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

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.

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

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. [Read more...]

How the Federal Government Taxes LLCs

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. [Read more...]

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

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. [Read more...]

5 Legal Mistakes Often Made By Startups

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.