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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 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: , , , , , , ,

How the Federal Government Taxes LLCs

October 31, 2011 By 1 Comment

One of the benefits to using a limited liability company is the flexibility of being able to choose how the entity is taxed. After a new LLC is formed, its owners must decide the method by which they would like their business taxed. By default, an LLC is treated as a pass-through entity, which means that it does not pay federal taxes directly, but its income or loss is allocated to the owners, who then pay taxes on that income. If the LLC has only one member, it files no tax return and all transactions of the LLC are treated as transactions of the owner for tax purposes. If the LLC has more than one member, the LLC files a partnership tax return, which reports the LLC’s income and how that income is to be allocated to each owner. Partnership style taxation is governed by Subchapter K of the Internal Revenue Code. However, the owner(s) of an LLC, whether the LLC has a single member or multiple members, may choose to have their LLC taxed as a corporation. In this case, the LLC can be taxed as a so-called “C Corporation,” which is governed under Subchapter C of the Internal Revenue Code, or an “S Corporation,” which is governed by Subchapter S. This ability of LLC owners to elect the company’s means of taxation is called the “check the box” regulations. Below are summaries of the four methods of taxation of an LLC:

  • Disregarded Entity – This is the default rule for any LLC that has only one member. A single member LLC is treated as though it does not exist for tax purposes and thus the owner is treated as if he were running a sole proprietorship. All transactions — income and expenses — are included on the owner’s tax return. Therefore, no separate tax return need be filed for the LLC.
  • Subchapter K (aka partnership taxation) – This is the most flexible form of taxation for a multi-member LLC. All income and losses of the LLC are allocated to the owners, who pay taxes on that income regardless of the amount of cash they received from the company. A distribution of cash to owners is itself a tax-free event. The owners of the LLC can be compensated for service to the company (called “guaranteed payments”) in which case the payments are treated as an expense to the partnership and income to the owner. Subchapter K is quite flexible, and allows the owners to allocate the income between themselves in a variety of ways, sometimes in quite complex formulas (subject to certain limited restrictions in the Internal Revenue Code). One downside to using a partnership taxation structure is that the income of the partners is generally subject to the self-employment tax.
  • Subchapter C – If an LLC elects to be taxed under Subchapter C, it is treated for tax purposes, as if it were a corporation. The company must file a corporate tax return (regardless of whether there is one member or multiple members) and the LLC itself pays taxes. Any income that is paid to owners in the form of dividends is also taxable income to the owner (so-called “double taxation”), though the dividends are taxed to the owner at the capital gains rate. Because of this, many C Corporation owners pay themselves a salary or bonus. Such income is deductible to the corporation, though the compensation must be “reasonable.” If the IRS were to deem the salaries paid to an owner as higher than what would be reasonable if the owner were just an ordinary employee, it could reclassify part of the salary as a constructive dividend, subjecting the company to additional taxes and potential penalties.
  • Subchapter S – If an LLC elects to be taxed under Subchapter S, it is treated for tax purposes, as if it were a corporation that had elected to be treated as an S Corporation. In this form, the company will still file a corporate tax return but does not itself pay taxes. Instead, each owner is allocated a portion of profits or losses based on the percentage interest that they each own. As in a partnership, the owners must then pay the taxes themselves, regardless of whether any cash has been distributed to them. Any cash payments to owners (called distributions or dividends) are tax-free. Active owners are considered employees of the company and can also be paid for their services to the company in the form of a salary or other payments, in which case, the payment will be deductible to the company and will be taxable wage income to the owner. The benefit of taxing an LLC as an S Corporation is that income that is not paid out as a salary is not subject to self-employment taxes. However, the IRS can scrutinize the salaries paid to owners and if it deems that the owners have been underpaid, it may reclassify some of the LLC’s income as wages, subjecting the LLC and the owners to additional payroll taxes and potential penalties. Another disadvantage to using Subchapter S is that the designation is very “fragile.” There are a number of requirements the company must adhere to (such as having only one class of stock and no more than 100 owners). If the company fails to adhere to these requirements, it will automatically be converted to a C-Corp and face double taxation. The single class of stock requirement is especially easy to violate inadvertently. If the LLC gives any owners preferred distributions or distributes distributions in any way except through a straight pro rata method, it could be deemed as having more than one class of stock. In addition, many of the default provisions in LLC statutes violate the single class of stock requirement, which means that the operating agreement of an LLC taxed under Subchapter S must be carefully written to override the default provisions.

As you can see, there are many factors to consider in choosing how to have an LLC taxed. Your final choice should be based on your own specific situation. Therefore, before making any decisions on your form of business, you should speak with your attorney or accountant.

