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Leveraging LLCs in Structuring M&A Transactions Navigating Complex Capital Account and Tax Allocation Principles in Drafting Operating Agreements
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WEDNESDAY, OCTOBER 10, 2012
Presenting a live 90-minute webinar with interactive Q&A
L. Andrew Immerman, Partner, Alston & Bird, Atlanta
Lee Lyman, Shareholder, Carlton Fields, Atlanta
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LLCs in Mergers and Acquisitions: Navigating Capital Account and Allocation
Provisions in Operating Agreements
Andy Immerman
Chris Rosselli
Lee Lyman
October 10, 2012
5
L. Andrew Immerman
Alston & Bird LLP
(404) 881-7532
Christopher M. Rosselli
Delta Air Lines Law Dept.
(404) 715-9704
Lee Lyman
Carlton Fields
(404) 815-2677
6
LLCs in M&A
LLCs are being utilized with increasing frequency as
vehicles for mergers and acquisitions.
M&A counsel should understand the principles associated
with capital accounts and the implications of tax allocations
when using LLCs to ensure that operating agreements
properly reflect the economic bargain of the parties.
Too often M&A practitioners skim through tax
"boilerplate" without understanding underlying principles
or the impact of language changes to the transaction,
leading to costly mistakes.
7
Goals Understand principles underlying
allocations and distributions in
LLC agreements (for LLCs taxed
as partnerships).
Understand vocabulary – Capital
Account, Allocation, Distribution,
Gross Asset Value, Booking Up.
Develop a sense of how these terms
are all connected.
Understand issues that impact
economics. 8
Ground Rules
We are not talking about wholly-
owned subsidiaries − LLCs that are wholly-owned
subsidiaries may elect to be taxed
as corporations OR they are
"disregarded entities."
LLCs taxed as partnerships − Joint Ventures.
− Minority Investments.
Federal Income Tax. − State and foreign income tax
treatment may differ.
− Other taxes may apply:
Sales and use tax, FICA,
excise taxes
9
"Investment Company LLC"
For purposes of illustration this presentation refers to a simple deal reflected in the "Investment Company LLC Agreement."
The parties are assumed to want partnership tax treatment, but this is not a tax-motivated transaction.
For simplicity, it is assumed that Investment Company LLC has no debt.
LLC debt, especially nonrecourse debt, vastly complicates the issues.
We will discuss LLC debt only briefly. 10
Investment
Company LLC
Limited Liability
Company
Agreement
August 5, 2012
LLCs Don’t Pay Income Tax;
LLC Members Pay Income Tax
The LLC is not subject to income tax. Code § 701.
But the LLC does compute taxable income – generally, as if the LLC were an individual. Code § 703.
11 11
Why Partnership Tax
Is So Complicated
12
The tension between:
Income computed by the partnership/LLC, and
Tax paid by the partners/members,
creates endless pitfalls and opportunities.
Distributions vs. Allocations
Members generally do not pay tax on cash
or property distributed to them (with
exceptions).
Members generally do pay tax on the share
of LLC income allocated to them on the
books of the LLC (with exceptions).
We will focus on these general rules, but the
exceptions are important.
13
One Reason These Rules
Matter to You The way many LLC agreements work, if the
allocation provisions are drafted incorrectly,
the distributions will not be what they are
supposed to be.
This means that the allocation provisions,
which you may think deal only with taxes,
can affect the actual dollar amounts that the
members are entitled to receive. 14
Possible Mischief
If we didn’t have rules…
Members could agree to allocate
all income to tax-exempt members
(or to members that have large net
operating losses), but to distribute
most of the cash to taxable
members.
If members could do this, the
government would lose vast
amounts of revenue.
15
General Principle Tax rules and corresponding provisions in the LLC
agreement are designed to make sure that allocations
of income and loss are consistent with the economic
bargain.
Allocations must have "substantial economic effect," or
the equivalent (or else be in accordance with the
"partner’s interest in the partnership," an extremely
vague standard).
Most LLC agreements attempt to achieve "substantial
economic effect" or the equivalent. 16
What Can the IRS Do?
The IRS cannot invalidate provisions that call for
contributions or distributions; these provisions are
matters of agreement among private parties.
The IRS can invalidate allocations, and assess
interest and penalties, for lack of "substantial
economic effect."
"Economic effect," rather than "substantiality," is
the focus of most of the mysterious LLC language.
So… How do you know if your allocations have
economic effect? 17
The "Secret" Formula!
CONTRIBUTIONS
+/-
ALLOCATIONS
=
DISTRIBUTIONS
18 18
Contributions +/- Allocations =
Distributions
Of course this formula is not a secret
but:
It is not made explicit in LLC agreements.
It is only occasionally made explicit in tax
discussions about LLCs.
It is easy to miss if you focus on the details
instead of on the big picture.
19
However, this Agreement and most others are designed
to satisfy the formula over the lifetime of the LLC.
Contributions +/- Allocations =
Distributions 1. Measured over the lifetime of the LLC.
2. Calculated using so-called "book value," as
determined under unique tax rules (as discussed
later, look for references in the LLC Agreement to
the Regulations under Code § 704(b)).
