tax implications of choice of entity for startups: an advanced examination for tax...

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Tax Implications of Choice of Entity for Startups:

An Advanced Examination for Tax Counsel Preserving Options for Future Issuance of Stock,

Venture Capital Funding, Spin Offs, Liquidation and Exit Strategies

Today’s faculty features:

1pm Eastern | 12pm Central | 11am Mountain | 10am Pacific

THURSDAY, AUGUST 27, 2015

Presenting a live 90-minute webinar with interactive Q&A

Leo Parmegiani, Tax Partner, O'Connor Davies, New York

George Beda, Senior Tax Manager, O'Connor Davies, New York

Steven Buchwald, Partner, Buchwald & Associates, New York

Thomas Riggs, Partner, O'Connor Davies, New York

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FOR LIVE EVENT ONLY

TAX IMPLICATIONS OF CHOICE OF

ENTITY FOR STARTUPS

BUSINESS ENTITIES Making the Right Choice

(Liability Protection; Tax Impact; Flexibility)

George Beda

Senior Tax Manager

Harrison, NY

[email protected]

mailto:[email protected]

Sole Proprietorship ADVANTAGES

• Business Tax Advantages Flow to Owner – Section 179 Deduction

– Credits, E.G. Empowerment Zone Employment Credit

– Losses

– No Entity Level Tax

• Ease of Formation – Organization costs are relatively low (Possible DBA)

– Publication not required

– Option to form entity at a later date

• Professional Costs (Legal & Accounting) are lower

• Administration is Less Complicated – Reported on Schedule C vs. full federal tax filing

• Simplified Decision Making

6

Sole Proprietorship (cont’d) DISADVANTAGES

• Unlimited Personal Liability – Single Member LLC may be formed for additional protection. Tradeoff would be additional formation

cost and ongoing State filing requirements & fees

• Self-Employment Tax – 50% deductible leaving 50% non deductible.

(S Corps can alleviate a portion of this tax)

– Additional Medicare Tax (.9%)

• Inability to Split Income with Family Members – Payroll can be used for this purpose

• Lack of Continuity; No Transferability

• Difficulty in Raising Capital

7

Partnership - GP, LP & LLP ADVANTAGES

• No Entity Level Tax (Taxes & Fees may apply on State & Local levels, e.g., CA & NYC) — Income, Deductions & Credits Flow through to Partners

• Special allocations are permitted - Income, Deductions, Credits and Distributions (Unlike S Corp)

• Limited Liability for limited partners (LP) & partners in LLP

• Family Limited Partnerships – Income splitting if structured properly

– Powerful tool for estate & gift tax savings and ease of administration (New IRS Regulations are expected)

• Choice for Real Estate Operations (LLC’s) — Ability to take losses without being Out-of-Pocket

— Ability to take Distributions without paying Tax

8

Partnership -GP, LP & LLP (cont’d) DISADVANTAGES

• General Partner’s liability isn’t limited

– Prior to LLC laws, it was common practice to have a Corp as GP

• Earnings are taxed even if not distributed

• Inability to exclude certain fringe benefits

– Sec. 125 exclusions not available

• Self employment Tax; Additional Medicare Tax (.9%)

• More Complicated Decision Making

9

Limited Liability Company ADVANTAGES

• Limited Liability to all Members

• LLC’s with more than one member can be recognized as partnerships or corporations – Generally set up as a partnership to combine benefits of partnership flexibility and S Corp protection

– Can elect to be taxed as a Corporation (C or S Corp)

• Similar Benefits to Partnerships – Flow through of income, deductions & credits

– Special allocations available

– Flow through of entity debt to establish Basis

– Estate planning discounts; trusts as members

– Distribution of appreciated property (excluding marketable securities)

• No limit to number of members vs. S Corp (limited to 100 S/H)

• Utilizing Series LLC’s to combine operations with one reporting requirement (state & local tax issues, e.g., CA)

10

Limited Liability Company (cont’d) DISADVANTAGES

• Since LLC’s are relatively new, there may be issues of liability protection from state to

state

• Additional state filings and fees, e.g., CA & NY

• Cost of Forming LLC (Legal, Publication Cost, etc.)

