiers of partnerships) tax-exempt partner is
allocated its share of the partnership’s business deductions and losses as
well as its income. Also, net operating losses from unrelated business
activities may be applied to offset UBTI recognized in other taxable years
under the principles of I.R.C. § 172 as modified by I.R.C. § 512(b)(6).
Accordingly, a tax-exempt investor may benefit from being allocated that
investor’s share of portfolio company losses to offset UBTI that it
recognizes from other sources. That may be an important consideration
with respect to many prospective portfolio companies that are expected to
not be able to generate taxable income for many years or, perhaps, at any
time prior to its sale or other disposition.
Because of the large amount of debt that PE/VC Funds historically have
incurred at the portfolio-company level to finance their investments in
those portfolio companies, a more troubling aspect of UBTI for those
Funds is the imposition of corporate income taxes on so-called “unrelated
debt-financed income” under I.R.C. § 514. Under I.R.C. §§ 512(b)(4) and
514, income and related deductions that I.R.C. § 512((b) otherwise would
exclude from UBTI (such as interest, dividends, rents, royalties, and gains
from the sale of investment property or property used in a trade or
business) are brought back into the computation of UBTI to the extent that
they are attributable to debt-financed property (which generally is
determined by the amount that the property’s average acquisition
indebtedness for a particular taxable year bears to the average adjusted
basis of that property for the year). I.R.C. § 514(a) and 514(b)(1)(B).
Under I.R.C. §§ 702(b) and 512(c)(1), the character of income and
deductions (including unrelated debt-financed income character) of a
partnership are passed through to its members. See, e.g., Example 4 of
Treas. Reg. § 1.514(c)-1(a)(2). Moreover, the IRS apparently takes the
position (some might say over-reaches to take the position) that a taxexempt partner will recognize the same amount of unrelated debt-financed
income regardless of whether the disposition of the portfolio company is
structured as an asset sale or the sale of membership or partnership
interests. See Tech. Adv. Mem. 9651001 (June 27, 1996) and similar
analysis in Rev. Rul. 91-32, 1991-1 C.B. 107 with respect to a foreign
partner’s recognition of ECI upon the disposition of his partnership
interest.
The IRS’s analysis in Tech. Adv. Mem. 9651001, however, arguably is
not supported by current law. Except for the limited extent provided in
I.R.C. § 751(a) for recharacterizing that part of the gain or loss from the
sale of a partnership interest that is attributable to the partnership’s
unrealized receivables and inventory as ordinary income or loss instead of
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as a capital gain or loss and the look-through rules under FIRPTA
(particularly, I.R.C. § 897(g)) and for § 1250 gain and collectibles gain on
the sale but not liquidation/redemption of a partnership interest under
Treas. Reg. §§ 1.1(h)-1(a) and -1(b)(3)(ii), the federal income tax law
consistently treats the sale of a partnership interest as not being a sale of
that partner’s indirect interest in the partnership’s assets. See, e.g., I.R.C.
§ 741 and the regulations promulgated thereunder; Rev. Rul. 68-79, 19681 C.B. 310 (the holding period of a partnership’s assets is not impacted by
the holding period of any partner’s partnership interest); Rev. Rul. 99-6,
1991-1 C.B. 432 (the sale of all of the outstanding partnership interests to
a single purchaser is treated as the sale of partnership interests under
I.R.C. § 741 by the selling partners and a purchase of assets by the buyer);
Prop. Reg. § 1.721-1(b)(2) (rejecting the recommendation of some
commentators that the partnership should recognize a portion of the builtin gain or loss of its assets on the transfer of an interest in the partnership
in payment for services provided to the partnership on the theory advanced
by those commentators that the partnership interest represents a fractional
interest in each of the partnership’s assets); and Brown Group, Inc. v.
Commissioner, 77 F.3d 217 (8th Cir. 1996), rev’g, 104 TC 105 (1995) (a
controlled foreign corporation’s distributive share of a foreign
partnership’s income did not become Subpart F income under the pre1987 version of I.R.C. § 954(d)(3) simply because it would have been
Subpart F income if earned by the CFC; the IRS subsequently amended its
regulations by promulgating Treas. Dec. TD 9008, issuing Treas. Reg.
§§ 1.702-1(a)(8)(ii), 1.952-1(g), 1.954-1(g), 1.954-2(a)(5), 1.954-3(a)(6),
1.954-4(b)(2)(iii) and 1.954-2(a)(3)). See also the preamble to REG105346-03, 70 Fed. Reg. 29675 (2005) reprinted in 2005-1 C.B. 1244.
See also William M. Shaheen, Selling a Partnership Interest May Create
UBTI Problems, 10 J. Tax’n Exempt Org. (Jan./Feb. 1999). But see I.R.C.
§ 752(d) and Treas. Reg. § 1.752-1(h) (neither of which is mentioned in
either Rev. Rul. 91-32 or Tech. Adv. Mem. 9651001), which provide that
the amount realized on the sale of a partnership interest includes the
selling partner’s share of the partnership’s liabilities – a corollary to the
adjusted tax basis of a partnership interest being increased, as if the
partner had contributed additional money to the partnership, under I.R.C. §
752(a) (which is cited as authority for the Service’s ruling in Tech. Adv.
Mem. 9651001) by the partner’s share of the partnership’s liabilities.
However, Subchapter K does not have a general look-through rule for
partnership liabilities as it has for items of partnership income, deductions
and losses under I.R.C. § 702, and the Service’s position in Rev. Rul. 9132 and Tech. Adv. Mem. 9651001, if valid, would make I.R.C. §
108(d)(6) (applying certain exceptions to partnership discharge of
indebtedness income at the partner level instead of at the partnership level)
superfluous. Lastly, the Service’s issuance of Rev. Rul. 2008-39, 200831 I.R.B. 252 (an upper-tier partnership is not considered to be engaged in
the trade or business of a partnership in which it is a partner for purposes
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of determining whether its management fees are deductible as ordinary
and necessary business expenses or as § 212 investment expenses)
suggests that the results in Rev. Rul. 91-32 and TAM 9651001 may be
avoided by injecting another partnership in the structure to hold the Fund’s
membership interest in the operating company; that way when the Fund
sells its partnership interest in the holding partnership and Section 741 is
ignored, then the Fund should be considered as selling its interests in the
holding partnership’s assets (i.e., its partnership interest in the operating
company, which is a capital asset under I.R.C. § 1221) not its indirect
interests in the assets of the operating partnership.
One way tax-exempts mitigate or eliminate unrelated debt-finance income
that might be attributable to their interest in an entity classified as a
partnership is to take advantage of the flexible rules under the Section 752
regulations and cause the partnership agreement to allocate as much of a
partnership’s liabilities to the taxable partners as possible. See Example 4
of Treas. Reg. § 1.514(c)-1(a)(2) and Tech. Adv. Mem. 9651001 (June 27,
1996). See also, Rev. Rul. 76-95, 1976-1 C.B. 172.
2.
ECI. Foreign persons (individuals and corporations) are taxed on income
that is considered to be effectively connected with the conduct of a trade
or business within the United States (including § 1231 gains and certain
gains from the sale of capital assets). I.R.C. §§ 864(c), 872(a)(2) and
882(a)(1) and Treas. Reg. § 1.864-4(c). If, however, a foreign person is a
resident of a country that has a tax treaty with the United States, then that
tax convention likely requires that the ECI (including gain from the
disposition of personal property) be attributable to a “permanent
establishment” (i.e., “a fixed place of business through which the business
of an enterprise is wholly or partly carried on”) in the U.S. for it to be
subject to the U.S. net income tax. Articles 5, 7, and 13 of the United
States Model Income Tax Convention of November 15, 2006 (the “Model
Treaty”).
