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Leveraging LLCs in
Structuring M&A Transactions Assessing Deal Structures; Navigating Complex Capital Account and Tax Allocation Principles
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THURSDAY, NOVEMBER 6, 2014
Presenting a live 90-minute webinar with interactive Q&A
Tarik J. Haskins, Partner, Morris Nichols Arsht & Tunnell, Wilmington, Del.
Joseph C. Mandarino, Attorney, Cohen Pollock Merlin & Small, Atlanta
David K. Staub, Member, Staub Anderson, Chicago
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FOR LIVE EVENT ONLY
M&A: LEVERAGING LLCs
IN STRUCTURING TRANSACTIONS
NOVEMBER 6, 2014
TARIK J. HASKINS PARTNER
COMMERCIAL LAW COUNSELING GROUP
MORRIS, NICHOLS ARSHT & TUNNELL LLP
(302) 351-9120
thaskins@mnat.com
Limited Liability Companies Generally
The limited liability company is an
unincorporated entity structure that has become
increasingly popular in the business community
and has arguably become the preferred form of
business entity.
6
Limited Liability Companies Generally (cont’d)
The popularity of the limited liability company form
arises primarily because it combines the limited
liability protection of a corporation together with the
pass-through taxation of a partnership and provides
the investors with a vast amount of flexibility.
7
Limited Liability Companies Generally (cont’d)
For LLCs that choose to be taxed as a partnership, it will be critical for the investors and the drafters of the limited liability company agreement to understand how the allocation, distribution and capital account provisions work.
A “capital account” is used to keep track of what each member is entitled to receive from the entity if it liquidates. A “capital account” shows how much each member put into the LLC and how much each member is entitled to receive.
The allocation provisions are NOT merely boilerplate, and failure to properly draft the allocation and distribution provisions may affect the actual dollar amounts that the members are entitled to receive.
8
Limited Liability Companies in Transactions
Limited liability companies are being used in many different ways in M&A Transactions: Acquisition Vehicle
Investing
Joint Ventures
Series LLC
Asset Sale
Mergers
LLC Interest Sale
9
Limited Liability Companies in Transactions (cont’d)
The Limited Liability Company Agreement is important.
In comparing the corporate form to the limited liability company form, the first thing to realize is how incredibly important the limited liability company agreement is with respect to limited liability companies.
Most Limited Liability Company Acts are enabling in nature and set forth default rules that can be adjusted pursuant to the LLC Agreement.
10
Limited Liability Companies in Mergers
Most limited liability company acts permit a
limited liability company to merge with one or
more limited liability companies or other
business entities.
The default consent requirement for approval of a
merger varies by jurisdiction, but more
importantly, the default merger consent can be
modified by contract.
11
Limited Liability Companies in Mergers (cont’d)
Under Delaware law, for example, Section 18-209 of
the Delaware LLC Act provides for the approval of a
merger by a majority in interest.
Delaware’s default LLC merger provision can, in some
instances, provide those in control of the LLC with the
ability to avoid super-majority votes, by amending the
LLC Agreement in connection with the merger.
This opportunity exists if the merger consent requirement is
different than the amendment provision.
12
Limited Liability Companies in Mergers (cont’d)
Section 18-209 of the Delaware LLC Act provides
that the equity interests in the merging entity may be
exchanged for or converted into cash, property,
rights or securities in the surviving or resulting
entity.
13
Sale of Limited Liability Company Interests
Nature of Limited Liability Company Interests
Limited Liability Company Interests are personal property.
A limited liability company interest, disaggregates the economic rights from the management rights.
Definition – The buyer must be careful to accurately define what is being transferred and ensure that the description is broad enough to include both economic interests and governance rights associated with the LLC interests.
Admission – In addition to transferring the limited liability company interest, it is also important to actually admit the transferee to the LLC, otherwise the transferee will merely be a holder of the economic interest therein.
14
Sale of Limited Liability Company Interests (cont’d)
The specific rights and remedies of the limited liability
company interests are established pursuant to the LLC
Agreement.
The Delaware LLC Act’s default allocation and
distribution provisions provides that allocations and
distributions shall be based upon the agreed value of the
contributions that have been made to the LLC.
In connection with the sale of interests in the LLC, the
transferee will succeed to Seller’s interest in allocations.
15
Sale of Limited Liability Company Interests (cont’d)
Transfer Restrictions – Many limited liability
company agreements contain restrictions on
transfer of interests.
Restrictions on transfers may be specifically
enforced.
16
Sale of Limited Liability Company Interests (cont’d)
“Pick your partner doctrine.”
Unless modified by contract, the admission of a
transferee would require the consent of the other
members.
17
Investments in Limited Liability Companies
Investments
Under the Delaware LLC Act, in contrast to corporations, a
limited liability company is not required to authorize and issue a
set limited number of interests.
This flexibility provides an opportunity to issue limited
liability company interests in connection with transactions.
Under the Delaware LLC Act, Section 18-302(c) provides in part,
that the relative rights, powers and duties of a member of a limited
liability company shall be as set forth in the LLC Agreement.
Coupled with the ability to modify fiduciary duties to an LLC and
its members, an LLC can structure truly preferred equity interests.
18
Investments in Limited Liability Companies (cont’d)
The flexibility inherent in the Delaware LLC Act enables
investors to structure their investment in an LLC in a way
that provides preferential allocations, distributions and
rights to interim and liquidating distributions and provide
control rights to such holders.