© 2011 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: , , , , ,

Obama’s Proposed American Jobs Act Contains Tax Increase on Private Fund Managers

September 22, 2011 By Leave a Comment

The American Jobs Act, recently proposed by President Obama, contains a provision closing the co-called “carried interest tax loophole” that benefits many investment fund managers.  Just about all hedge funds, real estate investment partnerships, private equity funds, and venture capital funds in the U.S. are structured as partnerships for tax purposes.  The incentive fee that the manager is paid (usually 20% of all net gains of the partnership) isn’t actually a fee at all.  Rather, when the partnership is formed, it is structured so that the manager (or an affiliate of the manager) owns a 20% interest in all profits generated by the fund.  The benefit to the manager in structuring the incentive fee this way is that all favorable tax treatment that the fund may receive for certain types of income are preserved for the fund manager.  For instance, if the fund earns a gain on the sale of assets that it owned for over one year or if the fund receives qualified dividends from stock, those gains and dividends are taxed at the lower capital gains rate (15%) rather than being treated as ordinary income.  In addition, the manager of the fund does not pay social security or Medicare taxes on the portion of the fund’s profits allocated to the manager, as he would if he were earning it as wages or were otherwise self-employed.  As a result, the fund manager only pays federal income taxes at a rate of 15% on a large portion of his income, and also pays no social security and Medicare taxes on any of the incentive fee earned by him. [1]  If the law were changed, fund manager incentive allocations would be taxed as ordinary income and would also be subject to the self-employment tax (ordinarily 15.3%) to pay both the employee and employer portions of social security and Medicare taxes on such income.

Arguments can go back and forth whether the current tax treatment of investment partnership incentive allocations is (a) a good idea or (b) fair.  Proponents of changing the law say that it is unfair that investment fund managers should pay a lower level of taxation than people in other professions, especially considering that this income is essentially a fee in substance, if not form.  Opponents counter that fund managers take a huge risk in taking much of their fees in this manner, because (a) it is contingent upon the fund making a profit and thus the fee may never materialize and (b) is often (but not always) deferred for a number of years until gains can be realized.  Because of these unique features, they argue that this favorable tax treatment is fair and reasonable.

Regardless of who you may think is right, luckily for fund managers, the legislation is unlikely to pass in the near term.  Given the gridlock in Washington, and the fact that the Republican-controlled House of Representatives would never approve such a provision, fund managers are currently safe.  However, in the long term, the outlook is far more uncertain.   With tax reform on the horizon, fund managers and their representation in Washington will need to be vigilant.  A change like this to the tax code is likely to be popular with voters and since the people who who would be negatively impacted by it are few, it could be an easy concession for Republicans to make in their quest to lower overall tax rates.  As always, stay tuned.

Footnotes

[1] However, the Health Care and Education Reconciliation Act of 2010, among other provisions, enacted a new additional tax, referred to as the “unearned income Medicare contribution,” on net investment income, like the partnership allocations of income and gain from investment funds at a rate of 3.8% which will, if no additional changes in law are enacted, take effect January 1, 2013.  The tax only affects individual taxpayers with a modified gross income over $250,000 for married taxpayers filing jointly, $125,000 for married taxpayers filing separately, and $200,000 for single taxpayers.

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© 2011 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: Investment Management Tagged With: , , , , , ,

5 Legal Mistakes Often Made By Startups

September 14, 2011 By 5 Comments

Entrepreneur magazine recently posted an article on their blog describing five overlooked legal mistakes that entrepreneurs often make. It’s a good worthwhile read. The mistakes mentioned are:

  1. Making handshake deals (i.e. not in writing) with clients and vendors.
  2. Choosing the wrong business structure (i.e. sole proprietorship, LLC, Corporation).
  3. Entering into a partnership without a detailed written agreement.
  4. Entering into a 50-50 partnership.
  5. Filing a trademark without doing a detailed and extensive search before hand.

I wholeheartedly agree with four out of the five common mistakes. Perhaps the one I may partially disagree with is mistake number 4: entering into a 50-50 partnership. 50-50 partnerships can certainly present challenges when it comes to governing a company and general decision-making when there is a deadlock between the partners. However, I think categorically ruling out such an arrangement is a mistake. Rather, if the partners desire to establish a 50-50 partnership and that relationship is important to them, they should plan ahead and consider adding detailed provisions in their partnership agreement which deals with deadlocks. In addition, the company buy-sell provisions will have to be carefully considered as well.

Article Referenced: Five Overlooked Legal Mistakes Entrepreneurs Make

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© 2011 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: Startups and Venture Capital Tagged With: , , ,
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