In addition to a foreign person having to pay U.S. income taxes on ECI, if
the foreign person is a corporation, that income likely also will be subject
to a second, “branch profits tax” to the extent (i.e., the “deemed equivalent
amount”) that it is deemed to be paid to, or otherwise repatriated by, that
corporation other than in connection with that foreign corporation
completely terminating all of its trade or business activities in the U.S.
(which, presumably, would include all of the foreign corporation’s direct
and indirect interests in unincorporated portfolio companies) and, thereby,
ceasing to directly or indirectly have any “U.S. assets.” I.R.C. § 884 and
Treas. Reg. § 1.884-2T. In the absence of an applicable tax treaty, the
U.S. branch profits tax is imposed at a flat 30% rate, which could cause
the effective tax rate on the foreign corporation’s U.S. ECI to exceed 50%.
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A foreign person is deemed to be engaged in the business conducted
directly or indirectly (through one or more tiers of partnerships) of each of
the partnerships in which the foreign person is a partner for purposes of
determining that person’s ECI and, if that foreign person is a foreign
corporation, branch tax liability. I.R.C. §§ 702(b) and 875(1). To ensure
that the tax on a foreign person’s distributive share of a partnership’s ECI
is paid, I.R.C. § 1446 requires the partnership to withhold and remit to the
U.S. Treasury the foreign partner’s income tax on the foreign partner’s
distributive share of that income calculated at the highest applicable
marginal federal income tax rate. Moreover, as mentioned in the above
discussion on UBTI, the IRS takes the dubious position that a foreign
person is to be treated as effectively owning an undivided interest in the
assets of a partnership in which that person is a member to determine the
amount of the gain from the sale of that partner’s interest in the
partnership that is to be taxed as ECI (i.e., based on the ratio of ECI that
the foreign partner would recognize had the partnership instead sold all of
its assets, discharged its liabilities, and distributed the remaining proceeds
to its members in liquidation of their interests in the partnership). Rev.
Rul. 91-32, 1991- C.B. 107. See also I.R.C. § 897(g) for similar rules
regarding that part of the amount realized from the sale of a partnership
interest that is to be treated as being attributable to the partnership’s U.S.
real property interests.
3.
Foreign Investors’ Obligation to File U.S. Tax Returns. A foreign person
is deemed to engage in the trade or business conducted in the U.S. by any
partnership in which that foreign person is directly (or indirectly through
tiers of partnerships) a partner. I.R.C. § 875(1). Every foreign person that
engages in a trade or business (whether directly or indirectly through one
or more partnerships) becomes a U.S. taxpayer and like other U.S.
taxpayers must file U.S. federal income tax returns regardless of whether
that person has any ECI or other income for a particular taxable year.
Treas. Reg. §§ 1.6012-1(b)(1)(i) and 1.6012-1(g)(1)(i). As for other U.S.
taxpayers, a foreign person that engages in a U.S. trade or business that
fails to timely file U.S. income tax returns is subject to penalties and, in
addition, if that foreign person is an individual, he or she is subject to
having deductions and credits (other than credits for taxes paid)
disallowed. I.R.C. §§ 874(a) and 882(c)(2); Treas. Reg. § 1.874-1(a).
4.
State and Local Taxes. If a PE/VC Fund invests in an unincorporated
portfolio company that conducts business in many states (presumably any
business activities of that company in foreign countries will be conducted
through foreign corporations), its investors either will need to be included
as part of composite returns filed by the partnership or separately incur the
expense and challenge of having to file their own income tax returns in
those states. Some states, however, do not give the partners this option;
instead, they require the partnership to withhold and pay state income
taxes on each non-resident partner’s share of the partnership’s income
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attributable to that state. See e.g., N.C.G.S. § 105-154(d) requiring the
withholding by the partnership of the North Carolina income taxes of
nonresident individuals’ shares of that partnership’s North Carolina
income (a nonresident corporation may forego being included in the North
Carolina composite return by executing an affirmation that it will file
North Carolina income tax returns and pay the North Carolina taxes owed
on its share of the partnership’s North Carolina income). For a general
discussion of the state tax issues that may arise when a business is
conducted by an LLC or other unincorporated entity, see Bruce P. Ely,
Noted Trends in the State Taxation of Pass-Through Entities, TAX
PLANNING FOR DOMESTIC & FOREIGN PARTNERSHIPS, LLCS, JOINT
VENTURES & OTHER STRATEGIC ALLIANCES, Practising Law Institute
(2008), with attached charts summarizing the manner in which each of the
50 states tax LLCs and other entities classified as partnerships for federal
tax purposes.
5.
General Inability of an LLC or Partnership From Making a Public
Offering of its Equity Securities or Merging Into a Publicly-Traded or
Privately-Held Corporation.
IPOs. Another reason given for PE/VC Funds insisting on their portfolio
companies being organized as corporations instead of LLCs or other
entities taxed as partnerships is to put those companies into position at the
outset for being able to make an initial public offering or to merge, on a
tax-free basis, into a publicly-traded or privately-held corporate
“acquirer.” While one may always hope and work towards having a
portfolio company “go public,” that aspiration usually is not realized. If it
is, then it is relatively easy to convert the LLC or other unincorporated
entity into a corporation prior to, or in connection with, the IPO. See Rev.
Rul. 84-111, 1984-2 C. B. 88. See also the 2008 amendments to SEC
Rule 144, which among other things generally reduced the holding period
for the resale of restricted stock issued by a publicly-traded (i.e., a
“reporting”) company and held by non-affiliated shareholders from one
year to six months (volume limitations and other requirements in addition
to the current information requirements generally must be satisfied for an
affiliated shareholder to sell restricted shares after holding them for six
months).
In addition, several companies have employed a variant of the UPREIT or
umbrella REIT structure to go public (generally referred to as the
barnesandnoble.com structure after one of the first non-REIT companies
made an initial public offering using this structure). See Registration
Statement of barnesandnoble.com, Inc. filed on Form S-1 on May 24,
1999, File No. 333-64211; see also Form 10-K filed May 1, 2000. In
notes 123 and 126 and the related discussion, Eric B. Sloan, Steven E.
Klig, and Judd A. Sher, Through the Looking Glass: Seeing Corporate
Problems as Partnership Opportunities, TAX PLANNING FOR DOMESTIC &
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FOREIGN PARTNERSHIPS, LLCS, JOINT VENTURES & OTHER STRATEGIC
ALLIANCES, Practising Law Institute (2008), identify the following
companies as using some version of the UPREIT/barnesandnoble.com
structure:
“Prospectus for Evercore Partners (August 11, 2006);
prospectus for Lazard Ltd. (May 2, 2005); prospectus for Texas Genco
Inc. (June 3, 2005) (later withdrawn due to sale of the company);
prospectus for Calamos Asset Management, Inc. (Oct. 26, 2004);
prospectus for Accenture Ltd. (July 18, 2001); prospectus for Charter
Communications, Inc. (Nov. 8, 1999); prospectus for barnesandnoble.com
Inc. (May 25, 1999) (on May 27, 2004, the structure was unwound when
barnesandnoble.com inc. merged with and into a wholly owned subsidiary
of Barnes & Noble, Inc).” See also Mark J. Silverman, Lisa M. Zarlenga,
Eric B. Sloan, and Lewis Steinberg, Thinking Outside the Box and Inside
the Circle (or Triangle): Use of LLCs in Consolidated Return Context, In
Corporate Acquisitions, and Otherwise, TAX STRATEGIES FOR CORPORATE
ACQUISITIONS, DISPOSITIONS, SPIN-OFFS, JOINT VENTURES, FINANCINGS,
REORGANIZATIONS & RESTRUCTURINGS, Practising Law Institute (2008) in
which the following additional companies are identified as using a
variation of this structure: “Highbridge . . . , National Cinemedia, Fortress
and Blackstone.”