Further, many of the protections sought in a preferred stock
investment are easily incorporated into the subject limited liability
company agreement, without the risk that such protections will be
found unenforceable.
19
Investments in Limited Liability Companies (cont’d)
Typically, the structuring of an investment in a
limited liability company will require an amendment
to the limited liability company agreement.
20
Investments in Limited Liability Companies (cont’d)
Under the Delaware LLC Act, if the applicable
LLC Agreement does not provide otherwise, an
amendment will require approval of all members.
An LLC Agreement that permits amendments with
less than unanimous consent will permit an
amendment to the LLC Agreement that could have
the effect of imposing restrictions on non-consenting
members and/or diluting their interests.
21
Sale of Substantially All of the Assets of an LLC
Sale of substantially all of the assets.
Very similar to a sale of assets by a corporation.
DGCL Section 271 provides for specific authorization
procedures in order to authorize a sale of substantially
all of the assets.
Unless the limited liability company agreement provides
otherwise, the Delaware LLC Act does not provide for a
specific statutory authorization to sell assets.
Authorization of the sale will be governed by the LLC
Agreement, as will the related decision to cause a dissolution
and liquidation of assets. 22
“Appraisal Rights”
Unlike many corporate statutes that provide
equityholders with appraisal rights with respect
to a merger or other transactions, most LLC Acts
do not provide appraisal rights.
A limited liability company agreement can provide
for appraisal rights.
23
Fiduciary Duties
Under Delaware law
Unless otherwise provided in the limited liability
company agreement, the traditional fiduciary duties
applicable to a Delaware corporation apply to the
managing and controlling persons of an LLC:
The duty of care
Equates to a gross negligence standard of care.
The duty of loyalty
Act in the best interest of the LLC and its investors.
24
Fiduciary Duties (cont’d)
Most Limited Liability Company Acts permit the
modification of fiduciary duties and the Delaware
LLC Act in fact permits the elimination of
fiduciary duties, provided that the implied
covenant of good faith and fair dealing cannot be
eliminated.
25
Fiduciary Duties (cont’d)
A complete elimination of fiduciary duties will
severely limit the ability of a minority investor to
challenge conduct by the controlling persons.
“When parties exercise authority provided by the LP
Act to eliminate fiduciary duties, they take away the
most powerful of a court’s remedial gap-filling
powers.”
Lonegran v. EPE Holdings LLC, 5 A. 3d 1008 (Del. Ch. 2010).
26
Fiduciary Duties (cont’d)
In the event that fiduciary duties are eliminated, a
party is left solely with an implied covenant of good
faith and fair dealing claim.
In general, the implied covenant of good faith and fair
dealing:
Protects a party from being deprived of the fruits of the
bargain;
Is based on reasonable expectations at the time contract was
entered into;
Applies to the exercise of discretionary authority.
27
Indemnification and Exculpation
Closely related to the consideration of fiduciary duties are the appropriate levels for indemnification and exculpation. Subject to public policy limitations, Delaware law
allows parties to include indemnification provisions that will permit a person to be indemnified by the LLC for his or her own acts.
Subject to public policy limitations, Delaware law allows parties to include exculpation provisions in an LLC Agreement that will protect a person from personal liability.
28
M&A: Leveraging LLCs in Structuring Transactions
───────────────────────
Capital Accounts and Tax Issues
29
Joseph C. Mandarino
November 6, 2014
Atlanta, Georgia
Cohen Pollock Merlin & Small, P.C.
3350 Riverwood Parkway
Suite 1600
Atlanta, Georgia 30339
www.cpmas.com
30
A. Understanding Capital Accounts
B. Basics of LLC Taxation
C. Preferred Interests
D. Liquidating Distributions
E. Incentive Compensation
F. Techniques Involving Disregarded LLCs
Capital Account Rules
31
Capital Account Rules Assets versus Liabilities
property $1,000 mortgage $500
cash $200 other $50
misc $100 sub-total $550
sub-total $1,300
total $1,300 total $550
Balance sheet does not "balance"!
Assets Liabilities
32
Capital Account Rules
Difference Plugged to Equity
property $1,000 mortgage $500
cash $200 other $50
misc $100 sub-total $550
total $1,300 total $550
Balance sheet does not "balance"!
Assets Liabilities
33
Capital Account Rules
Difference Plugged to Equity
property $1,000 mortgage $500
cash $200 other $50
misc $100 sub-total $550
member A $250
member B $250
member C $250
sub-total $750
total $1,300 total $1,300
Balance sheet balances!
Difference between assets and liabilities almost always "plugged" in equity.
For an LLC, the equity amounts are called "capital accounts"
Assets Liabilities
Capital
34
capital
accounts
Capital Account Rules • profits – increase capital accounts
• losses – decrease capital accounts
• contributions – increase capital accounts
• distributions – decrease capital accounts
35
Capital Account Rules
Capital Accounts Are Increased by Profits
property $1,000 mortgage $500
cash $500 other $50
misc $100 sub-total $550
member A $350
member B $350
member C $350
sub-total $1,050
total $1,600 total $1,600
Assets (cash) increase by $300 total.
No change in liabilities so capital accounts must increase by $300 total or will not balance.
Assumed that A, B and C share equally.
Assets Liabilities
Capital
36
Capital Account Rules Capital Accounts Are Decreased by Distributions
property $1,000 mortgage $500
cash $350 other $50
misc $100 sub-total $550
member A $300
member B $300
member C $300
sub-total $900
total $1,450 total $1,450
Assume $150 distribution, so cash decreased by $150 total.