3. These rules can be thought of as the IRS’s perception
of the economic deal, but they need not correspond to
financial accounting or to tax basis (or to reality).
20
21
To check, see what would happen if
-- at any given time --
the LLC liquidated (sold all its
assets and distributed the proceeds)
at book value. If, no matter when the LLC liquidates, the formula holds true, then the LLC has gone a long way towards complying with the key tax rules.
Are the Allocations Valid?
Lifetime Perspective
In partnership tax, focus on the
entire lifetime of the partnership.
In particular, always ask: What would happen on a complete liquidation at
"book value" (i.e., what would happen if the LLC
dissolved, wound up, sold its assets at "book
value," and distributed the proceeds)?
Many LLCs are intended to last
indefinitely, just like corporations,
but partnership tax was not designed
with indefinite life in mind. 22
How Does the LLC
Know it is On Track?
The capital account is a
snapshot that shows
whether the allocations are
on track for lifetime validity;
it generally shows the
amount the member would
receive if the LLC
liquidated at book value. 23
Answer: Capital Accounts
How Does the LLC
Know it is On Track?
At any given time:
Contributions +/-
Allocations –
Distributions =
Capital Account 24
Over the LLC’s lifetime:
Contributions +/- Allocations = Distributions
Capital Accounts Keep Score The capital account keeps score for
each member of the LLC.
It is intended to show what the LLC
member would be entitled to receive
(or contribute) if the LLC liquidated
at book value.
Upon liquidation, after final
distributions have been made to each
member, the score should be zero –
the members are not entitled to any
more distributions (and are not
required to make any contributions). 25
Capital Account
As Brokerage Account
A capital account is
something like a
brokerage account.
It keeps track of how
much you put into the
LLC, and how much
you are entitled to take
out.
26
Capital Account
As Brokerage Account When the LLC earns money, your share of
the earnings increases your capital account – the way earnings on your brokerage account increase your balance.
When the LLC loses money, your share of the losses reduces your capital account – the way losses on your brokerage account reduce your balance.
When you take money out of the LLC, you reduce your capital account – like withdrawing money from your brokerage account.
When the LLC liquidates, it is like closing your account – you should be left with a zero balance.
27
28
Avoid Common Misconceptions
The Capital Account is not just
Contributions less Distributions. Allocations of profits and loss must be shown in
the Capital Account.
Some LLC Agreements define a concept
such as "Unreturned Capital" consisting
of: Capital Contributions, less
Certain Distributions (those Distributions treated
as return of capital).
Do not assume that Capital Account
corresponds to Unreturned Capital.
29
Avoid Common Misconceptions
There is not necessarily any correlation
between Capital Account and tax basis.
The Capital Account is generally supposed
to reflect book value rather than tax basis.
The Capital Account does not include debt
because it is an equity interest.
However, a member’s basis in the LLC
interest will include the member's share
of the LLC's debt (almost, but not
exactly, as if the member incurred the
debt himself).
Final Capital Accounts Equal Zero
30
There are different ways to draft an LLC Agreement, but different drafting approaches generally aim for the same
result over the lifetime of the LLC:
Contributions +/-
Allocations –
Distributions =
Capital Account = 0
31
Final Capital Accounts Equal Zero It may be simpler to think of capital
accounts this way:
Capital accounts represent the net assets of the LLC (assets less liabilities).
When the LLC liquidates, it pays off its liabilities and distributes its net assets to the members.
After the LLC has paid off all its liabilities and distributed all its assets, it has no assets or liabilities.
If the LLC has no assets or liabilities, the capital accounts should be zero.
Allocations Can Be Negative Positive allocations are supposed to reflect
an increase in the amount that the member is entitled to receive, on liquidation if not before.
Negative allocations -- allocations in the nature of deductions or losses -- reflect a reduction in the amount a member is entitled to receive, and may even reflect amounts the member is required to contribute to the LLC.
For simplicity -- and also because businesses tend to be more interested in making money than in planning for losses -- this presentation focuses almost entirely on profits.
32
Capital Accounts Can Be Negative
Distributions and loss allocations could cause the capital account to be negative at a given point in time.
To ensure that the capital account equals zero on liquidation the LLC agreement may require:
Additional capital contributions.
Additional income allocations.
33
Capital Accounts Can Be Negative
LLC members are usually not required to make additional capital contributions to bring negative capital accounts up to zero, so additional income allocations are required instead.
The most complicated and confusing tax language in typical LLC agreements is designed to ensure that a member is allocated additional income to prevent a negative capital account after liquidation.
In the Investment Company LLC Agreement , these monstrous provisions are in Section 4.2.2 (the "Regulatory Allocations").
34
Tax Follows Book
35
With some exceptions, the Regulations say:
Tax income follows from "book" income.
Once you know the allocations on the "books" of the LLC, you generally (not always) know what taxable income each member of the LLC has.
An LLC may have to keep three
or more kinds of books:
Tax.
Financial reporting (GAAP, IFRS
or other).
"704(b)" (defined by Regulations
under Section 704(b) of the Code).
