equity compensation grants in partnerships and llcs:...
TRANSCRIPT
Equity Compensation Grants in Partnerships and LLCs: Overcoming Tax Challenges and Key Planning TechniquesImpact of Tax Reform, Profits vs. Capital Interests, Section 83, Options and Phantom Equity, Carried Interest, and More
Today’s faculty features:
1pm Eastern | 12pm Central | 11am Mountain | 10am Pacific
THURSDAY, JANUARY 9, 2020
Presenting a live 90-minute webinar with interactive Q&A
Michael P. Spiro, Partner, Finn Dixon & Herling, Stamford, Conn.
Craig P. Tanner, Counsel, Reed Smith, Palo Alto, Calif.
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Overview of Partnership Taxation
• “Flow-Through” Taxation
◦ Partnership itself is not a taxpayer
◦ Taxable income of the partnership is allocated among the partners.
• Capital Accounts
◦ Regulatory invention to create a means of tracking the partners’ economic
interests in the partnership.
◦ Rely on a set of accounting rules set out in Treasury Regulations §1.704-
1(b)(2)(iv).
◦ In order to have “economic effect” liquidating distributions must be in
accordance with capital accounts.
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Overview of Partnership Taxation (cont. )
• Allocations
◦ Income and loss of the partnership are generally first netted at the entity
level, then net income or loss is allocated among the capital accounts.
◦ In some cases, capital accounting income does not correspond to current
taxable income (i.e. upon a “book-up” of asset values).
◦ Taxable income allocated to a partner is reported to that partner on a
Schedule K-1 and included on that partner’s individual or entity tax return.
• Distributions
◦ Payments to a partner reducing its capital account balance and tax basis.
◦ Can be thought of as a withdrawal of a partner’s share of the capital of the
entity, including capital representing realized, but undistributed, income.
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State Law Considerations
Where to Form the Entity
• Either a “domestic” LLC in your home state or a “foreign” LLC in another
state.
• Factors to consider
◦ Legal System
◦ Tax Rates
◦ Regulatory Requirements
◦ Information Disclosure requirements
◦ Costs
◦ Location of Company
• States with reputations for business-friendly environment:
◦ Delaware
◦ Nevada
◦ Wyoming
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Capital Interests and Profits Interests
• Rev. Proc. 93-27
◦ Capital Interest
― Interest that entitles the holder to a current share in partnership capital.
― In a liquidation of the partnership immediately after the grant of the interest,
the recipient would receive proceeds.
― Taxable to recipient (and deductible to the partnership) on grant based on its
fair market value.
◦ Profits Interest
― An interest that is not a capital interest.
― Entitles the recipient to share only in future profits of the entity.
― Granted in consideration of services to or for the benefit of the partnership.
― Subject to certain exceptions, not taxable to recipient (or deductible to the
partnership) on grant.
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Capital Interests
• Taxable pursuant to Code Section 83.
◦ Upon grant if not subject to a substantial risk of forfeiture.
◦ Upon grant if subject to substantial risk of forfeiture and 83(b) election is made.
◦ Upon vesting if subject to substantial risk of forfeiture and no 83(b) election is made.
• Taxable amount is fair market value
◦ Generally can include valuation discounts for minority interest or lack of marketability.
◦ However, Proposed Regs. §1.83-3(l) and §1.83-6(b) would provide for “safe harbor”
valuing all partnership interests at liquidation value.
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Profits Interests
• A partnership profits interest has a liquidation value at grant of $0.00.
• Rev. Proc. 93-27 provides safe harbor. If the safe harbor is met, liquidation
value is used to value the interest at grant, resulting in $0.00 taxable value.
• Safe harbor does not apply if:
◦ Profits interest relates to a substantially certain and predictable stream of income
from partnership assets, such as income from high-qualify debt securities or a high-
qualify net lease.
◦ Within two years of receipt, the partner disposes of the profits interest; or
◦ The profits interest is a limited partnership interest in a “publicly traded partnership.”
