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Limited Liability Examined: Part 1 – Common Questions Related to Limited Liability in the Context of a New Business

September 9, 2012 By Leave a Comment

Do I need an LLC or corporation for my new business or is it safe to operate as a sole proprietor? Is purchasing insurance enough protection? If I form a limited liability company or corporation, is it still possible that I can be held liable for something? How can I make my entity “bulletproof?” Will my LLC provide asset protection to me? What can I do to limit my contract liability? If I decide to form a limited liability company or corporation, are there costs or downsides?

These are common questions we get from clients. In this series of posts, we’ll tackle these questions and maybe a few others and try to provide some practical guidance and suggestions.

First, let’s start with a discussion of the sources of liability. There are two basic sources of liability that need to be identified. First, there is contract liability, which arises from the contracts that you or your business enter into with other parties (e.g. your office leases, loan agreements, employment agreements, vendor agreements, etc). With contract liability, only the party to the contract will be held liable absent special circumstances. A simple example is your office lease, if the entity is the party to the contract and doesn’t pay rent, then it is liable for the unpaid rent (and probably other damages) based on the contract. You, however, are not personally liable for the rent, unless you guaranteed the lease or signed it in your individual capacity.

Second, there is tort liability, which is liability arising from the acts of someone. For example, if you are the member of an LLC that owns rental real estate and you personally handle the management of the real estate, then you may be held liable if you are negligent in making repairs which cause harm to a tenant of the LLC. It doesn’t matter that the contract is between your LLC and the tenant, since it’s your personal act that causes the harm and thus you are liable. Another simple example would be your bad driving while on business for the entity that causes harm to someone else. In this case, there is no contract between you and the other driver (or your entity and the other driver) but you are liable anyway. This seems to be a source of confusion for some new clients who mistakenly believe that a limited liability entity protects them from their own acts.

Owners starting new businesses need to think some about the types of contracts and business transactions they will likely enter into and think about the potential liabilities that may arise in the context of their specific business. This should help focus in on the relevant points and help decide if a limited liability entity is needed.

In the next post, we’ll focus more on the questions to be considered when deciding if you need a limited liability entity for your new business or whether insurance may provide sufficient protection.

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© 2012 Casey W. Riggs — This article is for general information only. The information presented should not be construed to be formal legal advice nor the formation of a lawyer/client relationship.

Filed Under: General Business Law Tagged With: ,

Retaining Key Employees in a Privately-Held Company through Equity Compensation – Part 4: “Profits Interests” in LLCs and Partnerships

July 6, 2012 By 4 Comments

This post is the fourth in a series exploring techniques to attract and retain key employees, directors, and other service providers of privately held companies through equity-based compensation arrangements and alternative arrangements that provide cash payments tied to the value of the company’s stock or ownership interests.

Previously, I provided an overview and discussed the tax treatment of various equity compensation arrangements typically used by corporations, such as stock options, restricted stock, phantom stock, and stock appreciation rights. In this post, I’ll discuss a popular technique, called a “profits interest,” which is available to entities taxed as partnerships, such as limited liability companies (or “LLCs”). Profits interests can provide a tax efficient way to reward key service providers. Since LLCs are the most popular type of entity taxed as a partnership, for the rest of this post, I will assume that the entity in question is an LLC.

A “profits interest” in an LLC is an interest in the LLC’s future profits but none of its existing capital. That is, a service provider who receives a profits interest starts with a capital account of $0 and the capital account increases as future profits are allocated to the recipient in accordance with the LLC’s operating agreement. If structured properly, a profits interest will not be taxed to the recipient at grant. However, the holder of the profits interest will incur taxable income for his share of the company profits. If the service provider later sells the profits interest at a price in excess of its value when the profits interest is granted (adjusted upward for any income allocated to the service provider along the way), then gain from such sale would be taxed as long-term capital gains. Therefore, it is hoped that the potential for these economic benefits to the service provider will retain or incentivize him to help the LLC achieve its financial goals.