Typical LLC agreements require
the LLC to keep 704(b) books. 36
How Many Books Do You Need?
Most of the allocation provisions in typical
LLC agreements are technically 704(b) book
allocations; they are not tax allocations.
704(b) books start from taxable income, but
make significant adjustments.
704(b) books represent, in effect, the IRS's
version of the real economics of the deal.
37
704(b) Books vs. Tax Books
The theory is that the real economics should
determine the tax consequences.
For example, if you will be entitled to a
distribution of profits, you – not another
member -- should be taxable when those
profits are earned.
In many situations, you cannot figure out the
tax consequences without first thinking about
the 704(b) books. 38
704(b) Books vs. Tax Books
Remember
Capital Accounts are maintained on the
books of the Company.
Capital Accounts are bookkeeping entries;
they do not represent cash.
Capital Accounts under the tax Regulations
are kept under a special set of "book"
principles. They do not necessarily reflect tax
basis or GAAP or anything else. 39
What We Know So Far: 1. Members generally pay tax on LLC income allocated to
them.
2. Allocations must have economic effect.
3. Allocations generally are valid if upon liquidation at
book value, Contributions +/- Allocations =
Distributions.
4. Capital Accounts represent what each member would
receive at liquidation if the LLC is honoring the
formula.
5. Capital Accounts are increased by contributions and
allocations of income; they are decreased by
distributions and allocations of loss. 40
Connecting the Pieces The 704(b) Regulations neatly tie together
the principal tax and economic provisions of the LLC agreement:
1. Contributions.
2. Allocations.
3. Distributions.
4. Capital Accounts.
The economic deal and the tax terms are interrelated.
There are other tax-related provisions but these four concepts are fundamental and are the ones we focus on.
41
In a sense, the Capital Accounts summarize the other three concepts. Capital Accounts are essential for typical LLC agreements and partnership tax.
Connecting the Pieces In the Investment Company LLC
Agreement, the most crucial tax-related sections are:
Section 4.1 (Distributions).
Section 4.2 (Allocations).
Section 1.4.2(e) (Liquidating Distributions).
Section 2.3 (Capital Contributions).
However, the Agreement relies heavily on Exhibit A ("Definitions").
Some of the most important and surprising provisions are tucked away in the definitions rather than in the text.
Do not neglect the definitions, especially not the definitions of "Capital Account" and terms relating to the Capital Account.
42
The Life Cycle Of The LLC Begins
Investor contributes cash and all the
issued and outstanding stock of Corp 1.
43
CASH CORP 1
Fair Market Value:
$1,000
$1,000
Basis:
$1,000
$0
LLC uses the cash to buy Corp 2. Asset Manager proposes to increase the value of Corp 1 and Corp 2 by providing services, and receiving a share of the proceeds from any increase in value.
The LLC is Born
44
Investor contributes cash
and Corp 1 stock.
Investor and Asset Manager form an LLC in
Year 1.
The LLC is Born
45
Contribution is Tax-Free Investor recognizes no gain on
contributing Corp 1.
Investor has in effect "sold" Corp 1 for $1,000 in LLC interests, but he defers tax on his gain.
However, the LLC holds Corp 1 with the same zero basis that Corp 1 had for the Investor.
The Investor has built-in gain on Corp 1, which will later come back to haunt him.
The LLC is Born
46
The book value of the LLC’s assets – generally, the fair market value of the contributed assets, as agreed by the parties – is equal to $2,000 (including $1,000 cash). $2,000 will be credited to Investor’s Capital Account.
However, the tax basis of the LLC in its assets (called "inside basis") is only $1,000, because the LLC inherits Investor’s basis in the property.
The excess of book value over basis at the time of contribution is built-in gain, equal to the amount of gain Investor would have recognized on a cash sale.
Capital Contributions
47
Capital Contributions include cash and the Gross Asset Value of property contributed. However, the amount of liabilities that the property is subject to is debited from the Capital Account.
"Capital Contributions" means, with
respect to any Member, the amount of
money and the initial Gross Asset Value
of any property (other than money)
contributed to the Company with respect
to the Membership Interest held by such
Member.
Documenting the Contributions
Exhibit B shows:
$2,000 value of capital contribution by
Investor.
$0 capital contribution by Asset Manager. Some advisors recommend that Asset Manager put in at least
some capital.
In any case, services are not capital.
Sometimes the LLC Agreement or a separate
"Contribution Agreement" will contain
representations and warranties as in a sale.
48
2.3.1 Member's Capital Contribution.
Each Member's initial Capital
Contribution is set forth on Exhibit B.
Gross Asset Value
49
The value of property reflected in Capital Accounts is often defined, as in the Investment Company Agreement, as "Gross Asset Value." Investment Company LLC has no debt so gross and net value are equal.
"Gross Asset Value" means, with respect
to any asset, the asset's adjusted basis
for federal income tax purposes, except
as follows:
Gross Asset Value
50
Focus on who gets to make the decision about what the Gross Asset Value of an asset is, especially after the initial contribution. Initial Gross Asset Value is usually a mutual decision between the Company and the contributor.