• Taxation of Undistributed Earnings

• Self Employment Tax; Additional Medicare Tax (.9%)

• Difficulty in Raising Capital

11

C Corporation ADVANTAGES

• Unlimited life & ease of transferring ownership • More availability of Fringe Benefits

• Use of Fiscal Year

– Personal service Corps should use calendar year (To avoid restrictions)

• Limited Liability

• Easier to Raise Capital

12

C Corporation (cont’d) DISADVANTAGES

• Subject to double taxation (corporate & individual levels) – A significant portion of this problem can be addressed by paying salaries (subject to “unreasonable”

compensation rules)

• Formation Costs

• Distribution of appreciated property, ex. Real Estate triggers gain based on FMV of property

• Potential for Accumulated Earnings Tax & Personal Holding Company tax

13

S Corporation ADVANTAGES

• No entity level tax (Excluding certain states & cities, e.g., CA & NYC) — Income, Deductions & Credits Flow through to shareholders

• Limited Liability

• Distributions are generally tax free – Distribution in excess of basis would trigger Capital Gains (similar to partnership treatment)

• Reduction in self employment taxes by not taking all profits in the form of salary

• Unlimited Life & ease of transferring ownership

14

S Corporation (cont’d) DISADVANTAGES

• Similar disadvantages to partnerships – Taxability of undistributed earnings

– Limitation on fringe benefits

• Distribution must be made in proportion to shareholder ownership %

• Formation Costs

• No flexibility in allocating income, deductions & credits – Based solely on stock ownership

• Stock Ownership Restrictions – Limited to 100 shareholders – Restricted to one class of stock

15

Summary • The correct choice of entity depends on the relative importance of Liability Protection, Tax

Impact and Flexibility. To paraphrase Spencer Johnson in his best selling book “Yes or No”: — Meet the real need

— Be informed of all options

— Think each option thru

• Once a choice has been made, there is an option to change the entity classification by filing Form 8832

• Regardless of the entity structure, ALL businesses need to register with the Department of State & State Tax Department

• All businesses will need a tax ID – can be issued online by the IRS

• In a multi-owned business, it is advisable to have a Buy-Sell Agreement in writing when starting the business

• Business owners should have an ongoing relationship with a trusted team of advisors which should include (but not limited to) legal, accounting, insurance & financial planning

16

George A. Beda CPA

17

International Issues – Inbound &

Outbound Structuring

Leo Parmegiani

Tax Partner

New York, NY

[email protected]


Inbound Structuring Considerations • Treaty Advantages – Is a Treaty Applicable

• Permanent Establishment (yes or no)

• P.E (Branch) vs. Separate Corporation

• Domestic vs. Foreign Corporation

• Investor Structuring Preferences

• Dividend Repatriation/Branch Profits Tax

• Estate and Gift Tax Implications

• Tax Law Restrictions on Ownership

• Withholding Tax Issues: FDAP/ FATCA

19

Outbound Considerations

• Flow through v. Opaque Treatment

• Foreign Tax Credits

• Subpart F Income/PFIC

• Check the Box Rules -Default Classification

• Potential Inversions

• Foreign Country Classification and related advantages and pitfalls

• US limitations: IRC 901(m), 909

20

Leo Parmegiani CPA

21

Equity Compensation

STARTUP EQUITY COMPENSATION ISSUES

Steven Buchwald Buchwald & Associates

Equity Compensation

1. Restricted Stocks

2. Incentive Stock Option (ISO)

3. Non Qualified Stock Option

23

Restricted Stock

• I.R.C. 83

• Available to any service provider

• Could be issued at less than FMV or at no cost

• Disadvantage: Pay purchase price upfront (but

could be minimal)

• No 83(b) election: Compensation income accrues

on monthly basis equals to FMV of shares at

vesting date less purchase price

Increasing income tax on illiquid stocks

24

Restricted Stock

• 83(b) election: Prepay taxes upfront at time of grant on

FMV at grant time less purchase price

• Early Termination: Unvested stocks are repurchased by

the company + no loss deduction for ordinary income tax

paid

• Advantageous holding period with 83(b): Start at time of

grant increases likelihood of capital gain treatment

25

For the Company:

• Without 83(b) election: no tax deduction upon

grant; income tax deduction at time of vesting

• Withholding and reporting requirements upon

vesting (if employee, no obligations for consultants)

• With 83(b) election: tax deduction at time of grant

26

Restricted Stock

Restricted Stock

The 83(b) Election

• Within 30 days of transfer AND

• Attach of copy of the 83(b) election with tax return for

the year of the grant

• If paid full value: inform that no income will be reported

• Best practice: sent by certified mail

• Spousal Signature in Community Property State (CA)

27

• I.R.C Section 83: transfer of property for services deemed “wages” (ordinary

income)