No change in liabilities so capital accounts must decrease by $150 total or will not balance.
Assumed that A, B and C share in distributions equally.
Assets Liabilities
Capital
37
Capital Account Rules Company is Liquidated Flat
property $1,000 mortgage $500
cash $350 other $50
misc $100 sub-total $550
member A $300
member B $300
member C $300
sub-total $900
total $1,450 total $1,450
Assets sold for face value, or $1,450 in cash..
Cash applied first to liabilities (i.e., $550).
After paying off liabilities, Company has $900 left over.
Balance is distributed to A, B and C in satisfaction of their interests.
Assets Liabilities
Capital
38
Capital Account Rules Company is Liquidated at Profit
property $1,600 mortgage $500
cash $350 other $50
misc $100 sub-total $550
member A $500
member B $500
member C $500
sub-total $1,500
total $2,050 total $2,050
Property worth $1,600, so total FMV of assets = $2,050 in cash.
Cash applied first to liabilities (i.e., $550).
After paying off liabilities, Company has $1,500 left over.
Balance is distributed to A, B and C in satisfaction of their interests
Assumed that A, B and C share profit equally.
Assets Liabilities
Capital
39
Capital Accounts -- Life Cycle of Business Example -- Year 1
member A member B member C total
40% 40% 20%
Year 1 start up initial contribution $1,000 $1,000 $500 $2,500
start up losses profit (loss) -$600 -$600 -$300 -$1,500
closing balance $400 $400 $200 $1,000
40
Capital Accounts -- Life Cycle of Business Example -- Year 2
member A member B member C total
40% 40% 20%
Year 1 start up initial contribution $1,000 $1,000 $500 $2,500
start up losses profit (loss) -$600 -$600 -$300 -$1,500
closing balance $400 $400 $200 $1,000
Year 2 continued losses opening balance $400 $400 $200 $1,000
profit (loss) -$200 -$200 -$100 -$500
closing balance $200 $200 $100 $500
41
Capital Accounts -- Life Cycle of Business Example -- Year 3
member A member B member C total
40% 40% 20%
Year 1 start up initial contribution $1,000 $1,000 $500 $2,500
start up losses profit (loss) -$600 -$600 -$300 -$1,500
closing balance $400 $400 $200 $1,000
Year 2 continued losses opening balance $400 $400 $200 $1,000
profit (loss) -$200 -$200 -$100 -$500
closing balance $200 $200 $100 $500
Year 3 slight profit opening balance $200 $200 $100 $500
profit (loss) $200 $200 $100 $500
closing balance $400 $400 $200 $1,000
42
Capital Accounts -- Life Cycle of Business Example -- Year 4
member A member B member C total
40% 40% 20%
Year 1 start up initial contribution $1,000 $1,000 $500 $2,500
start up losses profit (loss) -$600 -$600 -$300 -$1,500
closing balance $400 $400 $200 $1,000
Year 2 continued losses opening balance $400 $400 $200 $1,000
profit (loss) -$200 -$200 -$100 -$500
closing balance $200 $200 $100 $500
Year 3 slight profit opening balance $200 $200 $100 $500
profit (loss) $200 $200 $100 $500
closing balance $400 $400 $200 $1,000
Year 4 growing profit opening balance $400 $400 $200 $1,000
profit (loss) $500 $500 $250 $1,250
distributions -$300 -$300 -$150 -$750
closing balance $600 $600 $300 $1,500
43
Capital Accounts -- Life Cycle of Business Example -- Year 5
member A member B member C total
40% 40% 20%
Year 1 start up initial contribution $1,000 $1,000 $500 $2,500
start up losses profit (loss) -$600 -$600 -$300 -$1,500
closing balance $400 $400 $200 $1,000
Year 2 continued losses opening balance $400 $400 $200 $1,000
profit (loss) -$200 -$200 -$100 -$500
closing balance $200 $200 $100 $500
Year 3 slight profit opening balance $200 $200 $100 $500
profit (loss) $200 $200 $100 $500
closing balance $400 $400 $200 $1,000
Year 4 growing profit opening balance $400 $400 $200 $1,000
profit (loss) $500 $500 $250 $1,250
distributions -$300 -$300 -$150 -$750
closing balance $600 $600 $300 $1,500
Year 5 sell assets and opening balance $600 $600 $300 $1,500
liquidate profit (loss) $2,400 $2,400 $1,200 $6,000
distributions -$3,000 -$3,000 -$1,500 -$7,500
closing balance $0 $0 $0 $044
More Complex Allocations – Year 1
member A member B member C total
Year 1 start up initial contribution $2,000 $500 $0 $2,500
preferred return (10%) $200 $0 $0 $200
start up losses operating profit (loss) -$850 -$850 $0 -$1,700
closing balance $1,350 -$350 $0 $1,000
member A 10% preferred return; 50% of operating profits; 40% of capital profits
member B 50% of operating profits; 40% of capital profits
member C 20% of capital profits
45
More Complex Allocations – Year 2
member A member B member C total
Year 1 start up initial contribution $2,000 $500 $0 $2,500
preferred return (10%) $200 $0 $0 $200
start up losses operating profit (loss) -$850 -$850 $0 -$1,700
closing balance $1,350 -$350 $0 $1,000
Year 2 continued losses opening balance $1,350 -$350 $0 $1,000
preferred return (10%) $200 $0 $0 $200
operating profit (loss) -$350 -$350 $0 -$700
closing balance $1,200 -$700 $0 $500
member A 10% preferred return; 50% of operating profits; 40% of capital profits