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The basic structure is presented in the following diagram:
barnesandnoble.com Variant of the UPREIT Structure*
Prior owners or principals
of the Company
Cash or
portion of
interest in
LLC
Public shareholders
Super voting
stock
IPO proceeds
Principals and other
roll-over investors
GP or Manager
interest
Investors have right to
exchange or otherwise
convert membership interest
units in the operating
company for an equivalent
number of shares in P-Co
(i.e., the equivalent value of
the units in the operating
company and shares in PCo are maintained)
Corporation
(P-Co)
IPO proceeds
LLC or P/S
Operating
Company
Tax-Free Mergers. The Internal Revenue Code allows for certain
corporate mergers and other “reorganizations” described in I.R.C. § 368 to
occur tax-free (i.e., with the corporations or the shareholders participating
in the reorganization not recognizing gain or loss except for having to
recognize gain to the extent that cash or other “boot” is received in the
transaction). See Part II.C.2 of Warren P. Kean, M&A Transactions
Involving Partnerships and LLCs, Including Conversions, Mergers and
Divisions, TAX PLANNING FOR DOMESTIC & FOREIGN PARTNERSHIPS,
LLCS, JOINT VENTURES & OTHER STRATEGIC ALLIANCES, Practising Law
Institute (2008). This exception to gain or loss recognition only applies if
the entities involved in the reorganization are corporations. Thus, unless
I.R.C. § 351 applies, the merger or other combination of a partnership into
a corporation in exchange for stock of the surviving corporation (as
contrasted from a merger of a partnership with another partnership) is
taxable to the partnership and its members. Id. at Part VII.B. In addition,
the merger of a corporation into a partnership is taxable to the corporation
and its shareholders on the same basis had the corporation instead
liquidated. Id. at Part VII.A.
For a more in depth discussion of this structure, see Robert A. Rizzi, “Dot Com Exit Structures,”
barnesandnoble Reorganization Issues,” 27 J. Corp. Tax’n (Oct. 2000).
*
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If the PE/VC Fund intends to sell any shares it receives shortly after the
close of a merger, then having gain triggered by the merger or
combination may not be that significant, particularly if the acquirer is
willing to pay additional consideration for the step-up in the tax basis of
the target’s assets. If continued deferral is important, then [with
appropriate care so as to not run afoul of the step-transaction doctrine
(which under Treas. Reg. § 301.7701-3(g)(2)(i) applies to elective
conversions under the check-the-box rules)], before the merger or other
combination and under circumstances that establish that doing so has
independent, non-tax, significance and purpose, either the portfolio
company can convert into a corporation or the Fund can transfer its
membership interest in the portfolio company to a corporation formed to
hold the membership interest and then merge that corporation into the
acquirer or an acquisition subsidiary of the acquirer. Compare West
Coast Marketing Corp. v. Commissioner, 46 T.C. 32 (1966) (transfer of an
undivided interest in land to a newly-formed corporation when “the sale of
the land was imminent” for the sole purpose of being able to receive the
agreed-upon consideration for that land (i.e., shares of stock of the
acquiring corporation) in a tax-free B reorganization (demonstrated, at
least in part, by the acquiring corporation liquidating the new corporation
less than two months after the share exchange) was disregarded under the
step transaction doctrine; instead, the taxpayer was treated as having
transferred the undivided interest in the land to the acquiring corporation
in exchange for shares of that corporation’s stock) with Vest v.
Commissioner, 57 T.C. 128 (1971) (because there were valid, non-tax,
business reasons for the transfer of assets to a new corporation one month
before that corporation signed (and otherwise committed to) a share
exchange agreement and plan of reorganization with the acquiring
corporation (and before that transaction was otherwise “imminent”) and
two months before the transaction was consummated, the share exchange
was held to be a valid B reorganization even though the acquiring
corporation liquidated the target corporation shortly after the share
exchange) and Weikel v. Commissioner, T.C. Memo 1986-58 (holding that
the transfer of assets to a newly-formed corporation during the course of
negotiations for the purchase and sale or license of those assets to Johnson
& Johnson had “economic substance” that was “independent” of the share
exchange that was agreed to two months after the incorporation of the
targeted business and which was closed two months after that because (i)
at the time of the target’s incorporation, it was uncertain that an agreement
would be reached with J&J, (ii) the assets were of a business (as
contrasted from the passive, investment asset that were at issue in West
Coast Marketing Corp.), (iii) the business had become profitable and those
profits would be taxed more favorably if the business were incorporated,
(iv) J&J (for its own business reasons) wanted the business incorporated
so that it could acquire stock instead of assets of the business, and (iv) J&J
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continued to operate that business in the target corporation for almost
three years after it acquired the company).
Alternatively, and perhaps more likely to survive a collapsible transaction
attack, the Fund (and perhaps other members, as long as the LLC
continues to have at least two economic members after the transaction)
could transfer its membership interest in the LLC to a corporation and
have all of the stock of that corporation acquired by the acquiring
corporation in either a B Reorganization or a Reverse Triangular merger
that qualifies for tax-deferral treatment under I.R.C. § 368(a)(2)(E) with
the affirmative covenant that the acquirer maintain the target structure (of
a corporation holding a membership interest in the LLC that retains its
classification as a partnership for federal tax purposes) for a sufficient
period of time to establish the business and economic relevance (and nontransitory nature) of the pre-merger transaction(s). See Weikel v.
Commissioner, TC Memo 1986-58, discussed in the preceding paragraph
and compare that case to Intermountain Lumber Co. v. Commissioner, 65
T.C. 1025 (1976) (the sale of 50% of the total number of shares of stock
received in exchange for the contribution of assets to a newly-formed
corporation pursuant to an integrated agreement with the buyer caused the
selling shareholder to be deemed to own only the retained shares
“immediately after the exchange” and, therefore, the exchange did not
satisfy the “control” requirement for tax-free treatment under I.R.C. 3514)
and Rev. Rul. 70-140, 1970-1 CB 73 [the transfer of assets to the
transferor’s previously-established and operating, wholly-owned, target
corporation in connection with (i.e., as part of a “prearranged integrated
plan”) the transfer of all of the stock of that target corporation to the
acquiring corporation in exchange for stock in the acquiring corporation
was ruled, in substance, to have been transferred by the taxpayer to the
acquiring corporation, which the taxpayer did not control immediately
after the deemed exchange and, therefore, was taxable (however, the
continued viability of this ruling after Esmark, Inc. v. Commissioner, 90
T.C. 171 (1988), aff’d 886 F.2d 1318 (7th Cir. 1989) is debatable,
particularly in the situation where the target corporation is maintained and
not liquidated after the share exchange)].
The Court reasoned: A determination of ‘ownership,’ as that term is used in section 368(c) and for purposes of
control under section 351, depends upon the obligation and freedom of action of the transferee with respect to the
stock when he acquired it from the corporation. Such traditional ownership attributes as legal title, voting rights,
and possession of stock certificates are not conclusive. If the transferee, as part of the transaction by which the
shares were acquired, has irrevocably foregone or relinquished at that time the legal right to determine whether to
keep the shares, ownership in such shares is lacking for purposes of section 351. By contrast, if there are no
restrictions upon freedom of action at the time he acquired the shares, it is immaterial how soon thereafter the
transferee elects to dispose of his stock or whether such disposition is in accord with a preconceived plan not
amounting to a binding obligation.