• If a profits interest is outside of the safe harbor, it is tested under the case
law—primarily Diamond (492 F.2d 286 (7th Cir. 1974)) and Campbell (943 F.2d
815 (8th Cir. 1991)). These look primarily to whether the interest had an
ascertainable value at the time of grant.
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Full Value Awards
• Restricted Units
◦ Grant of a unit subject to forfeiture provisions.
◦ Typically not subject to Section 409A, unless there is a deferral feature.
◦ Subject to Section 83.
Appreciation Awards
• Options
◦ Non-Qualified Options.
◦ Subject to Section 409A.
◦ Fair market value exercise price.
◦ Not commonly granted because of uncertainty in treatment of members upon exercise.
• Profits Interests
◦ Most common and tax favorable equity incentive award for LLCs.
LLC Incentive Award Alternatives
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Cash Awards
• Phantom Awards
◦ Typically a cash award but may be settled in units.
◦ Payment based upon full value of unit.
◦ Subject to Section 409A.
◦ Payment dates based upon Section 409A permissible payment events.
◦ Good alternative if employee/partner classification cannot be resolved.
• Unit Appreciation Award
◦ Also typically a cash award but may be settled in units.
◦ Payment based upon increased value of unit over grant date value.
◦ Not subject to Section 409A.
◦ Often paid upon a change in control.
◦ Good alternative if employee/partner classification cannot be resolved.
LLC Incentive Award Alternatives
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• Separate Class of Units. Profits interest units should be a separate class of units.
Profits interest may be granted over common units but care must be taken to avoid
distributions before the benchmark amount is satisfied.
• Benchmark Amount. The benchmark amount is equal to the liquidation value of the
company at the time of issuance. The liquidation value is set by the company based
upon data such as recent unit sales, third-party valuation, book value, and earnings.
The benchmark amount represents the amount of distributions that must be made to
members before the participant becomes eligible to receive capital income
distributions.
• Hurdle Amount. A hurdle amount is useful to align the profits interest units with the
target return on investments for investors. The hurdle amount is in addition to the
benchmark amount when determining when a participant is eligible to receive
distributions. The hurdle amount is set based upon the guaranteed returns to
investors.
Terms for Profits Interest Awards
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• Catch-Up Rights. Catch-up rights are a useful tool to allow participants to share in
the total value of the company. These rights allow for a disproportionate
distribution of profits to a participant in order to allow the participant to receive
aggregate distributions based upon the full liquidation value of the company rather
than only appreciation in excess of the full liquidation value of the company.
• Ordinary and Capital Distributions. The distribution waterfall will be set out in the
LLC operating agreement. The participant may be eligible to receive both ordinary
distributions and capital distributions; or capital distributions only.
• Cap on Distributions. The company may set a cap on total distributions paid to
participants. Companies may apply a cap on distributions to align the potential
distributions to its service provider compensation goals.
Terms for Profits Interest Awards
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• Distributions for Unvested Units. Ordinary distributions may be paid to unvested
units. Companies may treat unvested units as vested for the purpose of ordinary
distributions or hold the ordinary distributions on behalf of the participant until the
units become vested.
• Tax Distributions. Participants will be subject to income tax on allocated profits
even though the profits may not be distributed to them. The tax distributions are
paid to the participants for the tax liability associated with allocated profits.
• Vesting. The vesting criteria is set at the discretion of the company and need not be
the same for all participants. The award may vest on an annual or monthly schedule
or on a performance schedule. In addition, the awards may vest upon the
occurrence of a liquidity event so long as the participant has continued to provide
service to the company from the date of grant to the payout date.
Terms for Profits Interest Awards
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• Acceleration of Vesting. The company has discretion to accelerate the vesting
criteria. For example, the award may become fully vested in the event of a change
in control or an IPO. The company also may accelerate vesting upon the
participant’s death, disability or retirement.
• Forfeiture. Unvested awards are forfeited upon termination of employment for any
reason. All awards, whether vested or unvested, may be forfeited upon a
termination for cause.