(a) The initial Gross Asset Value of
any asset contributed by a Member to
the Company shall be the fair market
value of such asset, as determined by
the contributing Member and the
Company;
The Business Deal
51
The business deal is that Investor gets back the first $2,000 of cash flow. Investor puts in $1,000 cash, and property that
the parties agree has a value of $1,000. Asset Manager benefits only to the extent that
the value of the LLC increases to more than $2,000.
For simplicity, we assume
that Investor has no
preferred return on his
capital.
Documenting the Distributions
Section 4.1.1(a) says that Investor first
receives a cumulative distribution
equal to his initial Capital
Contribution. He receives the first
$2,000 of distributions.
Section 4.1.1(b) says that after
Investor receives this first $2,000 of
distributions, distributions are made
20% to Asset Manager and 80% to
Investor. 52
Documenting the Distributions
53
(a) First, 100% to Investor until the
cumulative distributions under this
Section 4.1.1(a) equal Investor's
initial Capital Contribution.
(b) Second, twenty percent (20%) to
Asset Manager and eighty percent
(80%) to Investor.
What Gets Distributed?
Answer: "Net Cash Flow"
Net Cash Flow is defined by reference to defined terms such as "Disbursements," "Reserves," and "Gross Receipts."
Notwithstanding all these definitions, the upshot in this Agreement is that Net Cash Flow generally means whatever amount the Managers decide is available for distribution.
Members may want tighter controls. over distributions.
54
Net Cash Flow Different LLC agreements use
different terms for what gets distributed, including:
"Net Profits."
"Net Income."
"Distributable Income."
The exact term doesn't matter, but a phrase like "Net Cash Flow" is less misleading than some others:
Profits and income do not get distributed.
Cash (and sometimes property) gets distributed. 55
56
Don’t Confuse
Distributions with Allocations
Distributions are actual
cash or property.
Allocations are
adjustments on the
books of the LLC.
"Payments" to Members
Partnership tax practitioners often distinguish
"distributions" from "payments."
"Payments" do not enter directly into the formula.
"Payments" are treated entirely or partially as if
paid to third parties.
"Payments" are sometimes set forth outside the
LLC agreement, including:
"Guaranteed payments" for capital or services.
Payment of sales price for property sold to the LLC. 57
"Payments" to Members
However, this Agreement provides in vague terms for certain "payments."
58
3.1.9 Compensation. Compensation of
the Managers will be fixed from time to
time by an affirmative vote of a
Majority in Interest.
2.4.1 Loans to the Company. The
Members may lend money to the
Company as approved by the Managers.
What is Asset Manager’s Interest?
59
Answer: Asset Manager has a $0 interest in capital and a 20% interest in profits. In almost every LLC there are "capital interests" and "profits interests." It is often misleading to express ownership as either a single percentage or as a number of "units."
Capital:
$0.00
Profits:
20%
What is Asset Manager’s Interest?
60
"Capital Interest": Any interest that would give the holder a share of the proceeds if the partnership's assets were sold at fair market value and the proceeds distributed in liquidation of the partnership. "Profits Interest": Any partnership interest other than a capital interest. Rev. Proc. 93-27, 1993-2 C.B. 343.
Capital:
$0.00
Profits:
20%
Does Asset Manager Have
a Capital Account?
61
Answer: Yes and no. The Asset Manager starts with a zero Capital Account. However, the Asset Manager’s Capital Account will build up over time as income is allocated to the Asset Manager (and will be reduced again as the Asset Manager receives distributions).
Initial Capital Account
Investor $2,000
Asset Manager $0
Is Asset Manager Taxable on Receiving
the Profits Interest?
Answer: Generally no.
With a few exceptions, if a person
receives a profits interest for the
provision of services to or for the
benefit of a partnership in a partner
capacity or in anticipation of being a
partner, the IRS will not treat the
receipt of the profits interest as a
taxable event for the partner or the
partnership. 62
63
IRS may try to impose tax if: 1. The profits interest relates to a
"substantially certain and predictable stream of income" (like income from high-quality debt securities or a high-quality net lease).
2. Within two years of receipt, the partner disposes of the profits interest.
3. The profits interest is a "publicly traded" limited partnership interest.
Possible Exceptions
Capital:
$0.00
Profits:
20%
64
How to Draft Profits Interests
Elaborate terms defining and governing the Asset Manager's "profits interest" are not essential , although may be desirable.
A distribution scheme in which the Investor receives all his contributed capital, and profits are split 80/20, without more, represents a profits interest for Asset Manager.
65
How to Draft Profits Interests
Especially if the LLC has a formal equity compensation plan, it may want additional documents such as a "Profits Interest Plan," and individual "Profits Interest Awards" for each recipient.
The LLC may also want a service contract with the service provider.
However, the distribution provisions of the LLC agreement are essential; always check the LLC agreement.
So… How Does an LLC Allocate
Income and Loss?
66
Remember: allocations must be consistent with the economic deal as the Regulations construe it.
Over the LLC’s lifetime: Contributions +/- Allocations = Distributions.