member B 50% of operating profits; 40% of capital profits
member C 20% of capital profits
46
More Complex Allocations – Year 3
member A member B member C total
Year 2 continued losses opening balance $1,350 -$350 $0 $1,000
preferred return (10%) $200 $0 $0 $200
operating profit (loss) -$350 -$350 $0 -$700
closing balance $1,200 -$700 $0 $500
Year 3 slight profit opening balance $1,200 -$700 $0 $500
preferred return (10%) $200 $0 $0 $200
operating profit (loss) $150 $150 $0 $300
closing balance $1,550 -$550 $0 $1,000
member A 10% preferred return; 50% of operating profits; 40% of capital profits
member B 50% of operating profits; 40% of capital profits
member C 20% of capital profits
47
More Complex Allocations – Year 4
member A member B member C total
Year 3 slight profit opening balance $1,200 -$700 $0 $500
preferred return (10%) $200 $0 $0 $200
operating profit (loss) $150 $150 $0 $300
closing balance $1,550 -$550 $0 $1,000
Year 4 growing profit opening balance $1,550 -$550 $0 $1,000
preferred return (10%) $200 $0 $0 $200
operating profit (loss) $525 $525 $0 $1,050
distributions -$300 -$300 -$150 -$750
closing balance $1,975 -$325 -$150 $1,500
member A 10% preferred return; 50% of operating profits; 40% of capital profits
member B 50% of operating profits; 40% of capital profits
member C 20% of capital profits
48
More Complex Allocations – Year 5
member A member B member C total
Year 4 growing profit opening balance $1,550 -$550 $0 $1,000
preferred return (10%) $200 $0 $0 $200
operating profit (loss) $525 $525 $0 $1,050
distributions -$300 -$300 -$150 -$750
closing balance $1,975 -$325 -$150 $1,500
Year 5 sell assets and opening balance $1,975 -$325 -$150 $1,500
liquidate preferred return (10%) $200 $0 $0 $200
operating profit (loss) $525 $525 $0 $1,050
capital profit (loss) $1,900 $1,900 $950 $4,750
distributions -$4,600 -$2,100 -$800 -$7,500
closing balance $0 $0 $0 $0
member A 10% preferred return; 50% of operating profits; 40% of capital profits
member B 50% of operating profits; 40% of capital profits
member C 20% of capital profits
49
Basic Taxation
• “double taxation” v. “pass-through”
• check-the-box rules
50
Double Taxation
51
taxable income of Newco $100
corporate taxes (40%) -$40
cash flow available for dividend $60
dividend to Sam $60
tax to Sam on dividend income (25%) -$15
net after-tax cash flow $45
all taxes $55
effective tax rate 55%
Single Taxation
52
taxable income of Newco $100
taxes on Newco (0%) -$0
cash flow available for distribution $100
tax to Sam on her allocable share of Newco’s income (40%) -$40
distribution to Sam $100
tax to Sam on distribution (0%) -$0
net after-tax cash flow $60
all taxes ($40) $40
effective tax rate 40%
Check-the-Box Rules • The check-the-box rules provide for default classification for certain
entities.
• In the case of a partnership or LLC, the default classification is a partnership (if there are two or more owners) or a disregarded entity (“DRE”) if there is only one owner.
• A partnership or LLC can also elect to be taxed as a corporation.
• A partnership or LLC that wants to elect to be taxed as a corporation, or wishes to make a safe-harbor election as to its default classification makes the election on IRS Form 8832.
• Generally, the effective date of the election is the date the form is filed. However, the entity can select and effective date as much as 75 days prior to the filing date or as much as 12 months after the filing date. In addition, the IRS will sometimes grant an extension of time to make an election.
• Generally, an entity cannot change its election for 60 months, but there are exceptions.
53
Preferred or Senior Interests
54
• As noted, partnership and LLC interests can be designed in an almost unlimited fashion.
• In general, a preferred or senior interest will entitle the holder to distributions and profits earlier than other holders.
• In some cases, senior investors may prefer to structure their investment as debt and require a special allocation of interest.
55
Preferred or Senior Interests
56
Senior Interests -- Example
senior owners other owners total owner/lenders other owners total
preferred payment 750$ -$ 750$ -$ -$ -$
common payment 125$ 125$ 250$ 125$ 125$ 250$
preferred allocation 750$ -$ 750$
common allocation 125$ 125$ 250$ 500$ 500$ 1,000$
interest expense (750)$ -$ (750)$
taxable income 875$ 125$ 1,000$ (250)$ 500$ 250$
tentative income 875$ 125$ 1,000$ 500$ 500$ 1,000$
less interest expense -$ (750)$ -$ (750)$
taxable income 875$ 125$ 1,000$ (250)$ 500$ 250$
partnership income 875$ (250)$
interest income -$ 750$
net income to senior owners 875$ 500$
preferred payment 750$ -$
common payment 125$ 125$
interest payment -$ 750$
total cash to senior owners 875$ 875$
preferred units treated as equity preferred units treated as debt
Liquidating Distributions
57
Liquidating Distributions
• In general, a liquidating distribution can be analogized to a stock redemption.