• Repurchase Right. The purpose of the repurchase right is to protect the company
from being contractually bound to pay distributions under vested awards to former
service providers. The repurchase right is triggered by the termination of the
participant or by the company learning that the participant has violated an
agreement with the company after termination of service. The repurchase price is
set by the company at its discretion or upon a pre-set formula.
Terms for Profits Interest Awards
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• Call Option / Put Option. Call options and put options allow for the sale of the units
to the Company. These options are useful alternatives to monetize the units if a
liquidation event is not anticipated.
• Transferability. Typically, profits interest units are granted for the benefit of the
participant and may not be sold, loaned, pledged or otherwise transferred by the
participant other than by will or by the laws of descent or distribution.
• Voting Rights. The company has discretion to allow the participant to vote on
company matters. Typically, profit interest unit holders do not have voting rights
because they have no financial investment in the company.
• Access to Company Financial Information. Subject to state law requirements, the
company may or may not allow a participant access to financial information. The
restrictions on access to financial information should be set out in the LLC operating
agreement.
Terms for Profits Interest Awards
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• Under Section 83, unvested property is taxed at the time of vesting based upon the
property’s fair market value at the time of vesting.
• Section 83(b) election is made by a participant to characterize the unvested property as
vested for tax purposes and to be taxed on the fair market value at the time of grant.
• Revenue Proc. 2001-43
◦ A Section 83(b) election is not necessary for unvested profits interest units if the
participant is treated as a partner for tax purposes and receives income allocations on
a fully vested basis; and
◦ Applies only to profits interests compliant with the Revenue Proc. 93-27 safe harbor.
• Important for profits interest units outside of the safe harbor and subject to testing
under case law.
• No downside to filing a protective Section 83(b) election.
• Must be filed no later than 30 days after issuance of profits interest units.
Section 83(b) Elections
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Partner vs. Employee Classification
• Under current IRS guidance the owner of a partnership interest (either a profits or a
capital interest) cannot simultaneously be treated as an employee of the partnership. Rev.
Rul. 69-184. As a result, if a profits interest is granted to an employee then:
◦ What was formerly salary will become self-employment income (i.e. guaranteed payments).
Guaranteed payments are reported to the partner on a Schedule K-1 rather than a Form W-2.
◦ The partnership will not withhold and remit taxes on guaranteed payments. Instead, the
partner will be required to compute and remit quarterly estimated tax payments.
◦ The partner will be required to remit quarterly estimated tax payments on the partner’s share
of partnership income.
◦ The partnership will not pay the employer share of social security and Medicare taxes.
Instead the partner will pay self-employment tax
◦ The new partner will not be eligible to continue participation in employee only benefit plans
such as cafeteria plans. There may also be other differences with respect to employee
benefit plan participation.
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“Qualified Business Income” Deduction
• Tax reform legislation introduced a new deduction for “qualified business income.”
◦ The deduction is taken at the partner or S-corporation shareholder level.
• Qualified business income is generally income attributable to a “qualified trade or
business,” except:
◦ (i) investment income; and
◦ (ii) compensation income.
• The deductible amount is the partner or S-corporation shareholder’s pro rata share
of 20% of “qualified business income” or:
◦ Greater of:
― 50% of W-2 wages paid by the entity; or
― Sum of:
➢ 25% of W-2 wages plus
➢ 2.5% of tax basis of tangible property.
― Plus: 20% of “Qualified REIT Dividends” and “Qualified Publicly Traded Partnership
Income.”
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“Qualified Business Income” Deduction (cont.)
• Exemption:
◦ Income Threshold: Neither the requirement of “qualified business income”
nor the W-2 wage/property cap apply to a partner/shareholder with
adjusted gross income below a “threshold amount” ($415,000 for married
filing jointly subject to phase-out between $315,000 and $415,000 of
adjusted gross income).
• Structuring Options to Maximize the W-2 Wage Limitation:
◦ As previously noted, guaranteed payments to a partner are reported to the
partner on a Schedule K-1 rather than a Form W-2.