At any given point in time: Contributions +/- Allocations – Distributions = Capital Account
What is Allocated?
67
Answer: "Profits" (and "Losses" and other "items"). You can use other terms, but be clear that allocations are accounting entries and not actual money or property. "Net Cash Flow" gets distributed, not allocated.
"Profits" and "Losses"
68
The definition of "Profits" and "Losses" starts from taxable income and then makes adjustments.
"Profits" or "Losses" means, for each
Allocation Year, an amount equal to the
Company's taxable income or loss for such
Allocation Year, determined in accordance
with Section 703(a) of the Code (for this
purpose, all items of income, gain, loss or
deduction required to be stated separately
pursuant to Section 703(a)(1) of the Code
shall be included in taxable income or loss),
with the following adjustments:
"Profits" and "Losses"
69
The adjustments bring taxable income and loss into line with "book" income and loss. However, these are the "704(b)" books – the books kept under the 704(b) Regulations – and not tax books or financial accounting books.
(a) Any income of the Company
that is exempt from federal income
tax and not otherwise taken into
account in computing Profits or
Losses pursuant to this definition
shall be added to such taxable income
or loss;…
"Profits" and "Losses"
70
Adjustments are needed to get to Profits from taxable income because Profits is a book concept, supposedly reflecting the economic deal. For example, Tax-exempt income must be allocated because it
increases the amount that the LLC has available to distribute and so affects the economics.
"Book value," and not basis, determines the total amount that may be depreciated (but depreciation schedules are still calculated under tax rules and not, for example, under GAAP).
71
Draft Distributions First
Drafting Tip: When drafting an LLC Agreement
for a business deal:
Focus first on the distributions,
Then see how the allocations
will come out, and whether the
distributions should be adjusted
in light of the allocations.
In most deals, the distributions are
the primary concern.
72
Allocating Profits and Losses
Section 4.2 of the Investment Company
LLC Agreement illustrates two
alternative styles of drafting
allocations:
"Layered" (also known as "layer
cake" or "waterfall").
"Targeted" (also known as "forced").
Layered Allocations
73
Layered allocations fit within one of the
"safe harbors" in the Regulations.
They require liquidation in accordance
with capital accounts.
If the capital accounts are not what the
parties intended then the liquidating
distributions will not be what the parties
intended. For example, an unknown
drafting error in the allocations may
unintentionally increase some capital
accounts at the expense of other, leading
some members to receive more than
intended
Layered Allocations: First Tier
74
The first "tier" of Profit allocations offsets ("charges back" or "reverses") any prior Losses.
Although this tier comes first, it is generally not the first in importance.
This presentation focuses on Profits.
If there are no Losses this first tier of Profit allocations is irrelevant.
Layered Allocations: First Tier
75
Crude explanation of this charge back of prior Losses: Asset Manager starts with a zero Capital Account Losses reduce Capital Accounts; initial Losses can’t be
allocated to Asset Manager or else she would have a negative Capital Account.
Initial Loss allocations to Investor means that his Capital Account is less than $2,000; he is entitled to less than $2,000 on liquidation at book value. If there are no later Profits, the Company really has
lost some of Investor’s $2,000, and he can’t receive his full $2,000.
However, if there are later Profits offsetting the initial Loss, the initial Loss was temporary; the Company now can give Investor back his $2,000, and his Capital Account should reflect $2,000 or more.
Layered Allocations: First Tier
76
(i) First, Profits shall be allocated one
hundred percent (100%) to Investor in an
amount equal to the excess, if any, of the
cumulative Losses allocated to Investor
pursuant to Section 4.2.1(b)(ii) for all prior
Allocation Years over the cumulative Profits
allocated pursuant to this Section 4.2.1(a)(I)
for all prior Allocation Years.
The Company allocates Profits first to Investor to charge back prior Losses, bringing his Capital Account back up to $2,000, the minimum amount he should receive over the lifetime of the Company.
Layered Allocations: Second Tier
77
Assuming there are no prior Losses remaining to be charged back, Profits are simply allocated 80/20. The second tier of allocations is actually the general rule.
(ii) Second, after giving effect to
the allocations made pursuant to
Section 4.2.1(a)(I), Profits shall be
allocated twenty percent (20%) to
Asset Manager and eighty percent
(80%) to Investor.
Targeted Allocations
78
Many LLC agreements nowadays omit specific allocation rules, in favor of "targeted" allocations.
The targeted capital account provision says: Allocate so that Capital Accounts (with certain adjustments relating to nonrecourse debt) equal the amounts the members would receive in a liquidating distribution.
Targeted Allocations
79
Instead of following detailed allocation instructions specified in
the LLC agreement, the LLC’s accountants must figure out each
year how to make allocations based on what the LLC would
distribute if the LLC liquidated at book value at the end of the
year.
This is sometimes called the
"forced" allocation approach
because allocations are forced to
correspond to a hypothetical
liquidating distribution for each
Member.
Targeted vs. Layered
80
Both methods are intended to get to the same place.
However, if something goes wrong, the different methods seek
to save different aspects:
Targeted allocations: economic terms (distributions) are
thought to be safe.