• The partner receives a distribution from the partnership in exchange for or liquidation of his or her interest in the partnership.
• Can be a single or series of distributions.
58
Liquidating Distributions
• The tax treatment of a liquidating distribution varies depending on what type of property is distributed.
• cash – gain/loss recognized
• “marketable securities” – treated same as cash
• all other property – generally no gain/loss – instead take the property with a carryover basis.
59
Liquidating Distributions
• Cash includes “deemed” cash distributions from relief of liabilities.
• “Marketable securities” are financial instruments and foreign currencies that are actively traded – these are treated as cash substitutes and the same tax consequences attend them.
• “financial instruments” defined as stocks and other equity interests, debt, options, forward or futures contracts, notional principal contracts, and derivatives
60
Liquidating Distributions
• If cash or marketable securities are received, and the total exceeds the partner’s outside tax basis, then the difference is recognized as gain.
• Loss can be recognized but only if the to the extent the distribution consists solely of cash or §751 assets.
• Receipt of other property generally will not result in gain or loss. Instead, the partner’s outside tax basis will be spread over the received property.
61
Liquidating Distributions -- Example
• A and B are unrelated corporations. They decide form AB Co. to manufacture and exploit a new product.
• A contributes technology and other intangible property valued by A and B at $1 million.
• B contributes a factory and equipment which A and B value at $1 million.
• A and B agree to share all items 50/50.
62
Liquidating Distributions -- Example
• At the end of year 3, it is clear that the new product is not selling well and A and B agree to end the relationship.
• AB Co. distributes (i) the technology and other intangible property back to A, and (ii) the factory and equipment back to B.
63
Liquidating Distributions -- Example
First Observation:
• In general, this will not be a taxable transaction.
• Note, in contrast, that the break up of a similar joint venture housed in a corporation could be taxable depending on the facts; even if it qualified as a tax–free split up, the transaction would likely trigger significant tax compliance costs and delays.
64
Liquidating Distributions -- Example
Second Observation:
• Assume that there is a pool of receivables and cash, in addition to the property originally contributed by A and B.
• The cash likely can be received tax-free, but will reduce the basis of A and B in the property they receive.
• The A/R probably can be received tax-free.
65
Liquidating Distributions -- Example
Third Observation:
• Assume that there are also some payables and other liabilities.
• Depending how these are allocated between A and B, one or the other partner could be treated as being relieved of a liability that was previously included in basis. This is treated as a deemed cash distribution.
66
Compensation Planning, Options and Incentive Arrangements
A. Overview
B. Capital vs. Profits Interests
C. Section 83 and Vesting
D. Options to Acquire LLC Interests
E. Consequences to the LLC
F. Proposed IRS Regulations
67
Compensation Planning, Options and Incentive Arrangements
• In general, the receipt of an LLC interest in exchange for services performed (or to be performed) for the LLC is taxable to the recipient. The amount of income is equal to the fair market value (“FMV”) of the LLC interest, and is taxed as compensation income.
• However, this general rule is subject to numerous exceptions.
68
Capital vs. Profits Interests
• The first exception to the general rule is that the receipt of a profits-only interest is usually not taxable to the recipient. In order to understand the operation of this exception, it is important to distinguish between profits and capital interests.
• An equity interest in an LLC can give the holder an interest in the LLC’s capital, its profits, or both.
69
Capital Interest
• A capital interest is an interest in the LLC’s capital.
• Example 1: Smith and Jones form Newco, LLC, by investing $500 each. Newco has a total capital balance of $1,000. A day later, Newco issues a 20% capital interest to Dewey, in exchange for Dewey’s promise to perform services for Newco.
• A 20% capital interest should entitle the recipient to 20% of the capital of the LLC. Here, the LLC has a capital balance of $1,000, so the FMV of the interest is $200. Absent any other facts, Dewey will be treated as receiving $200 in compensation income as a result of this award.
70
Profits Interest
• A profits interest is an interest solely in the profits of the LLC.
• Example 2: Smith and Jones form Newco, LLC, by investing $500 each. A day later, Newco issues a 20% profits interest to Dewey, in exchange for Dewey’s promise to perform services for Newco.
• A 20% profits interest should entitle the recipient to 20% of the profits of the LLC. However, unless the LLC actually earns profits, the holder is not entitled to anything.
• As discussed below, the IRS has taken the position that in general the grant of a profits interest in exchange for services is not a taxable event. (The recipient will, of course, be taxable on his or her share of any income earned by the LLC.)
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Distinction
• A good test to determine whether an LLC interest is taxable is to determine what would happen if the LLC immediately vested.
• In general, the holder of a capital interest would be entitled to his or her share of LLC capital, while a profits interest generally only entitles a recipient to profits going forward.
• In the absence of unusual facts (i.e., an LLC which holds government bonds), the IRS has taken the position that future profits are too speculative to warrant taxing a profits interest on the front end.
• In analyzing a grant of an LLC interest it is very important to focus on the specific terms of the grant. For example, a back-dated grant of a profits interest could be a capital interest.
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Distinction
• Example 3: The facts are the same as Example 2, but the profits interest is drafted so that it entitles Dewey to a 20% interest in the profits of the LLC for the entire year. As a factual matter, the interest was actually granted on July 1, 2006.
• In this case, the back dating of the grant has converted a non-taxable profits interest into a taxable capital interest. This is because Dewey receives a right to already-earned income, even though the interest purports to be a profits interest. The interest would be taxable to Dewey at least to the extent of the already earned income.