After considering the entire record, we have concluded that Shook and Wilson intended to consummate a sale of
the S&W stock, that they never doubted that the sale would be completed, that the sale was an integral part of the
incorporation transaction, and that they considered themselves to be co-owners of S&W upon execution of the stock
purchase agreement in 1967.” [Id. At 1031-32 (citations omitted)].
4
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See also the discussion of the foregoing issues in Part II.A.2 and 3,
particularly Part II.A.3.c, of Laurence E. Crouch, Revival of the Choice of
Entity Analysis: Use of Limited Liability Companies for Start-Up
Business, TAX PLANNING FOR DOMESTIC & FOREIGN PARTNERSHIPS,
LLCS, JOINT VENTURES & OTHER STRATEGIC ALLIANCES (2008).
6.
Inability to Sell Substantial Built-In Losses. With the passage of the
American Jobs Creation Act of 2004, a purchaser of an interest in a
partnership that has a “substantial built-in loss” (i.e., the partnership’s
adjusted inside basis in its assets exceeds the fair market value of those
assets by more than $250,000) is to receive a special downward basis
adjustment in the partnership’s assets, regardless of whether the
partnership has a Section 754 election in effect, to cause that purchaser’s
share of the partnership’s inside basis to conform with the outside basis of
the acquired partnership interest. I.R.C. §§ 743(b) and (c) and 755.
7.
Potential Increase in the Self-Employment Tax of the Fund’s Management
Team. The general partner of a PE/VC Fund usually is a limited liability
company or other entity classified as a partnership for federal tax purposes
so as to allow the capital gains character of the general partner’s share of
the Fund’s income to flow through to the principals and other participating
personnel of the Fund’s sponsor. In addition to capital gains, the character
of other income also will flow through the general partner to sponsor
personnel. Thus, the general partner’s share of an unincorporated
portfolio company’s operating income will flow through to its members
and may cause them to have to pay additional self-employment tax
(currently a 15.3% tax, comprised of a 12.4% social security (old age,
survivors and disability insurance) tax under I.R.C. §§ 3101(a) and
3111(a) that is subject to a cap under I.R.C. § 3121(a) on the first
$106,800 of wages and net earnings for 2009 under Notice 2008-103,
2008-46 I.R.B. 1156) and a Medicare (hospital insurance) tax of 2.9%
under I.R.C. §§ 3101(b) and 3111(b) (which has no cap). Because of the
cap on social security taxes, any additional self-employment taxes
attributable to the earnings of an unincorporated portfolio company likely
will be limited to the 2.9% Medicare tax. Also, any member who is, or is
deemed to be, a “limited partner” under I.R.C. § 1402(a)(13) need pay
self-employment taxes only on “guaranteed payments,” not allocations of
his or her distributive share of the partnership’s income. Similarly,
employment taxes are owed only on the wages paid to an S corporation’s
shareholder/employee for the services he or she renders to the corporation
and not on that person’s share of the S corporation’s income.
8.
Phantom Income. Generally speaking, a shareholder will recognize
income as payments are received with respect to the shareholder’s
investment in the corporation. No such relative assurance may be given to
partners in a partnership, particularly with respect to the recapture or other
chargeback of prior deductions.
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9.
Complexity of the Governing Documents and Tax and Financial
Accounting for Unincorporated Entities. The governing documents of
LLCs and other unincorporated entities (particularly with regard to their
incorporation of many tax accounting concepts, and those tax accounting
rules in general), often are viewed as more complex than their corporate
counterparts. For a discussion of the common mistakes that can be made
when drafting partnership or operating agreements, see Warren P. Kean,
“Common Mistakes and Oversights When Drafting and Reviewing LLC
Operating Agreements,” 11 J. Passthrough Entities 23 (Jan./Feb. 2008).
See also, Warren P. Kean, A Partner’s Interest in the Partnership for
Purposes of Section 704(b), TAX PLANNING FOR DOMESTIC & FOREIGN
PARTNERSHIPS, LLCS, JOINT VENTURES & OTHER STRATEGIC ALLIANCES
(2008). A strong argument, however, may be made that LLC documents
are no more complex and, perhaps, are less complex (or at least more
coordinated and organized, usually with a single set of defined terms in
the operating agreement) than the array of their corporate counterparts of
certificates of incorporation and designation, bylaws, and shareholders’,
securityholders’, investors’ rights, voting rights, indemnification, and
rights of first refusal and co-sale agreements. Accordingly, perhaps a
better description for this perceived disadvantage of LLCs is that some or
many professionals, investors, and business people are less familiar with
LLCs and their organizational documents than they are with corporations
and their organizational documents. Although, this comfort gap has
narrowed significantly over the last decade.
10.
Delay in Providing Tax Information to Partners. Because each partner
must include that partner’s distributive share of the partnership’s income
or loss in computing the partner’s tax liability, the delay in providing this
information to partners is often a source of frustration and irritation for
investors.
11.
Efficiency\Expediency of Using Familiar or Customary Templates –
Inertia? Using the approach, structure and documents of prior deals
allows for a more efficient and streamlined set of negotiations and closing
for the Fund, its investors, and its professionals as they work to expedite
the process for creating or replicating “the next ____.” This very practical
rationale for maintaining the status quo begs the question: What would be
the choice of entity for portfolio companies if we were starting from
scratch? Is the tide turning (or has it already turned) against PE/VC firms
rejecting out of hand investing in companies other than corporations?
12.
The Income Tax Rules for Corporations May be Less Than the Income
Tax Rules for Individuals. The maximum federal income tax rate for C
corporations for 2008 was 34% on taxable income of more than $75,000
but less than $10 million and (generally speaking) 35% on taxable income
of more than $10 million. I.R.C. § 11(b). The maximum federal income
tax rate on ordinary income for married individuals filing jointly for 2009
20
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was, generally speaking, 25% and 33% for taxable income above $65,100
and below $357,700 and 35% for taxable income above $357,700. I.R.C.
§ 1(f) and (i). Individuals are taxed at lower rates (generally 15%) on
capital gains. Corporations are not. The federal tax brackets for
individuals are adjusted for inflation. I.R.C. § 1(f). The federal tax
brackets for corporations are not adjusted for inflation. Many states also
tax corporations at lower income tax rates than for individuals. For
example, the maximum North Carolina 2008 income tax rate for
corporations was 6.9%, but its maximum income tax rate for individuals
was 7.75%. Corporations, however, usually also are subject to a separate
franchise tax that is not imposed on individuals.
13.
Unavailability of the Benefits of “Qualified Small Business Stock”; I.R.C.
§§ 1202 and 1045. Noncorporate purchasers of “qualified business
corporation stock” (“QSB” stock) may, upon satisfying a fairly long list of
requirements, defer and exclude the recognition of capital gain from the
sale of that stock. I.R.C. §§ 1045 and 1202. The amount of the exclusion
is 50% (60% for certain empowerment zone businesses) of 28% (because
capital gains from the sale of QSB, before being reduced by 50%, are
subject to a 28% tax rate instead of the 15% tax rate applicable to most
other long-term capital gains). I.R.C. §§ 1(h)(4)(ii) and (7). The
difference between that rate (50% of 28% or 14%) and the regular rate for
long-term capital gains of 15% is, therefore, only 1% (even less for lowincome investors, and that 1% difference essentially can be eliminated by
the application of the alternative minimum tax by the lower rate being
treated as a “tax preference” under I.R.C. § 57(a)(7)). The exclusion rate,
however, was increased from 50% to 75% (for an effective 7% federal
income rate – i.e., an 8% rate reduction to the regular 15% capital gains
rate) under Section 1241(a) of the American Recovery and Reinvestment
Act of 2009, but only for QSB stock that is purchased before January 11,
2011. I.R.C. § 1202(3). Of course, if the 15% rate on long-term capital
gains is increased as it is scheduled to do in 2011, the rate difference may
be even greater. Of more importance for most investors, however, is the
ability to rollover and otherwise defer the recognition of gain from the sale
of QSB stock under I.R.C. § 1045.