Layered allocations: tax treatment is thought to be safe.
Of course the distribution provisions still need to be carefully
thought through when using targeted allocations.
Targeted allocations are especially handy when there is an
elaborate multi-tier distribution waterfall.
However, targeted allocations are not used in some situations
(for example, certain investments by tax-exempts in real estate
LLCs, where the dreaded "fractions rule" is relevant).
Why Does the Allocation
Language Go On So Long?
81
Answer: The possibility of negative capital accounts.
Most LLC agreements include a series of complicated
exceptions to the primary allocation provisions. These are sometimes called the "regulatory" (or "special"
or "curative") allocations. These allocations are directed at actual or potential negative
capital accounts. A positive capital account should imply an ultimate right to
receive distributions. Does a negative capital account therefore imply an ultimate
obligation to make contributions?
Why Does the Allocation
Language Go On So Long?
82
But remember: The IRS has no authority to require capital
contributions. The most the IRS can do is to force allocations to be made in
such a way that: A negative capital account will not arise except to the extent that the
member has (or is deemed to have) an obligation to contribute capital; or If such a negative capital account arises anyway, then to the extent
possible, income will be allocated to the member to increase the capital account.
Many agreements use the term "Adjusted Capital Account" to refer to the result of adding required contributions on to the capital account.
Adjusted Capital Account Deficit
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The "Adjusted Capital Account Deficit" starts with the Capital Account.
It adds back amounts that the Member: Is obligated to restore (none under our facts), or Is deemed obligated to restore (this would only arise if there
are distributions or deductions attributable to nonrecourse debt).
It subtracts certain deductions and distributions that are expected to be made later.
"Adjusted Capital Account Deficit" means, with respect to
any Member, the deficit balance, if any, in such Member's
Capital Account as of the end of the relevant Allocation
Year, after giving effect to the following adjustments: . . .
Nonrecourse Debt
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Perhaps the most common situations in which the
Regulatory Allocations come into play are those in
which members take deductions or distributions
attributable to (funded by or sourced to) nonrecourse
debt.
Roughly speaking, a deduction or distribution is
attributable to nonrecourse debt to the extent it
reduces a capital account below zero.
Deductions or distributions are not necessarily
attributable to nonrecourse debt, even if the LLC has
nonrecourse debt.
Nonrecourse Debt
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"Minimum Gain" can be thought of as the amount of
negative capital account that is attributable to nonrecourse
debt – the amount that the lender, and not the member,
stands to lose.
The member has no obligation to make a Capital
Contribution to eliminate the negative Capital Account; the
debt is nonrecourse.
However, the IRS can require the LLC to eventually
allocate income to the member in order to eliminate the
negative Capital Account.
Roughly, the "Minimum Gain Chargeback" is income that
is allocated to eliminate a negative Capital Account
attributable to nonrecourse debt .
What Have We Learned So Far?
Capital Accounts begin with a contribution of cash or property.
If contributed property is appreciated (i.e., its value is higher than
its tax basis), there will be built-in gain, which will be allocated to
the member over time in accordance with Code § 704(c).
Allocations of income and loss are made in accordance with Code §
704(b) to ensure allocations have economic effect.
Safe harbors exist for "Layered Allocations," but the modern trend
is to instead use "Targeted Allocations."
The "Regulatory Allocations" address special situations that involve
or could involve negative capital accounts.
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Sale of Corp 2
Assume that Corp 2 is sold in Year two for $2,000, resulting
in $2,000 in proceeds, $1,000 in book income, and $1,000 in
tax income.
The business deal is that the first $2,000 in cash is returned to
Investor.
However, the $1,000 book income represents profits, and is
allocated $800 to Investor and $200 to Asset Manager.
There has been $1,000 of profits (the value of the LLC
increased by $1,000 over the initial value of $2,000), and the
business deal is that, over the lifetime of the LLC, Asset
Manager is entitled to 20% of all profits.
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Asset Manager Has
"Phantom Income"
Asset Manager has "phantom income"
in year two – she has $200 of taxable
income, but no distribution to pay it
with.
Phantom income here is a consequence
of the economic deal.
It is not the result of faulty legal
draftsmanship or inept accounting. 88
Minimum Tax Distribution A common solution to the phantom income problem is a minimum tax distribution:
Require the LLC to first distribute enough to the parties so that they can pay tax on the income allocated.
This solution means that Investor is not getting all of the first $2,000 of cash, but he is getting most of it. 89
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Minimum Tax Distribution
4.1.2 Minimum Tax Distribution. Except
as otherwise provided in Section 1.4.2,
notwithstanding Section 4.1.1 the
Company shall make distributions out of
Net Cash Flow to the Members at such
times and in such amounts as are
reasonably estimated by the Managers to
be at least sufficient to enable each
Member to make timely payments of
federal, state and local income taxes ,
including estimated taxes, attributable to
such Member's Membership Interest.
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Minimum Tax Distribution Section 4.1.2 only requires the tax
distribution to be a reasonable estimate of the amount needed to pay taxes. The estimate may be less than is actually needed.