Considerations in structuring a profits interest include the following:

  • The profits interest must not result in the recipient receiving an interest in the LLC’s capital at date of grant. This is tested by doing a hypothetical liquidation analysis in which it is assumed that the LLC’s assets are sold at their fair market values immediately after the date of grant and the proceeds are then immediately distributed to the LLC members in accordance with the liquidation provisions of the LLC’s operating agreement. If the recipient would receive $0 upon this hypothetical liquidation analysis, then the recipient is deemed to have received no interest in capital and there will be no tax at the date of receipt of the profits interest. Capital accounts of the existing LLC members (those other than the recipient of the profits interest) can be “booked up” to achieve this result.
  • The profits interest can be vested or unvested at date of grant. Frequently a profits interest is granted which vests over some period of time (e.g. 20% per year for five years). However, whether the interest is vested or not, the service provider should be treated as the owner of the interest from the date of grant for income tax purposes (i.e. the service provider will receive his or her pro rata share of income, loss, etc. under the LLC’s operating agreement). Therefore, a mechanism to deal with taxes due on phantom flow-through income to the recipient needs to be established, such as having the company make distributions to the service provider to assist him in meeting his increased tax burden. In addition, the recipient will generally want to make an 83(b) election for any unvested interests so that the interest is taken into account for tax purposes at date of grant (when the value for tax purposes is $0) instead of later upon vesting when it would generally have value.
  • An employee who receives a profits interest will thereafter be deemed a partner for tax purposes and thus “self-employed”. Therefore, the new partner/former employee will be subject to self-employment taxes and will no longer be able to participate in certain employee only benefit plans. This may be one negative associated with a profits interest granted to an employee of the LLC as opposed to a phantom unit or unit appreciation plan. A potential solution to this problem is to create tiered structure in which a second LLC owns an interest in the operating entity, and then the employees are granted interests in the second LLC. The result would be that the employees will remain employees (and not partners/members) of the operating entity.
  • The granting LLC and its existing members will want to have the profits interest recipient sign on to and be bound by the operating agreement. In addition, it may be necessary to amend the operating agreement to set forth transfer restrictions, drag along rights, repurchase rights of the LLC or the existing members (e.g. upon termination of employment), and other rights or restrictions.

Granting a profits interest to an employee or existing member of an LLC (or other entity taxed as a partnership) is fairly complex, but can be a great way to align the interests of the entity and its key employees or members.

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© 2012 Casey W. Riggs — This article is for general information only. The information presented should not be construed to be formal legal advice nor the formation of a lawyer/client relationship.

Filed Under: Startups and Venture Capital Tagged With: , , , , , , ,

When does a deal involve securities regulation? Part 3: Partnerships and Limited Liability Companies

April 13, 2012 By 1 Comment

This post is the third in a series exploring when securities laws impact business transactions.

In my previous posts, I provided a general overview of the definition of a “security” under federal securities laws.  One of the categories of investments that constitutes a “security” under federal law is an “investment contract.”  The term is a rather open-ended one, but under the so-called Howey Test, the term includes any arrangement or transaction that is “an investment in a common venture premised on a reasonable expectation of profits to be derived from the entrepreneurial or managerial efforts of others.”  As a result, any transaction which constitutes an investment contract is a security under federal securities law.  In this post, we’ll explore when an interest in a limited liability company (“LLC”) or a partnership constitutes an investment contract, and consequently, a security.

When the Securities Act of 1933 was written, there was no such thing as an LLC or a limited partnership.  The only type of partnership-like entity available was a general partnership, which featured unlimited joint and several liability for the partners.  As a result, it was very rare that someone would invest in a partnership in a passive role.  Therefore, partnership interests were left out of the definition of a “security” under the Securities Act.

Now, with the advent of limited partnerships, limited liability partnerships, limited liability limited partnerships, and limited liability companies, there are a myriad of choices available that allow an investor to invest in a partnership and enjoy limited liability.  Therefore, passive investing in partnerships and partnership-like entities is now common.  But because interests in these kinds of entities are not listed within the definition of a “security” under the Securities Act, a partnership or LLC interest will only be considered a security if it constitutes an investment contract.

That said, interests in many LLCs and partnerships fall under the definition of an investment contract.  For instance, in manager-managed LLCs, the non-managing members are essentially passive owners.  The same also applies to limited partners in a limited partnership.  An investment contract is, quintessentially, an arrangement where a passive owner invests money with another person who promises to use that money to make a profit for the passive owner.  Therefore, in each of these instances, the non-managing member interests and the limited partnership interests would be considered investment contracts and consequently securities.[1]

Conversely, a general partnership interest in a partnership or a managing member interest in an LLC are generally not securities, because the control that the general partner or managing member has over the company causes the general partner or managing member’s interest to fail to meet the final prong of the investment contract definition (that is, profit arising primarily from the efforts of people other than the investor).  Likewise, members in a member-managed LLC are usually not deemed to be holders of securities if they have the ability to participate in management.