The numerous requirements that have to be satisfied to get the benefit of
QSB treatment include the following: (i) the stock must be purchased
from the issuing corporation (i.e., stock purchased in a secondary transfer
does not qualify for the §§ 1045/1202 benefits; thus, a buyer will not pay
the seller a premium for the SBC stock because of its SBC character;
instead, as discussed above, the buyer likely will discount the purchase
price for the built-in tax gain of the corporation’s assets); (ii) the issuing
corporation must be a C corporation (not an S corporation); (iii) the QSB
must be held for more than 5 years (instead of the one-year requirement
for long-term capital gain treatment; but for deferral treatment under
I.R.C. § 1045, the stock need be held only for more than six months if the
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rollover occurs within 60 days of the sale of the QSB stock); (iv) the
amount of gain from an investment that is subject to this special treatment
is limited to $10 million; (v) the issuing corporation must be engaged in a
“qualified,” “active business” (which excludes many service business,
such as those in the fields of health, engineering, architecture and other
professional services, performing arts, consulting, athletics, financial
services and brokerage services, businesses engaged in banking,
insurance, financing, leasing, investing or similar business, any farming
business, any oil and gas business, and any hotel, motel, restaurant, or
similar business); (vi) the “aggregate gross assets” (generally the value) of
the corporation at the time of the purchase of its stock by the investor must
not exceed $50 million; and (vii) not more than 10% of the value of the
corporation’s assets may be in real estate. All of these types of restrictions
and requirements for favorable SBC stock tax treatment and certain other
ambiguities, complexities, and problems with the wording and the
application of these provisions (particularly in the context of SBC stock
held by entities taxed as partnerships), and the relatively small benefit of
that treatment over regular tax treatment, have significantly limited the
interest of structuring investments in portfolio companies as purchases of
QSB stock. For a discussion of some of the problems encountered by
investment funds and other partnerships considering investing in QSB
stock with the wording of I.R.C. § 1045 for rollover tax treatment, see
Melanie W. Levy, “Exclusion of Capital Gain on Sale of QSB Stock” 7
Bus. Entities 18 (July/Aug. 2005) and the Treas. Reg. § 1.1045-1, issued
by Treas. Dec. 9353 on August 13, 2007.
Choice of Entity Resources. For a more thorough comparison of corporations and
partnerships, see any of the many choice of entity books, articles, and other materials on the
subject, including those referenced in Part A of this outline. Two worthwhile articles that take
contrary positions on whether partnerships or corporations are more efficient and effective
vehicles for organizing a portfolio company of a PE/VC Funds are Victor Fleischer, “The
Rational Exuberance of Structuring Venture Capital Start-Ups,” 57 Tax L. Rev. 137 (2004) and
Daniel S. Goldberg, “Choice of Entity for a Venture Capital Start-Up; the Myth of
Incorporation,” 55 Tax Law, 923 (Summer 2002).
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D.
Blocker Structures.5 The structures diagrammed in this part have been employed to
reduce or eliminate UBTI and ECI for a PE/VC Fund’s tax-exempt and foreign limited
partners/investors.
Typical Fund Structure
General
Partner
Limited
Partners
Fund
Management Fees
Management
Company
Management or
Monitoring Fees
Portfolio
Company6
(p/s or corp.)
5
For a discussion of these and other structures and arrangements to deal with UBTI/ECI recognition concerns,
see Part VII.D, Andrew W. Needham and Anita Beth Adams, 735 BNA Tax Management Portfolio, Private Equity
Funds, and Robert D. Blashek and Scot M. McLean, Investments in “Pass-Through” Portfolio Companies by
Private Equity Partnerships: Tax Strategies and Structuring, TAX PLANNING FOR DOMESTIC & FOREIGN
PARTNERSHIPS, LLCS, JOINT VENTURES & OTHER STRATEGIC ALLIANCES, Practising Law Institute (2008).
6
If a partnership, then there will be flow-through tax treatment under I.R.C. §§ 702, 512(c), and 875(1) through
the Fund and other tiers of partnerships in the ownership structure between the ultimate owners and the portfolio
company.
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Simple Subsidiary Blocker Structure
Limited Partners
(including tax-exempt and
foreign investors)
GP
Tracking allocations and
distributions attributable to the
7
Blocker Corporation
Fund
Tax-exempt and
foreign investors
capital contributions
100%
Blocker
Corporation
Non-tax-exempt and
non-foreign investors
capital contributions
(see also the
barnesandnoble.com
structure described in
Part C.5 above)
Founders, members of
management, and other
investors
B
Sub
Portfolio
Company
7
A Fund might invest in the unincorporated portfolio company both directly (with the non-tax-exempt and nonforeign investors’ capital contributions) and indirectly through a blocker corporation (with the tax-exempt and
foreign investors’ capital contributions).
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Simple Parent Blocker Structure
Tax-exempt and
foreign investors
GP
Blocker
Corp. #18
Limited
Partners
Blocker
Corp. #27
Fund
Portfolio
Company #1
Portfolio
Company #2
8
A new blocker corporation is established for each unincorporated portfolio company to avoid being subject to
branch profits tax (if the blocker corporation is a foreign corporation) by allowing the foreign corporation to
completely terminate its trade or business activities as contemplated by Treas. Reg. § 1.884-2T(a)(2) and to cause
the distributions that it makes to its shareholders to be treated as liquidating distributions instead of as dividends
subject to withholding taxes under I.R.C. §§ 1441 and 1442 if the blocker corporation is a domestic corporation.
Alternatively, if the branch profits tax and FDAP withholding taxes are not concerns, each tax-exempt and foreign
investor that wants to avoid UBTI or ECI may establish its own blocker corporation or all participating tax-exempt
and foreign investors may elect to invest in the Fund through one blocker corporation.
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Parallel Fund Structure
Limited
Partners
Electing tax-exempt
and foreign investors
General
Partner
Main
Fund
Parallel
Fund
100%
Blocker9
Corporation
B
Sub
Portfolio
Company
9
The benefit of a foreign blocker organized in a tax haven is that the FDAP income of the corporation will not be
subject to U.S. tax, and it may make payments to its owners/shareholders without having to pay withholding taxes.
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Certain tax and other issues to keep in mind:
E.
1.
I.R.C. § 269.
2.
Agency principles.
3.
Substantiality rules of Treas. Reg. § 1.704-1(b)(3).
4.
Constructive or imputed partnership risk.
5.
Tax rates of foreign investors’ domicilary countries and amount of tax credit
available for payment of U.S. and other taxes.
6.
ERISA “Plan Assets” rules.10
Use of Convertible Notes and Warrants.