Section 4.1.2 only requires the tax
distribution to be made out of "Net Cash Flow." For example, the Company does not need to borrow money to make a tax distribution.
No matter what the LLC agreement
says, there is always some risk that a Member will have phantom income.
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Minimum Tax Distribution Distributions under this Section 4.1.2 shall
be made twenty percent (20%) to Asset
Manager and eighty percent (80%) to
Investor. Any amount distributed pursuant
to this Section 4.1.2 will be deemed to be an
advance distribution of amounts otherwise
distributable to the Members pursuant to
Section 4.1.1(b) and will reduce the
amounts that would subsequently
otherwise be distributable to the Members
pursuant to Section 4.1.1(b) in the order
they would otherwise have been
distributable.
Minimum Tax Distribution A tax distribution is normally treated as an advance on
amounts that otherwise would be distributed in the future.
Tax distributions affect the timing of distributions but in general are not intended to alter the total distributions that the member is entitled to receive over the lifetime of the LLC.
Tax distributions have no special status under tax law; they are treated for tax purposes the same as any other distributions.
Tax law does not require tax distributions.
The LLC can make distributions for any reason or no reason; some distributions happen to be designed so that the members have enough cash to pay their taxes.
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Minimum Tax Distribution
There are many ways to draft tax distribution provisions; no approach is ideal.
Tax distributions are usually based on assumed tax rates, specified conventions and/or estimates; actual tax liability is harder to determine than you might think.
Carefully consider tax distributions, especially if you are in the position of the Asset Manager (i.e., the service provider).
Assuming that the LLC wants to give the members some relief from the problem of phantom income, there are techniques other than tax distributions, such as loans or special allocations.
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Sale of Corp 1 Assume that Corp 1 is sold in Year three for $2,000,
yielding:
$2,000 in cash proceeds.
$1,000 in book income.
$2,000 in tax income.
Investor got the first $2,000 of proceeds in Year two
(assume no Minimum Tax Distribution in Year two),
so Year three cash of $2,000 is split 80/20:
$1,600 to Investor.
$400 to Asset Manager. 95
Liquidating Distributions For tax purposes, and under the
Agreement, the distribution of Year 3
proceeds is a liquidation of the LLC; the
LLC has no more assets.
Liquidating distributions are drafted in
different ways.
Two common approaches are:
In accordance with positive Capital
Accounts (typical with "Layered
Allocations").
In accordance with specific distribution
instructions in the LLC agreement
(typical with "Targeted Allocations"). 96
Liquidating Distributions
97
1.4.2 Liquidation of Property and
Application of Proceeds. Upon the
dissolution of the Company, the Managers
(or, if none, a liquidator appointed by the
Personal Representatives of the deceased
Members) will wind up the Company's
affairs in accordance with the Delaware Act,
and will take any and all actions
contemplated by the Delaware Act that are
necessary or appropriate, including, without
limitation: …
Liquidation provisions generally begin by requiring the Managers to take the steps required by law.
Liquidating Distributions
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(e) distributing the proceeds of
liquidation and any undisposed
Property to the Members in
accordance with [their positive Capital
Account balances] [Section 4.1.1].
For the members, the crucial provision on liquidation relates to the distribution of amounts remaining after creditors have been paid or reasonable provision has been made for their payment. This residual will be distributed either in accordance with Capital Accounts, or in accordance with a distribution scheme spelled out in the LLC agreement.
Liquidating Distributions
99
In our example, liquidating in accordance with Capital Accounts or in accordance with Section 4.1.1 has the exact same results, as intended. Although the drafting trend in recent years is to require liquidation in accordance with a specified distribution schedule, if things work out right, the results will be the same under either approach.
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Over the Lifetime of the LLC, the
Formula Works Just Right
INVESTOR
Year Contributions Allocations Distributions
One: $2,000 0 0
Two: 0 $800 $2,000
Three: 0 $800 $1,600
Life of LLC: $2,000 + $1,600 = $3,600
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Over the Lifetime of the LLC, the
Formula Works Just Right
ASSET MANAGER
Year Contributions Allocations Distributions
One: 0 0 0
Two: 0 $200 0
Three: 0 $200 $400
Life of LLC: 0 + $400 = $400
Aren’t We Forgetting Something
About Corp 1? The book income of $1,000 (and $1,000 of the tax
income) on the sale of Corp 1 was allocated the same
way as it was for Corp 2: $800 to Investor and $200
to Asset Manager.
However, there is $2,000 of tax income, which is
$1,000 more than the book income. Corp 1 stock had a zero basis when contributed.
Corp 1 stock had a $1,000 book value when contributed.
How do we reconcile the $2,000 tax income with the
existence of only $1,000 book income? 102
The Formula Revisited
103
The formula applies to the $1,000 of book income, and
to tax income to the extent that the tax income equals
the book income (i.e., to $1,000 of tax income).
The $1,000 of built-in gain when Investor contributed
the property is not book income.
However, the $1,000 of built-in gain was deferred when
Investor contributed Corp 1
Investor got $1,000 of Capital Account credit on
property with a zero basis.