However, even if a member of an LLC or a partner in a partnership has management rights on paper, the LLC or partnership interest could still be considered an investment contract, if in practice, there is no expectation that the investor will be active in generating profits.  In securities law, substance often trumps form.  Thus under Williamson v. Tucker, 645 F.2d 404 (5th Cir 1981), the Court of Appeals for the Fifth Circuit held that a general partnership interest could be a security if the investor was dependent on the promoter and could not exercise meaningful control.  Examples of such a situation are (i) where the managing partner cannot be replaced or is very difficult to replace, (ii) where the investors are inexperienced in business affairs and cannot exercise their abilities to participate in management, or (iii) where the promoter has unique managerial abilities which cause de facto reliance on the promoter.  Generally, if one of these situations exist at the time of initial investment, then the investment is likely to be an investment contract.

Whether a partnership interest or an LLC interest is a security often depends highly on context.  The less involved the holder of the interest is in the activities of the company, the more likely that the interest will be considered a security.  In addition, the relative sophistication of the purchaser of the interest as compared with company management also has a role to play.  Interests sold to less sophisticated investors are more likely to be considered a security than those sold to more sophisticated ones.  Unfortunately there is no bright line test that determines whether an LLC or partnership interest is a security, and consequently, the context of the transaction pays a significant role.

Footnotes

[1] It is possible that a limited partnership interest or a non-managing member interest in an LLC could be outside the definition of an investment contract if the economic realities indicate that the limited partner has significant and legal control of partnership management.  See Steinhardt Group v. Citicorp, 126 F.3d 144 (3rd Cir. 1997).

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© 2012 Alexander J. Davie — This article is for general information only. The information presented should not be construed to be formal legal advice nor the formation of a lawyer/client relationship.

Filed Under: General Business Law Tagged With: , , , , , , ,

When does a deal involve securities regulation? Part 2: The “Howey” Test

April 5, 2012 By Leave a Comment

This post is the second in a series exploring when securities laws impact business transactions.

In my previous post, I provided a general overview of the definition of a “security” under federal securities laws.  The Securities Act of 1933 provides for a very far reaching definition of a security, including “any note, stock… investment contract…, or, in general, any interest or instrument commonly known as a ‘security’…”  As explained in my prior post, this definition, taken literally, can result in both overinclusiveness and underinclusiveness.  I’ll discuss the issue of overinclusiveness and how it is addressed in future posts; this post will discuss how the inclusion of an “investment contract” within the definition of a security allows the definition to include classes of investments that are not specifically listed, like limited liability company interests and limited partnership interests, which are both concepts that had not even been invented when the Securities Act was passed.

The principal case which defined the term “investment contract” under federal law is SEC v. W.J. Howey Co., 328 U.S. 293 (1946).  In the case, the defendant, Howey was sued by the SEC to enjoin it from selling plots of land that had citrus trees planted on them.  Along with the plots of land, Howey offered management contracts where the purchaser would lease the plots back to Howey and Howey would harvest them.  However, the purchaser was not required to enter into such a management contract and could purchase the land without doing so.  Nonetheless, the Supreme Court held that the land sale together with the management contract collectively constituted an investment contract, and thus a security.

In this decision, the Supreme Court set forth a test, now known as the Howey test, for determining whether a transaction constitutes an investment contract.  Under the Howey test, a contract or transaction is an investment contract if “a person invests his money in a common enterprise and is led to expect profits solely from the efforts of the promoter or a third-party.”  Please note however that while the Supreme Court in Howey stated that the profit must arise “solely” from the efforts of others, later decisions by lower courts and the Supreme Court[1] have expanded this, so even if the investor has the power to be involved, the transaction may still be an investment contract if the efforts of others predominate.  Therefore, there are three essential components for this test: (1) investing money in a common enterprise, (2) the expectation of profit, and (3) the profit arising primarily from the efforts of people other than the investor.

In future posts, I’ll explore how the Howey test operates in specific situations.  In addition, I’ll also explore situations where some classes of investments are excluded from the definition of a “security” even if they are listed within the federal definition.

Footnotes

[1] More recently in United Housing Foundation v. Forman, 421 U.S. 837 (1975), the Supreme Court stated that an investment contract is “an investment in a common venture premised on a reasonable expectation of profits to be derived from the entrepreneurial or managerial efforts of others.”  The word “solely” was conspicuously left out.

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© 2012 Alexander J. Davie — This article is for general information only. The information presented should not be construed to be formal legal advice nor the formation of a lawyer/client relationship.