• Advantageous to the employee: Turning ordinary income into capital gain

but AMT taxation

• I.R.C Section 422 Restrictions (9 factors):

(1) Only for employees (not directors, consultants or other service providers)

(2) Approved by shareholders

(3) Maximum Term of 10 years

(4) Maximum Option Amount of $100K per year

(5) Nontransferable except by will

(6) Does not say it’s not an ISO

(7) Written Plan

(8) at least at FMV at time of grant

(9) Vested option exercisable within 3 months of termination

28

Incentive Stock Option (ISO)

• Additional Holding period to be taxed at long term capital gain rate:

(1) Hold for 2 years from date of grant AND

(2) Hold for 1 year from date of exercise

• Not considered wages but AMT can be substantial + state tax is not

deductible

• AMT amount paid can often be credited against future capital gain tax

liability

• Generally: Probationary Period for new employees: vesting schedule

usually 25% vest after the first year of employment then vest monthly

29



• For the Employee: AMT tax at time of tax return (no withholding) for

FMV on exercise date less exercise price (preference income)

• For the Company:

At time of grant: Must record a compensation expense. FASB 123 (R).

At time of exercise: Company does NOT receive a tax deduction + no

withholding or reporting responsibility on subsequent transfer

• Often ISO options do not achieve ISO treatment

(demanding holding period)

30

Non Qualified Stock Options

• Stock Options that does not meet the ISO requirements (AKA Non-

Statutory Options)

• Broad Class of Service Providers: Employees, directors, and

consultants

• Option Price should be no less than FMV on grant date

(otherwise deferred comp. rules, Sec. 409A, applies = taxation on

vesting + penalty taxes)

• Generally: untransferable (except by will)

• Generally: all grant made within 10 years of plan’s effective date

• Flexible: No annual limit on options that can be granted +

Shareholder approval is not required (usually Board authorization)

31

Non Qualified Stock Options

• For the Individual: At time of exercise: The taxable compensation

income is FMV on date of exercise less exercise price

No tax impact upon grant or vesting as long as granted at least FMV at

grant time

If private company at time of exercise: Must pay tax wage withholding

+ employment tax + state tax immediately out of the individual’s own

resources

• For the Company:

At time of grant: Must record a compensation expense. FASB 123 (R).

At time of exercise: Company receives a tax deduction

32

Steven Buchwald is startup lawyer and founding partner of Buchwald & Associates in New York, focusing on representing tech startups. Steven frequently counsels emerging growth companies on business formation, equity distribution, startup financing and intellectual property law matter.

Steven Buchwald, Partner Buchwald & Associates 40 Wall Street, 28th Floor New York, New York 10005 T: (212)-729-8505 [email protected]

33


Structuring the LLC Start-Up Enterprise

-Selected Tax Topics-

Thomas J. Riggs JD, CPA, MAS

Partner, Director Financial Services

Tax

[email protected]


Table of Contents

I. Advantages of an LLC structure vs a Corporation.

II. The Carried Interest.

III. Preferred Start Up Allocation Framework:

Targeted Capital accounts.

IV. Section 409A.

V. Early buyouts and Redemptions: Section 736.

VI. Bio

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Slide Number

33

35

50

65

71

86

I. Advantages of an LLC structure vs a Corporation

Why structure your start-up as a Partnership or LLC?

1) Formation: - Flexibility under state law – The Operating Agreement. - Accommodating Non-Cash Contributors – The Carried Interest. 2) Early stage: - Losses flow through for immediate utilization. (Sec. 701) 3) Mid stage: - Single layer of tax on profits. (Sec. 701) - Special allocations of income/loss permitted. (Sec. 704) - Ease of capital infusions & asset distributions. (Secs. 721 & 731) - Benign deferred compensation rules (inapplicability of Sec. 409A) 4) Exit stage: - Flexibility of payouts under Subchapter K – Section 736

36

I. Advantages of an LLC structure vs a Corporation

Some common concerns:

“We want to ultimately take the company public.”

- Ease and non-taxability of conversion from LLC to corporation

(after early stage utilization).

“Won’t a Subchapter S Corporation provide the same benefits?”

- An S-Corporation is treated as a C-Corporation under all areas of the

tax code, except for flow through of income/losses.

- Less flexibility in allocating income and/or crafting compensation.

- Asset infusions/distributions are generally taxable.

- Conversion to C-Corporation generally taxable.

37

II. The Carried Interest

First a political note: Will the ‘carried interest’ survive?

a) It has become somewhat of a political football over the

last decade.

b) Perennially listed in the annual “Green Book” as a priority

of Democratic administrations to eliminate or curtail its

use.

c) A lot will depend on the political landscape coming out of

2016, where the Republicans are seen as vulnerable.