Now that the property is sold, it is time for him to
pay the tax.
Book/Tax Reconciliation
104
Investor wound up getting total cash distributions of $3,600 from the Company. Investor's initial tax basis in the property contributed to the Company was $1,000. Thus he should have $2,600 of taxable income, and not $1,600. Allocating the extra $1,000 entirely to Investor seems quite fair.
Book/Tax Reconciliation
105
Investor got the economic benefit of that $1,000 of value and there is no reason Asset Manager should pay tax on it.
In some cases, the contributing member’s gain is triggered long before the property is sold.
Code § 704(c) and related Code provisions – seek professional help!
Book/Tax Reconciliation
(Section 4.2.6)
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4.2.6 Tax Allocations. Tax Allocations. In accordance with
Section 704(c) of the Code and the Treasury Regulations
thereunder and with Treasury Regulations Section 1.704-
1(b)(2)(iv)(f)(4) and 1.704-1(b)(4)(i), income, gain, loss and
deduction with respect to any property contributed to the
capital of the Company or property revalued on the Company's
books and in the Capital Accounts shall, solely for tax purposes,
be allocated among the Members so as to take account, under
the [SPECIFY METHOD] as defined by Treasury Regulations
Section 1.704-3, of any variation between the adjusted basis of
such property to the Company for federal income tax purposes
and its Gross Asset Value.
Capital Account:
Further Explanation
107
The remainder of this presentation: Goes over the definition of
Capital Account in somewhat more detail.
Explains how the concept of "booking up" affects the Capital Accounts.
Capital Account
108
Credit Capital Account With Contributions and Profit Allocations
(a) To each Member's Capital Account
there shall be credited such Member's
Capital Contributions, such Member's
distributive share of Profits and any items
in the nature of income or gain that are
allocated pursuant to Section 4.2 hereof,
and the amount of any Company liabilities
assumed by such Member or that are
secured by any Property distributed to such
Member;
Capital Account
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Debit Capital Account for Distributions and Loss Allocations
(b) To each Member's Capital Account
there shall be debited the amount of cash and
the Gross Asset Value of any Property
distributed to such Member pursuant to any
provision of this Agreement, such Member's
distributive share of Losses and any items in
the nature of expenses or losses are allocated
pursuant to Section 4.2 hereof, and the
amount of any liabilities of such Member
assumed by the Company or that are secured
by any property contributed by such
Member to the Company;
Capital Account
110
If the Member assumes liabilities of the Company, the Member is treated as making a capital contribution; If the Company assumes liabilities of the Member, the Member is treated as receiving a distribution.
(d) In determining the amount of any
liability for purposes of clauses (a) and
(b) of this definition, there shall be taken
into account Section 752(c) of the Code
and any other applicable provisions of
the Code and Treasury Regulations.
Capital Account
111
Capital Accounts are affected by liabilities that the Member assumes or that the LLC assumes.
Capital Accounts are not affected by the Member's "share" of the Company's liabilities, even though the Member's "share" of liabilities is included in the Member's basis.
If the Member's tax basis is higher than the Member's Capital Account, the reason is often that the tax basis – but not Capital Account – includes a share of the Company's liabilities.
Capital Account
112
Transferee succeeds to Capital Account of transferor.
(c) Subject to the other provisions of
this Agreement, in the event all or any
portion of a Membership Interest is
Transferred in a Permitted Transfer, the
transferee shall succeed to the Capital
Account of the transferor to the extent it
relates to the Transferred interest . . .
Booking Up
Booking up Capital Accounts means reflecting new fair market values for the LLC’s assets, and adjusting Capital Accounts accordingly.
Technically the procedure is a "restatement," since it can lead to booking down as well as booking up.
It can be thought of as "marking to market."
In the Investment Company LLC Agreement, the concept of booking up is part of the definition of Gross Asset Value.
Booking up is often essential to prevent distortion of the economic deal.
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Booking Up Gross Asset Value is typically "booked up" when an
additional interest is issued to a new or existing Member (other than de minimis interests), when property is distributed, or upon liquidation. See Clause (b) of the definition of "Gross Asset Value."
Although the provision on booking up looks like neutral tax definitional boilerplate, the appearance may be deceiving.
Decisions about booking up can have major effects on the economics of the deal.
Focus on how booking up decisions are made; decision-making procedures vary widely.
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Booking Up
Example: Suppose that Investment Company LLC at some point needs extra cash and New Investor agrees to contribute $2,000.
If the net assets of the LLC at the time have increased in value to $4,000 (rather than the $2,000 original book value), New Investor’s contribution will represent $2,000 out of the total $6,000 value.
New Investor should be credited with owning only 1/3 of the capital – not ½.
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Booking Up The $2,000 increase in value that
accrued before the new investment should be credited to the Capital Accounts of Investor and Asset Manager, as if the assets had been sold.
This increase in Capital Accounts is not taxable to Investor and Asset Manager, but creates built-in gain that can eventually come back to haunt them – almost as if Investor and Asset Manager had contributed appreciated property to a new partnership with New Investor.
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