Filed Under: General Business Law Tagged With: , , , , , ,

When does a deal involve securities regulation? Part 1: Introduction

March 29, 2012 By 3 Comments

Business owners and attorneys without a securities background will often engage in transactions that, while on first blush do not involve securities regulation, but actually are a securities transaction, and thus subject to federal and state securities laws.  For instance, real estate developers often finance projects by bringing in outside investors as limited partners.  They are likely to hire a real estate attorney to complete the deal, who will dutifully draft a limited partnership agreement for the transaction.  What neither of them often realize is that a securities transaction is occurring as part of the deal.  The sale of limited partnership interests is usually a securities transaction under federal and state law.  This means that the interests are subject to registration with the SEC and with the state of each investor’s residence[1], unless an exemption can be found. In addition, all statements made in discussions with limited partners are subject to the anti-fraud rules.

The reality is that the definition of “security” is a whole lot broader than many people realize.  In fact, it is a lot broader than what many attorneys realize, at least those without a background in securities law.  In this series of posts, I’ll explore when securities laws apply and when they don’t apply to particular transactions.

The Federal Definition of a Security

Each of the main federal statutes (the Securities Act of 1933, the Securities Exchange Act of 1934, the Investment Company Act of 1940, and the Investment Advisers Act of 1940) has a definition of the term “security.”  For the most part, they are all very similar, with only minor differences between them.[2]  So lets start with the definition used in the Securities Act of 1933:

“[U]nless the context otherwise requires… [t]he term ‘‘security’’ means any note, stock, treasury stock, security future, security-based swap, bond, debenture, evidence of indebtedness, certificate of interest or participation in any profit-sharing agreement, collateral-trust certificate, preorganization certificate or subscription, transferable share, investment contract, voting-trust certificate, certificate of deposit for a security, fractional undivided interest in oil, gas, or other mineral rights, any put, call, straddle, option, or privilege on any security, certificate of deposit, or group or index of securities (including any interest therein or based on the value thereof), or any put, call, straddle, option, or privilege entered into on a national securities exchange relating to foreign currency, or, in general, any interest or instrument commonly known as a ‘‘security’’, or any certificate of interest or participation in, temporary or interim certificate for, receipt for, guarantee of, or warrant or right to subscribe to or purchase, any of the foregoing.”[3]

That’s quite a lot to digest, but there are a couple of initial important points.  First, a large number of different types of transactions are securities transactions.  For instance, stock in a closely held business or a note evidencing a loan are both potentially within the definition of a “security.”  Therefore, when incorporating your business, the sale of stock to your fellow co-founders can indeed be a securities transaction.  In addition, the issuance of a promissory note, which happens in most loan transactions, can also be a securities transaction.  So there are a lot of transactions that may be subject to securities laws that you would ordinarily not think of as a securities transaction.  I’ve seen many entrepreneurs think that simply issuing notes, rather than equity, to investors gets them out of complying with securities law.  So does this mean that all loans are securities transactions?  No, it doesn’t, as I will explain below.

The second thing that should be pointed out is what the list contained in the paragraph above does NOT include.  Two examples that immediately come to mind are partnership interests and limited liability company interests.  In fairness, limited liability companies weren’t even invented at the time the Securities Act was passed, but Congress has amended the Securities Act several times since then (in Sarbanes-Oxley, Dodd-Frank, and many other instances as well) and it could have added to the definition.  So does this mean that limited liability company interests are never securities?  Again, the answer is no.

The potential overinclusiveness and underinclusiveness of the federal securities definition is ameliorated by the two phrases which I highlighted above in bold.  The phrase “unless the context otherwise requires” allows a court to, for example, treat a note that is issued clearly as part of an ordinary loan as an ordinary loan and not as a security.  Likewise, courts have interpreted the term “investment contract” very broadly, covering some limited liability company interests, partnership interests, and even the sale of citrus trees (though in this instance, what was being sold was more than just citrus trees).  Therefore, courts have wide latitude to exclude specific instances of the items listed within the “security” definition and to also include items that were not listed as well.

In future posts, I’ll explore what the legal standards are for such exclusion and inclusion in specific scenarios.

Footnotes

[1] And the interests are also potentially subject to registration in the states in which the interests are offered but not sold.  This is, if you send out any promotional material to any residents of a state, it is possible that the securities may need to be registered in that state.

[2] It is unclear if, but unlikely that, any of these minor differences actually makes a difference in the end result of whether a particular transaction involves securities.

[3] The bolding of certain phrases is mine, and is not in the statute.  The explanation of why I highlighted these phrases is explained later in the post.

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© 2012 Alexander J. Davie — This article is for general information only. The information presented should not be construed to be formal legal advice nor the formation of a lawyer/client relationship.

Filed Under: General Business Law Tagged With: , , , , , , ,
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