In 2003, the IRS issued proposed regulations on the taxation of noncompensatory
partnership options and convertible securities. REG-103580-02, 68 Fed. Reg. 2930
(2003) reprinted in 2003-1 C.B. 543. The proposed regulations generally provide that the
issuance and exercise of a noncompensatory option or convertible security does not cause
the recognition of gain or loss by the issuing partnership, the option holder, or the other
partners. The proposed regulations contain rules to account for any capital shifts that
may result upon the exercise of such options or conversion rights (i.e., the extent to which
upon the exercise of those rights, the holder becomes entitled to share in partnership
capital in an amount that differs from the amount paid to the partnership in respect of the
options or convertible securities). The amount of such a nonrecognition capital shift (i.e.,
The trustee, or deemed trustee, of the assets of an ERISA pension plan (so-called “plan assets”) must invest and
otherwise manage those assets in accordance with the fiduciary standards (including the prohibited transaction rules
(and subject to the 15% (and possibly up to 100%) excise tax on prohibited transactions under I.R.C. § 4975)) of
Part 4 of Title I of the Employee Retirement Income Security Act of 1934, as amended (“ERISA”). Money invested
by an ERISA pension plan in a PE/VC Fund (or other non-publicly traded equity security or security that is not
issued by a regulated investment company registered under the Investment Company Act of 1940) is considered to
be a plan asset for which the Fund (i.e., its general partner or manager) must comply with those ERISA fiduciary
standards unless an exception applies. The two exceptions that PE/VC Funds typically try to fit under are (i) the
“venture capital operating company” exception (generally referred to as the VCOC exception under Labor
regulations § 2510.3-101(d)(1) (i.e., 29 C.F.R. § 2510.3-101(d)(1)) and (ii) preventing ERISA pension plans (or
other “benefit plan investors”) from having a significant participation in the Fund (i.e., holding 25% or more of the
value of any class of equity interest in the Fund (or any other non-publicly traded investment entity, ERISA §3(42)).
10
Under the Labor regulations, a VCOC is an entity (such as a PE/VC Fund) that at least 50% of its assets
(determined by the cost of those assets and without regard to certain short-term investments) being invested in
“venture capital investments” (or certain “derivative investments”). A venture capital investment is defined as an
investment in an operating company (other than a VCOC) in which the Fund (or other applicable entity) has
contractual rights “to substantially participate in, or substantially influence the conduct of,” that operating
company’s management. In addition, to be a VCOC, the Fund (or other applicable entity) must not only have such
management rights in the operating company to which it invests but it, in fact, must exercise those rights in the
ordinary course of its business “with respect to one or more of the operating companies in which it invests.” An
“operating company” for this purpose is defined as “an entity that is primarily engaged, directly or through a
majority owned subsidiary or subsidiaries, in the production or sale of a product or service other than the investment
of capital.” Labor Regulations § 2510.3-101(a)-(d).
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in the case of an option holder, the amount by which the option holder’s capital account
exceeds the premium paid for the option and the option’s exercise price for the
partnership interest) is to be accounted for first by allocating unrealized (“book up” or
“book down”) income, gain, loss, or deduction in the partnership’s assets to the
exercising partner up to the amount of the capital shift and then, to the extent of any
remaining amount of the capital shift, by reallocating partnership capital among the
partners, as provided in Prop. Reg. § 1.704-l(b)(2)(iv)(s). The amount of the capital shift
will then be taxed in accordance with the principles of I.R.C. § 704(c) (so called “reverse
Section 704(c) allocations”) and, to the extent necessary, “corrective allocations” under
Prop. Reg. § 1.704-l(b)(2)(iv). See Treas. Reg. §§ 1.704-l(b)(2)(iv)(f)(4) and 1.7043(a)(6) and Prop. Reg. §§ 1.704-l(b)(2)(iv)(s)(4) and 1.704-1(b)(4)(ix) and (x). For a
discussion of these proposed regulations, see IRS Publishes Proposed Regs on Tax
Treatment of Noncompensatory Partnership Options, 98 TAX NOTES 502 (Jan. 27, 2003);
NEW YORK STATE BAR ASSOCIATION TAX SECTION REPORT ON THE PROPOSED
REGULATIONS RELATING TO PARTNERSHIP OPTIONS AND CONVERTIBLE SECURITIES, REP.
NO. 1048 (Jan. 23, 2004), available electronically in the TAX NOTES Today file of the
FEDTAX Library of LEXIS at 2004 TNT 16-80; and Matthew P. Larvick,
Noncompensatory Partnership Options: The Proposed Regulations, presented at TAX
PLANNING FOR DOMESTIC & FOREIGN PARTNERSHIPS, LLCS JOINT VENTURES & OTHER
STRATEGIC ALLIANCES, Practising Law Institute (2008).
In the case of convertible securities, the preamble to the proposed regulations state that
the proposed regulations do not change the general tax rules that treat a conversion right
embedded in convertible debt or convertible equity as part of the underlying instrument
(and not a separate instrument). See also, Prop. Regs. §§ 1.1272-1(e), 1.1273-2(j), and
1.1275-4(a)(4).
F.
General Discussion of Warrants.
Part of an Investment Unit. When a warrant is received in conjunction with a debt
instrument, the amount paid for that investment unit must be allocated between the warrant and
the debt instrument based on their relative fair market values. I.R.C. § 1273(c)(2). The
allocation usually will generate imputed interest on the debt instrument under the original issue
discount rules of I.R.C. § 1272.
Holder’s Income and Loss Recognition. That part of the purchase price of an investment
unit that is allocated to the warrant is capitalized and is included in the adjusted tax basis of the
property purchased by the exercise of the warrant. Rev. Rul. 78-182, 1978-1 C.B. 265. The
holder will recognize a capital gain or loss (assuming the property that the holder had the right to
purchase with the option would have been a capital asset in the hands of the holder) upon the sale
or other taxable disposition of the warrant, depending on whether the sales price is more or less
than the holder’s adjusted tax basis in the warrant (generally what the holder paid for the
warrant). Id. If the holder does not sell or exercise the warrant (i.e., allows it to lapse), the tax
treatment to the holder will be the same as if the holder had sold it for nothing on the expiration
date of the warrant. Rev. Rul. 78-182, 1978-1 C.B. 265 and I.R.C. § 1234(a)(2) and Treas. Reg.
§ 1.1234-l(b).
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No gain or loss is recognized upon the exercise of the warrant, except in the case of a
warrant to acquire shares of stock of a corporation, the holder may have to recognize gain to the
extent that cash is received in lieu of fractional shares. Rev. Rul. 72-71, 1972-1 C.B. 99. The
partnership counterpart to such treatment is the possible application of the disguised sale rules
under I.R.C. § 707(a)(2)(B).
Warrants (and other Stock Rights) Treated as Stock under I.R.C. § 305 (d) --Adjusting or
Failing to Adjust the Exercise Price. Warrants and other rights to acquire stock of a corporation
are treated as “stock” and their holders as “shareholders” under I.R.C. § 305. I.R.C. § 305(d).
There is no comparable rule for partnerships.
No Tacking of the Warrant’s Holding Period. The holding period of the stock or
partnership interest or other property purchased by the exercise of a warrant begins on the day
that the warrant is exercised, not when the warrant was acquired. I.R.C. § 1223(5); Treas. Reg.
§ 1.1223-1(f), and Weir v. Commissioner, 10 T.C. 996 (1948), aff’d per curiam, 173 F.2d 222
(3rd Cir. 1949) (holding that the holding period for the stock acquired by the exercise of a
warrant begins on the day after the date that the warrant is exercised). If instead of exercising a
warrant, the warrant is exchanged (or treated as being exchanged) for stock (other than
nonqualified preferred stock) in a corporate recapitalization or other corporate reorganization
(other than a divisive “D” reorganization) under I.R.C. § 368, then (as a technical matter),
because the warrant is to be treated as a “security” under I.R.C. § 354, the warrant’s holding
period should be included (tacked on) to the holding period of the stock acquired. See Treas.