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Section 83 and Vesting
• A capital interest that is granted subject to certain conditions can be received tax free.
• The IRS takes the position that section 83 applies to LLC interests. Accordingly, if property is transferred to a taxpayer in exchange for services, the taxpayer must include the FMV of the property in income. However, if the property is subject to a substantial risk of forfeiture, the income event does not occur until the risk lapses. The FMV of the property at that time (the vesting date) is the amount included in income.
• Thus, if an otherwise taxable capital interest is granted to a taxpayer, but the grant is subject to certain types of restrictions, then the FMV of the interest is not included in income until the restrictions lapse.
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Section 83 and Vesting
• The most common type of restriction that qualifies for this treatment is a requirement that the recipient continue to perform services. Thus, if a grant of a capital interest is conditioned on the recipient working for the LLC for four years, and if the interest would be forfeited because of a violation of this condition, then the receipt of the interest will not be taxable. When the interest vests in four years, the recipient will have to include the then-FMV into income.
• Another common restriction is a requirement that the LLC’s earnings increase by a stated percentage or dollar amount.
• Although the matter is not clear, it appears that until a recipient’s LLC interest vests, he or she is not treated as a member of the LLC for tax purposes. Any distributions to the recipient by virtue of his or her rights in the LLC under state law are treated as compensation income to the recipient. 75
Section 83(b) Election
• The Code provides a significant tax election that permits the recipient of property subject to a substantial risk of forfeiture to ignore that restriction for tax purposes.
• In effect, this allows a recipient to override the regular rules of section 83 and take property into income as of the date of grant (rather than the date it vests).
• Thus, if the grant is likely to be much more valuable by the time it vests, it may make sense to treat the grant as a taxable event today, and thereby avoid having to treat the increase in value at the time of vesting as income.
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Section 83(b) Election Example:
• Smith and Jones form Newco, LLC, by investing $500 each. A day later, Newco issues a 20% capital interest to Dewey, in exchange for Dewey’s promise to perform services for Newco. The terms of the grant require Dewey to forfeit his interest if he does not provide certain stated services to Newco for the next four years. As of the date of the grant, Dewey’s capital interest is worth $200. Assume that four years after grant, Dewey’s capital interest is now worth $2,000.
• Absent a §83(b) election, Dewey is taxed at the time of vesting on compensation income of $2,000.
• HOWEVER -- if Dewey makes a §83(b) election, he is taxed at the time of grant on compensation income of only $200.
• Note that this tax election has a very short fuse and must be filed within 30 days of the date of grant.
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Option to Acquire LLC Interest
• A compensatory option to acquire an interest in an LLC is generally not treated as a property interest which is taxable under section 83. As a result, until the option is exercised there is no taxable event. If the interest received as a result of the grant is a profits interest, the transaction will usually not result in any taxable income.
• If the interest received is a capital interest, the recipient will have to include the value of the interest in income. However, if the interest is subject to a substantial risk of forfeiture, then the income event will be deferred until the risk lapses.
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Effects on LLC • The grant of an LLC interest in exchange for services may give rise to two LLC-
level tax consequences.
• First, the value of the grant will be a compensation expense for the LLC.
• If the timing of the income is deferred by section 83, the timing of the compensation expense will also be deferred. Generally, the amount and timing of the income included by the recipient should match the amount and timing of the deduction for the LLC.
• Note that in many cases compensation expense is an ordinary and necessary business expense and can be deducted in full under section 162. However, if the capitalization rules apply, the expense will have to be capitalized into basis and recovered (possibly) through depreciation and amortization deductions over time.
• Second, if the grant is a capital interest there is an argument that the resulting capital shift may trigger LLC-level gain. This would only be the case if some or all of the LLC’s assets are appreciated. There is no guidance on the matter and reasonable arguments can be made for and against.
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Proposed IRS Regulations
• In 2005, the IRS proposed extensive rules to govern the granting of partnership and LLC interests in exchange for services.
• They substantially conform to current IRS practice.
• Thus, a vested capital interest is taxable to the recipient.
• A vested profits interest is also taxable, but the IRS would establish a special valuation safe harbor that would treat such an interest as having zero value. If the safe harbor is not used, a grant of a profits interest could be taxable to the recipient, but it would depend on the value of the interest.
• In the case of unvested interests, the section 83 regime would apply, with the effects described above.
• The proposed regulations also appear to state that the issuance of a capital interest would not trigger taxable gain to the LLC.
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Techniques Involving Disregarded Entities
A. Treatment of LLC as Disregarded Entity
B. Simple Example – Transfer of Real Estate
C. Transfer of Risky Assets
D. Corporate Reorganizations
E. Regulatory Issues
F. Like-Kind Exchanges
G. Alternative to Series LLC
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Treatment of LLC as Disregarded Entity
• If an LLC has only a single owner, by default the LLC will be treated as a “disregarded entity” or “DRE”. Alternatively, the owner can elect to treat the LLC as a corporation.
• An LLC treated as a DRE is, as the term implies, ignored for tax purposes.
• Thus, the assets and liabilities of the DRE are treated, for tax purposes, as the assets and liabilities of the sole owner of the DRE.
• In addition, in many cases the actions of the DRE are treated as the actions of the sole owner.
• This can provide significant planning opportunities.
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Simple Example – Transfer of Real Estate
• One of the simplest uses of DREs is to hold real estate.