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Alternative Structures for Profits Interests
• Various structures have been developed with a view to allowing profits
interest holders to enjoy the benefits of equity ownership while
continuing to be treated as an employee for certain compensation and
benefits purposes.
• Tiered partnerships
◦ Service providers receive profits interests in a separate partnership that
owns underlying interests in the employer partnership. This is done so that
the profits interest holders are not direct owners of the operating
partnership.
• The IRS has announced that it is considering whether in at least
certain circumstances dual status as a partner and an employee should
be permitted.
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Tiered Partnership Structure #1: Management Aggregator
Operating
Partnership
InvestorsManagement
Aggregator, LLC
Profits Interests
Employee profits interest holders
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Tiered Partnership Structure #2: Upper Tier Partnership Holdco
Holdco
Partnership
Investors and Employee Profits Interest Holders
Interco (C-corporation)
100%
Operating
Partnership
0.5%99.5%
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IRC §1061
• With respect to an “Applicable Partnership Interest”:
“[A] taxpayer's net long-term capital gain with respect to such interests for such taxable
year, over the taxpayer's net long-term capital gain with respect to such interests for such
taxable year computed by applying paragraphs (3) and (4) of sections 1222 by substituting
“3 years” for “1 year”, shall be treated as short-term capital gain, notwithstanding
section 83 or any election in effect under section 83(b).”
◦ “Applicable Partnership Interests”: Any interest in a partnership transferred to a taxpayer in connection with
the performance of substantial services in an “applicable trade or business.”
◦ “Applicable Trade or Business”: An activity that consists of raising or returning capital and either investing in
(or disposing of) specified assets (or identifying specified assets for investment or disposition).
◦ “Specified Assets”: Securities, commodities, real estate held for rental or investment, cash, options or
derivatives.
• Exclusions: Does not apply to:
◦ (i) Interests held by a corporation;
◦ (ii) “Capital interest in the partnership which provides the taxpayer with a right to share in partnership capital
commensurate with—the amount of capital contributed (determined at the time of receipt of such partnership
interest), or the value of such interest subject to tax under section 83 upon the receipt or vesting of such
interest.”
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• LLC Operating Company
◦ Profits interests in an operating company engaged in a business other than asset
management are likely not “applicable partnership interests” as they are not awarded
for services in an “applicable trade or business.”
• LLC Parent of Lower Tier Partnership or C-Corporation
◦ Where an LLC holding company holds stock in an operating C-corporation or a lower
tier LLC that is a separate partnership engaged in a business other than asset
management, the holding LLC might itself be engaged in an “applicable trade or
business” as it exists solely to invest in securities of the lower tier entity.
◦ However, the statute exempts from the special rule “an interest held by a person who
is employed by another entity that is conducting a trade or business (other than an
applicable trade or business) and provides services only to such other entity.”
◦ Although unclear, this exemption would appear to protect profits interests held with
respect to the appreciation in value of a lower-tier entity.
Application to Employee Profits Interest Plans
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Fee Waiver Proposed Regulations
• While primarily aimed at certain “management fee conversion” techniques common
to private equity fund managers (which go beyond the scope of this presentation),
certain proposed IRS regulations under Section 707(a)(2)(A) treating a purported
partnership interest as “disguised compensation” could limit some of the flexibility
associated with partnership equity compensation.
• Applies if:
◦ A partner performs services for a partnership,
◦ There is a related direct or indirect allocation and distribution to such partner, and
◦ The performance of services and the allocation and distribution, when viewed together, are
more properly characterized as a transaction occurring between the partnership and a
partner acting other than in his capacity as a partner.
◦ Key factor in distinguishing between fees and allocations is “entrepreneurial risk.”
• Consequence: The allocation/distribution may be recast as a fee for services.
• Regulations are currently in proposed form, and are effective only when finalized.
Finalization is not on current priority guidance plan.
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Thank You
Michael P. Spiro, Partner
Finn Dixon & Herling
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Craig P. Tanner, Counsel
Reed Smith