Dec. 8752, reprinted in 1998-1 C.B. 611 (adding subsection (c) to Treas. Reg. § 1.354-1, treating
options and other rights to acquire stock as securities with no principal amount), I.R.C.
§ 354(a)(2) (shares of nonqualified preferred stock are not treated as stock or securities when
they are exchanged for shares of stock other than nonqualified preferred stock); and 1223(1)
(tacking of holding periods for substituted basis property received in an exchange). Thus, the
cashless exercise of a warrant to purchase shares of stock of a corporation may allow the tacking
of the warrant holding period to the holding period of the acquired stock. See Martin D.
Ginsburg and Jack S. Levin, MERGERS, ACQUISITIONS, AND BUYOUTS, ¶ 604.1.2 (Aspen, 2008
ed.) (particularly the discussion of Example 7 and footnote 19 thereof) (“Ginsburg & Levin”).
There is no comparable theory for treating an “exchange” of a warrant for a partnership interest
in connection with a recapitalization or other reorganization of the partnership as other than the
exercise of the warrant (i.e., it is questionable whether a cashless exercise of an option to acquire
a partnership interest will be treated as an “exchange” of property for that partnership interest
instead of as the “exercise” of the option).
The period of time that a taxpayer is treated as holding a capital asset is important for
individuals because for an individual taxpayer to be taxed at the 15% current maximum capital
gains rate (instead of at ordinary income tax rates, for which the maximum rate currently is 35%
-- there is no rate differential on capital gains for corporations), that individual must be deemed
to have held the capital asset for more than one year prior to its sale or exchange (so-called longterm capital gains). See I.R.C. §§ l(h) and l(i). For that reason, holders of warrants usually
negotiate to sell their warrants instead of exercising the warrants to sell the underlying stock or
other property. See also Prop. Reg. §§ 1.721-2(e)(1) and 1.761-3(b)(2): “A contract that
otherwise constitutes an option shall not fail to be treated as such for purposes of this section
merely because it may or must be settled in cash or property other than a partnership interest.”
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No Gain or Loss to the Issuer. A corporation does not recognize gain or loss when it
receives money or other property in exchange for shares of its capital stock or when warrants
paid to acquire its stock lapse. I.R.C. § 1032(a). A partnership is subject to similar treatment
under I.R.C. § 721(a) and the proposed noncompensatory option rules discussed in Part E above.
“Penny Warrants.” If under the particular facts and circumstances, the purchaser of a
warrant in substance acquires the benefits and burdens of ownership of the underlying property,
the option will be ignored for federal income tax purposes, and the holder will be treated as
purchasing the underlying property. Thus, if a person pays $70 for a warrant giving the holder
the right at any time, upon paying an exercise price of $30, to purchase stock that on the date that
the warrant is purchased has a fair market value of $100, that person will be treated as owning
the stock, not a warrant to purchase that stock. See Rev. Rul. 82-150, 1982-2 C.B. 110 and a
similar example in Example 3 of Prop. Reg. 1.761-3(d) in which an investor pays $14x to
purchase an option to acquire a partnership interest that has a value of $15x on the date that the
option is issued. See also Priv. Ltr. Rul. 9747021 (Nov. 21,1997) in which the IRS had no
difficulty in ruling that warrants having a “nominal exercise price” of a penny per share were to
be treated as stock. But see Rev. Rul. 85-87, 1985-1 C.B. 268 (the purchase of an “in-the-money
option” to require the issuer to buy stock that on the date that the option was acquired had a fair
market value that was “substantially less” than the put price was treated for purposes of the
I.R.C. § 1091 wash sale rules as a contract to purchase the stock subject to the put because at the
time the put option was sold there was “no substantial likelihood that the put would not be
exercised”). Tax practitioners frequently cite Ginsburg & Levin for the following rule of thumb
concerning the possible recharacterization of warrants or other options: “Although there is little
helpful precedent, it appears that where the option price is less than 10% of the option stock’s FV
at grant, the likelihood that the option grant is treated as a transfer of the underlying stock is
high; if the option price is between 10% and 25% of FV, treatment of the option grant (option
versus underlying stock) is unclear and likely turns on additional relevant facts; and if the option
price is 50% or more of FV, the option grant is unlikely to be treated as a transfer of the
underlying stock.” Ginsburg & Levin at 1502.1.2.2 (n. 52). It is important to note, however, that
this rule of thumb is made by Messrs. Ginsburg and Levin in the context of nonqualified
compensatory stock options, not investment warrants that are either purchased by the holder or,
because they are part of an investment unit, are deemed to have been purchased by the holder;
and therefore, the holder has a risk of loss (i.e., it is a “risk investment” for which the holder has
some burden of ownership) that was a critical part of the IRS’s analysis in Rev. Rul. 82-150.
Prop. Reg. § 1.761-3(a) recognizes that the principles discussed in the preceding
paragraph and related concepts apply for determining whether a contract right to acquire a
partnership interest is, in fact, an option or substantively the partnership interest itself: “A
noncompensatory option . . . is treated as a partnership interest if the option (and any rights
associated with it) provides the holder with rights that are substantially similar to the rights
afforded to a partner.” Prop. Reg. § 1.761-3(a), however, goes on to provide: “This paragraph
applies only if, as of the date that the noncompensatory option is issued, transferred, or modified,
there is a strong likelihood that the failure to treat the holder of the noncompensatory option as a
partner would result in a substantial reduction in the present value of the partners’ and the
holder’s aggregate tax liabilities.” For an example of how those rules are intended to apply, see
Example 3 of Prop. Reg. § 1.761-3(d). For a description of rights that are considered to be
“substantially similar” to the rights of a partner and the factors to consider in determining
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whether it is “reasonably certain” that a warrant will be exercised, see Prop. Reg. § 1.761-3(c).
The preamble to the proposed regulations also makes it clear that the IRS will not challenge the
option character of a partnership warrant or a convertible note if that warrant or convertible note
is being employed in a way that does not reduce the amount of the overall taxes paid to the
federal treasury:
Treasury and the IRS recognize that treating a noncompensatory option holder as
a partner may, in some circumstances, frustrate the intent of the parties without
substantially altering their aggregate tax liabilities.
For these reasons, the proposed regulations generally respect
noncompensatory options as such and do not characterize them as partnership
equity. However, the proposed regulations contain a rule that characterizes the
holder of a noncompensatory option as a partner if the option holder’s rights are
substantially similar to the rights afforded to a partner. This rule applies only if,
as of the date that the noncompensatory option is issued, transferred, or modified,
there is a strong likelihood that the failure to treat the option holder as a partner
would result in a substantial reduction in the present value of the partners’ and
option holder’s aggregate tax liabilities. [Preamble to REG-103580-02, 68 Fed.
Reg. 2930-01, 2932 reprinted in 2003-1 C.B. 543; emphasis added.]
G.
Techniques/Structures That May Be Employed to Manage the Complexity of
Federal and State Tax Reporting and Payment.
1.