• Example 1: Smith and Jones form Newco, LLC with $1 million each. Newco desires to purchases four separate apartment buildings, each costing $2 million. Newco goes to a bank and arranges for a $1.75 million loan on each building (it uses the contributed cash to fund the balance of each purchase price).
• In the absence of any additional structuring, this arrangement poses the following potential problems:
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Simple Example – Transfer of Real Estate
• Liability Protection – Because each building is held in a separate entity, the assets of one DRE are walled off against the liabilities of the other DREs.
• Transfer Taxes – If Newco desired to sell one of the buildings, it simply transfers its membership interest in the DRE that owns that building. This (under current law) should not trigger real estate transfer taxes. In addition, if the assets consisted of tangible personal property, a transfer of a DRE that owned the assets should also avoid sales tax.
• Recordation/Delays – Because Newco need only transfer its membership interest in one of the DREs to effectuate a transfer, there is no need to record the change and no fees associated with that. Furthermore, such a transfer can generally be accomplished faster and cheaper than a transfer of real property.
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Simple Example – Transfer of Real Estate
• Example 2: Same facts as Example 1, except that Newco forms four DREs below it, each of which holds a different apartment building. Each DRE separately borrows $1.75 million and Newco contributes $250,000 to each, so that each DRE can purchase one of the building buildings.
• This arrangement resolves the potential problems listed above:
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Transfer of Risky Assets • As noted above, assets that may have liabilities
associated with them can benefit from being held in an LLC.
• Risky assets can include assets with potential liability from past actions (i.e., real estate which may have environmental complications) or assets that may incur liability in the future (i.e., a business that is now subject to potentially damaging liability – i.e., fast food franchises, database companies, etc., that could be sued as part of a class action).
• If a business is considering moving risky assets, a DRE can be used
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Example • FoodCo is a limited partnership that owns 20 fast
food franchises throughout the southeast. Because of concern over potential class action lawsuits, FoodCo would like to restructure.
• One approach is for FoodCo to create a separate DRE for each franchise and hold it as a subsidiary. This would be particularly helpful in connection with future risks. Because FoodCo historically operated the businesses that are being sued, this may not fully protect FoodCo if the basis for liability includes past actions.
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Example • Another approach is for FoodCo to distribute out to
its owners any assets that are not at risk. For example, assume that FoodCo also operates several service businesses that are not targets of class-action programs.
• In that case, it may be effective to distribute FoodCo’s “safe” assets out and operate them as separate businesses. FoodCo could form DREs to hold each safe business and distribute the DREs to its owners.
• In this way, the owners of FoodCo would receive a complete business, would be shielded from any potential liability associated with the business, and the business could operate without interruption.
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Corporate Reorganizations -- Simple Mergers
• Assume X Corp would like to acquire Y Corp. The shareholders of Y Corp agree, but would like the acquisition to be non-taxable.
• One way to do this is for Y to merge into X, with Y going out of existence. The shares of Y are cancelled and convert into shares of X in an agreed upon ratio.
• Assume that Y is a consumer information database company and X is concerned that any inappropriate sharing or leak of information could subject the business to significant liability. If Y is merged into X, then any liability associated with the operations of Y could threaten X’s other businesses.
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Simple Mergers
• One solution is for X to form a DRE, Newco, LLC, and have Y merge into Newco, with Newco surviving. This can be accomplished on a tax-free basis with the shareholders of Y receiving X stock in exchange for their shares.
• Note that this could also be accomplished by using a corporate subsidiary of X. The benefit of using an LLC in this situation is primarily ease of use.
• However, if X owned a subsidiary, Z Corp, and wanted to acquire Y below Z, then it could not form a new corporate subsidiary below Z to do this. Instead it would have to use a DRE.
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C Reorganizations • Assume that X Corp wants to acquire Y Corp, but that Y owns a tract
of land that has significant potential environmental liability associated with it. If Y requires that the transaction be structured as a tax-free reorganization, the use of a merger may be resisted by X as that would put Y’s tract inside X (or a subsidiary). In this situation, X and Y can enter into what is called a “C” reorganization.
• Under a C reorganization, X (or a subsidiary of X) acquires substantially all the assets of Y and issues shares to Y in return. Y liquidates, distributing any remaining assets along with the X shares to its shareholders.
• This generally is tax-free to Y’s shareholders, and means that X can acquire Y’s business assets without acquiring the risky tract of land.
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C Reorganizations
• However, further protection can be added by the use of DREs.
• Even though the transaction can be structured so that X (or a subsidiary) specifically does not acquire the tract of land that has a significant liability associated with it, there may still be a risk that X (and/or its subsidiary) will nonetheless share some liability solely because of the acquisition of the balance of Y’s assets.
• One approach to better protect against this is for X to form a subsidiary that in turn forms a DRE to receive the assets.
• This arguably will place two layers of protection between the assets and X Corp.
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C Reorganizations • In addition to the possible protection afforded to X Corp, a
DRE can provide protection to Y’s shareholders.
• Recall that as a condition to the C reorganization, Y must liquidate and distribute the X stock and its remaining assets to Y’s shareholders.
• If the tract of land were received directly by the shareholders, there may be additional liability.
• One way to protect against this is to drop all or some of Y’s assets into a DRE and distribute out LLC interests in lieu of direct ownership.