38


Concept of the Carried Interest comes into play

most often in one of two contexts:

1) At formation, when a non-capital contributing partner

or LLC Member is granted an ownership interest, or

2) During the life of the enterprise whenever equity is

granted as compensation.

39


To properly structure and implement a carried interest award, we

must first understand Code Section 83; Property in exchange for

services:

When property is transferred to any person in exchange for services,

the FMV of the property, less any amount paid in exchange,

constitutes taxable income in the year in which such property

essentially ‘vests’, meaning when the property:

a) becomes ‘transferable’, or

b) is no longer subject to a ‘substantial risk of forfeiture’.

40


Definitions:

‘Property’ is essentially all non-cash compensation, meaning all

real or personal property other than money, it includes:

a) Intangible assets, securities and

b) Later proposed Regulations explicitly included

partnership interests.

41


‘Substantial risk of forfeiture’ exists where a recipient’s right

to full enjoyment of the property is conditioned by some

future occurrence, including future performance of substantial

services.

Property is ‘Transferable’ when the holder can transfer, sell or

otherwise monetize the property to a person other than the

holder.

42


And where compensation income would not

otherwise be includable in income currently;

Section 83 provides for an election (the Section 83(b) election),

which accelerates income recognition to the date of the grant.

The Section 83(b) election must be made

within 30 days of the transfer.

43


Effect of the election:

1) Cuts off the ‘compensation component’ (ordinary income

component) of the grant. 2) All further accretion in value characterized as investment income (capital gain). 3) If at the date of grant the ordinary income recognition (future earnings stream) is speculative, it should allow for valuation at or near zero.

44


Tax aspects of Section 83 income recognition:

a) The employer is allowed a §162 compensation deduction

in the tax year and in the amount of income recognized by

the service provider.

b) The income constitutes wages to a corporate employee,

guaranteed payment to a partner.

c) The compensation is fully subject to SE tax.

45


For years the IRS litigated the point that the grant of any interest in a partnership in exchange for services was ‘property’ and had

substantial taxable value, no matter how speculative or contingent.

But the courts consistently resisted the IRS position, since

a) The grant is a right to future earnings and is therefore

speculative (no profits, no payment).

b) Recipient subject to entrepreneurial risk of the enterprise.

c) Grant not subject to accurate valuation (Black Scholes

perhaps?).

d) Tax issues of dealing with subsequent income recognition.

46


There is validity to the IRS position, as one would certainly pay

something for the right to future profits in a business entity

(similar to the purchase of an out of the money option).

But after 20 years of losing litigation, in 1993 the IRS capitulated

and agreed to no longer attempt to tax the award of a pure interest

in profits.

47


The IRS conceded defeat in 1993 by issuing Rev. Proc. 93-27

drawing a distinction between a:

‘Capital interest’, which would be taxable

at the date of grant, and a

‘Profits interest’ which would not.

48


‘Capital interest’ is defined as an interest that would entitle the

holder to a payout if immediately after the grant the entity were to

sell all assets at FMV and distribute the proceeds in complete

liquidation in accordance with the underlying agreement.

This is generally referred to as the ‘constructive liquidation’ test.

49


A ‘Profits interest’ was defined as any interest which does not

constitute a ‘capital interest’, except where:

a) The interest is sold or otherwise monetized within two years of

the date of grant, or

b) The interest represents a predictable and secure income stream

(similar to the return on a bond), or

c) The entity constitutes a Publicly Trade Partnership (PTP), in

which case it is essentially a corporation.

50


So as practitioners, we structure grants in such a way that they do NOT constitute ‘capital interests’.

This is a fairly straightforward exercise where the interest is fully vested at date of grant, as long as the operating agreement:

a) Requires capital account revaluation upon the issuance or

retirement of ownership interests, and

b) Upon liquidation all positive capital account balances are

zeroed out prior to distribution according to the ownership

percentages.

51


A note on interests granted for past services rendered

versus future services still to be performed:

Rev. Proc. 93-27 makes no distinction between the two.

So it appears that a profits interest can be granted in exchange even

for past services already performed, as long as the otherwise applicable

principles of Section 409A and ‘constructive receipt’ are complied with.

52

III. Preferred Allocation Framework:

Targeted Capital accounts

History:

Income driven deals

Cash driven deals

Targeted Capital Accounts

53



Advantages of a

Targeted capital account allocation framework:

1) Automatically accommodates non-capital

contributors at inception (creates carried interests).