Special Allocations. Under the substantial economic effect and related
rules of Treas. Reg. § 1.704-1(b)(2), -(b)(4) and -2, entities taxed as
partnerships are given broad latitude in determining how their income and
loss (including individual items of income, gain, loss, and deduction) are
allocated among its members. Accordingly, to minimize both the
administrative costs and complexity of members preparing tax returns for,
and paying the taxes to, many states, the partnership agreement might
provide that, to the extent possible, income earned by a partnership in a
particular state is to be allocated to members who are residents of that
state. For example, instead of allocating to each partner a pro rata share of
income earned by the partnership in all states, the partnership could first
allocate the partnership’s income earned in Florida, Texas, and other states
that either have no income taxes or relatively low income taxes to the
partners who reside in those states to the extent of their distributive shares
of the partnership’s overall income. That way the favorable tax treatment
afforded by those states is not lost (or, at least, the extent of that loss may
be minimized) by allocating income earned in those states to members
who live in states with moderate to high income tax rates. Partners living
in states with high income tax rates will have to pay those high rates
regardless of where the income is earned subject to tax credits for taxes
paid to those jurisdictions where the income is earned.
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2.
Use of Noncompensating Options and Convertible Securities.
discussion in Parts E and F above.
3.
Use of Transitory Allocations to a Principal or Provisional Member or
Corporate Blockers. Under this strategy, income or loss is allocated to one
member (which may be a provisional member; i.e., a member whose sole
purpose is to manage the allocations made to other members) only to be
reversed (including offsetting the consequences of those allocations) later
without running afoul of the substantiality rules of Treas. Reg. § 1.7041(b)(2)(iii). Alternatively, corporate blockers may be used in the manner
contemplated under Part D.
(a)
Corporate carryback and carryover periods
(b)
4.
See
(i)
NOLs. Corporations may carry net operating losses back 2 years
and forward 20 years. I.R.C. § 172(b)(1)(A). Section 1211 of the
newly enacted American Recovery and Reinvestment Act of 2009
(the so-called stimulus bill) provides that certain “eligible small
businesses” may elect to carryback certain 2008 net operating
losses back either 3, 4 or 5 years.
(ii)
Capital Losses. Corporations may carry net capital losses back 3
years and forward 5 years. I.R.C. § 1212(a)(1).
Individual carryback and carryover periods
(i)
NOLs. Individuals may carry net operating losses back 2 years
and forward 20 years. I.R.C. § 172(b)(1)(A). Section 1211 of the
newly enacted American Recovery and Reinvestment Act of 2009
(the so-called stimulus bill) provides that certain “eligible small
businesses” may elect to carryback certain 2008 net operating
losses back either 3, 4 or 5 years.
(ii)
Capital Losses. Individuals may deduct $3,000 of net capital
losses against their ordinary income for the year and carry the
remainder forward indefinitely. I.R.C. §§ 1212(b) and 1211(b).
Ability to Cause the Purchase (but not the “Sale”) of Equity Interests to be
Treated for Federal Income Tax Purposes as (or Substantially Equivalent
to) the Purchase of the Target’s Assets. Rev. Rul. 99-6, 1999-1 C.B. 432
and I.R.C. §§ 754 and 743(b). But see, Rev. Rul.. 91-32, discussed above
in Parts C.1 and C.2.
CONCLUSION
Arguably, the biggest advantage of LLCs and partnerships over corporations is the
flexibility and generally more favorable treatment afforded LLCs and partnerships both under
federal and state tax law and state entity law. Thus, if it ultimately is determined that the entity
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and its owners will be better off if it were organized as a corporation instead of as an
unincorporated entity, such a conversion usually may be accomplished relatively easily. The
converse, however, generally will not be the case. The costs [particularly a corporation’s built-in
tax gain and having to pay one (for S corporations that have not been C corporations during the
built-in gain period of I.R.C. § 1374, generally ten years) or two (for C corporations or S
corporations that were C corporations during the built-in gain period of I.R.C § 1374) levels of
income tax] for converting a corporation into an entity treated as a partnership for federal tax
purposes (other than, at least for federal income tax purposes, a subsidiary of a common parent
of a group of corporations filing consolidated federal income tax returns) frequently will make
such a conversion economically unfeasible.
It is the flexibility accorded unincorporated entities that allows one to solve and
otherwise overcome many, if not all, of the perceived deficiencies and disadvantages of these
entities as compared to corporations in the PE/PC context. That being the case, the question
becomes: Is that flexibility and the other advantages of organizing and operating a business as
an LLC or partnership worth breaking from the use of past archetypes and biases of PE/VC firms
for investing in corporations over LLCs and partnerships? When LLCs were new and unfamiliar
to many clients, business people and professionals, the answer given by many was no. Now, as
LLCs have become popular and widely accepted with a reasonably developed and understood
body of case, regulatory and statutory law, and with LLCs increasingly being recognized as the
“entity of choice” for private-held businesses, ventures, and other enterprises, it perhaps is time
for PE/VC firms to reconsider investing in, and otherwise organizing their portfolio companies
as, LLCs.
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Appendix A
Commentator Questioning PE/VC Funds’ Bias for Corporations
In the euphoria of the initial public offering boom of the late twentieth century,
the tax planning that went into the choice of legal entity of a new business often
took a back seat to a “cookie-cutter” approach of organizing all new businesses as
corporations. There were many reasons for this phenomenon. First, a “cookiecutter” mentality certainly existed in which financial advisors and attorneys opted
to spit out entities that had the same features as prior successful IPO companies.
Organizers of new businesses also desired to employ the exact same formula of
the company that went public the week prior. Second, organizers optimistically
saw an extremely short time period between initial financing and an IPO.
Because the organizers believed that they needed to be organized as a corporation
to go public, the organizers did not see the ability to achieve long-term benefits
from operating in any form other than a corporation. Third, the choice to organize
a new business as a corporation often was legitimized by financial advisors that
correctly noted that venture capitalists (“VCs”) and other third-party investors
only are willing to own stock in a corporation. Fourth, in addition to these
marketing issues, certain technical tax issues and compensation planning issues
raised by organizing a business as an LLC have been noted as reasons to organize
a new business as a corporation rather than an LLC.
The recent rationalization of the IPO, technology and internet markets has led
organizers of new businesses to focus on the most productive way to operate their
new business, and, accordingly, the most advantageous form of entity to operate
the new business. As a result, there has been a resurgence of the use of limited
liability companies, taxed as partnerships for federal income tax purposes
(“LLCs”), as the entity of choice to organize a startup business.
* * * *
Although there are significant issues to the use of LLCs, organizers should not
“throw in the towel” and organize their new business as a corporation rather than
an LLC. In this new rational market environment, there may be a significant
period of time between the organization of a new business and VC-rounds of
financings or an IPO. During this period, there may be significant tax advantages
to operating the business as a pass-through entity such as a LLC. An LLC
generally can easily convert into a corporation on a tax-free basis. However, once
a new business is organized as a corporation, it generally cannot convert into an
LLC on a tax-free basis. In addition, most of the technical tax and compensation
planning issues raised by organizing a new business as an LLC can be addressed
by having a corporate member to the LLC. This structure is referred to in this
outline as “barnesandnoble” structure, named after the initial use of such a
structure by an e-commerce company: Barnesandnoble.com.
Appendix A - 1
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Because the “barnesandnoble” structure was used in an IPO, the structure often is
viewed as merely an IPO structure. However, the principal theme of this outline
is that the “barnesandnoble” structure may be used prior to an IPO to address
most of the “marketing,” technical tax issues and compensation planning issues of
organizing a business as an LLC.
Laurence E. Crouch, Revival of the Choice of Entity Analysis: Use of Limited
Liability Companies for Start-up Business, TAX PLANNING FOR DOMESTIC &
FOREIGN PARTNERSHIPS, LLCS, JOINT VENTURES & OTHER STRATEGIC ALLIANCES
Appendix A - 2
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