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Triangular Mergers • As noted, if X Corp owns Z Corp, and Z would like to
acquire Y Corp for stock of X Corp, but does not want Y Corp to merge directly into Z Corp, it can accomplish this by forming a DRE below Z and having Y merger into the DRE with the DRE surviving.
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Regulatory Issues
• Regulatory issues can also be resolved with the use of a DRE.
• For example, in some states, a bank and a bank holding company cannot merge.
• However, a bank may be able to merge into a DRE owned by a bank holding company.
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Like-Kind Exchanges
• Under Code section 1031, a taxpayer can avoid gain on property by exchanging it for property of “like kind.” Particularly with respect to real estate, there is wide latitude as to what constitutes like kind property. As a result, many owners of real estate frequently engage in like kind exchanges rather than taxable sales.
• However, any direct interaction with real estate creates a certain amount of risk. One solution is to acquire the new property in a DRE. For tax purposes, the acquisition of a DRE that owns a piece of real estate will be treated the same as the acquisition of a piece of real estate directly.
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Alternatives to Series • Series LLCs are not yet permitted in most states.
• It is unclear how a series LLC from, say Delaware, would be treated in a state that does not recognize such an entity, either as a matter of state tax law or state LLC law.
• Given the complexity associated with series LLCs and the uncertain state law and state tax treatment, are there viable alternatives?
• holding company LLC with LLC subsidiaries
• multiple separate LLCs
• single LLC with schedular allocations 97
Holding LLC with Subs
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LLC A
Member 1 Member 2 Member 3 Member 4
A = 25%
B = 1%
C = 90%
D = 1%
A = 1%
B = 1%
C = 1%
D = 59%
A = 73%
B = 8%
C = 8%
D = 10%
A = 1%
B = 90%
C = 1%
D = 30%
LLC B LLC D LLC C
Holding LLC
Holding LLC with Subs
• Holding LLC owns 4 separate LLCs, each a “subsidiary” LLC.
• Note that by using separate LLCs, the assets of each LLC are walled off from the other LLCs.
• The Holding LLC also provides an additional layer of protection, and need not be an LLC that is formed under the same jurisdiction as the subsidiary LLCs.
• Each subsidiary has only a single owner, so should be treated as “disregarded entities” for income tax purposes.
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Holding LLC with Subs
• Will Holding LLC be treated as a separate partnership for income tax purposes?
• This an open question because of the schedular allocations. Under current law, Holding LLC may be ignored and the four subsidiary LLCs may be treated as separate entities.
• In fact, it may be preferable to ignore Holding LLC and treat the subsidiary LLCs as separate entities.
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Separate LLCs
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LLC A
Member 1 Member 2 Member 3 Member 4
A = 25%
B = 1%
C = 90%
D = 1%
A = 1%
B = 1%
C = 1%
D = 59%
A = 73%
B = 8%
C = 8%
D = 10%
A = 1%
B = 90%
C = 1%
D = 30%
LLC B LLC D LLC C
Separate LLCs
• The use of separate LLCs to hold, say, related real estate projects, is a structure that is frequently used.
• The tax treatment should be identical between the separate LLCs and a series LLC with schedular allocations.
• Note that by using separate LLCs, the assets of each LLC are walled off from the other LLCs.
• But, the use of separate LLCs can often be unwieldy. For convenience sake, it may be easier to form a single entry point and then as each investment opportunity comes up, provide for the specific economics of each investment.
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Single LLC
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Member 1 Member 2 Member 3 Member 4
A = 25%
B = 1%
C = 90%
D = 1%
A = 1%
B = 1%
C = 1%
D = 59%
A = 73%
B = 8%
C = 8%
D = 10%
A = 1%
B = 90%
C = 1%
D = 30%
Asset/Line of Business A Asset/Line of Business B Asset/Line of Business C Asset/Line of Business D
GiantCo LLC
Single LLC
• In this variation, we form a single LLC, put all the assets in it, and set out allocations based on specific assets or lines of business.
• Does not wall off one group of assets from another.
• Will this will be viewed as four separate LLCs for income tax purposes because of the asset/business allocations?
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Important Issues to Consider
David K. Staub Staub Anderson LLC
Chicago, Illinois dstaub@staubanderson.com
Corporations raise capital by issuing shares LLC capital contributions governed by agreement Loans vs. additional capital contributions Capital calls
Limitations on additional capital contributions Who decides on additional capital contributions Valuing non-cash capital contributions Tax consequences
Consequences of failure to meet capital call Protect against 3rd parties forcing a capital call
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General Rule: No gain or loss Exceptions Services Partnership investment company Disguised sale Assumption of indebtedness
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Loan from the other members Reduction in percentage interest Sale or redemption at appraised value Forfeiture Subordination Elimination of voting rights Elimination of all rights as a member Charging interest on the amount of the
defaulted capital call Foreclosure on the ownership interest
of the defaulting member
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Two types of anti-dilution provisions “Full ratchet” anti-dilution Weighted average anti-dilution
Anti-dilution carve outs Interests reserved for employees Interests issued pursuant to a merger, acquisition, or similar business combination Interests issued pursuant to a financing Interests with respect to which the members waive their anti-dilution rights
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Notice of proposed sale Exercise of preemptive rights Transferability of preemptive
rights Limitation on ability to issue
interests and/or admit members
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Priorities of payments to LLC members
Buyout transactions
Priority return of invested capital and preferred return
Participating or nonparticipating
Profits interests payments
o Percentage reserved for the management profits interest pool
o Vesting requirements
Joint ventures
111
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