2) Directs loss allocations to those who bear the economic

risk of the loss, typically the capital contributors.

3) Allows for ease of awarding deferred compensation

when coupled with a ‘Revaluation’ provisions.

54



First A Note on Drafting:

The use of Targeted Capital Accounts is only effective as if the underlying Operating Agreement is drafted properly,

and among other things should reflect the following 1) At liquidation (and after debt repayment), cash must first be distributed to zero out all positive capital account balances prior to any prorata distributions, and 2) Capital accounts must be REVALUED immediately prior to capital infusions or grants of compensatory equity.

55



The ‘roadmap’ of Targeted Capital Accounts

These are ‘cash driven deals’, where:

1) At the end of each tax period, the entity undergoes a “hypothetical liquidation”, with all assets deemed sold for cash, then

2) The liquidation section of the agreement determines how the cash would be distributed,

3) Income allocation follows the those hypothetical cash distribution(s).

56



First, A Note on Drafting:

The use of Targeted Capital Accounts is only effective

if the underlying Operating Agreement is drafted properly,

and among other things should reflect the following:

1) At liquidation (and after debt repayment), cash must

first be distributed to zero out all positive capital account

balances, and

2) Capital accounts must be REVALUED immediately

prior to capital infusions or grants of compensatory

equity.

57



Example of the Mechanics:

1) A tech start up is formed in an LLC, with two members.

2) Member A contributes software with a fair market value of

$1,000,000, and takes back a 90% interest in the entity.

3) Member B agrees to operate the business, but provides no

capital, taking back a 10% interest in the entity as sweat equity.

4) So the initial capital accounts are: Member A: $1,000,000

Member B: Zero

58



Now Assume:

1) During its the initial year the business loses $100,000.

So what happens under a traditional allocation waterfall?

Recall: These operating agreements typically call for

allocation(s) of income/loss, as well as liquidation rights,

to be allocated according to the ownership percentages.

59



So in our example, Two potentially adverse consequences result:

First: Since 90% of the loss will be allocated to member A, and 10% to Member B: - Member B has no tax basis in the entity against which to take the loss, it must be carried forward. - Member B bears the economic risk of 100% of the loss, but only receives 90% of the tax loss.

60



Second:

If the entity were liquidated immediately after formation, Member B would be entitled to 10% of the liquidation value of the enterprise, meaning 10% of

Member A’s capital account, so:

Under current law, Member A’s ‘sweat equity’ interest would constitute a “capital interest”.

Means that that member A may be deemed to have received $100,000 of taxable phantom income upon formation.

61



Alternatively, what would happen under a

Targeted Capital Account framework?

Recall: Under this approach income follows where

available cash would go if the entity were liquidated, and

the liquidation section calls for zeroing out positive

capital balances prior to further distributions.

62



The loss allocation analysis would proceed as follows:

1) If the entity were liquidated at the end of the initial tax year, there would be $900,000 to distribute ($1,000,000 contributed by Member A, less the $100,000 lost). 2) The $900,000 of cash would be absorbed Member A’s positive capital account, leaving a $100,000 loss. 3) Since Member A bears 100% of the risk of loss, 100% of the loss is allocated back to Member A.

63



And there is no phantom income

issue at formation:

Recall: the operating agreement calls for available cash at liquidation to go first to zero out

the positive capital balances:

So if the entity were liquidated immediately after formation, Member A’s positive capital account balance would absorb the full $1,000,000 in the entity with nothing going to Member B.

64



If instead of a $100,000 loss in the initial year,

lets instead assume a $100,000 profit:

The income allocation should be identical in the first year under either approach.

Traditional approach: $100,000 profit split according to the

percentages: 90% to Member A and 10% to member B.

But the phantom income issue would remains upon formation.

65



Under a Targeted Capital Account approach, the income

allocation of the profit would proceed as follows:

1) If the entity were liquidated at the end of the initial tax year, there would

be $1,100,000 to distribute: ($1,000,000 contributed by Member A, plus

the $100,000 profit).

2) Under the liquidation section, the first $1,000,000 would go to zero out

Member A’s positive capital account, leaving $100,000 left to distribute.

3) The excess $100,000 would go according to the ownership percentages,

or 90% to Member A and 10% to member B.

4) The income allocation would then follow the excess cash: 90%/10%.

66



Note: Utilization of Loss allocations:

Under either approach, the deductibility of loss allocations is

subject to certain statutory limitations:

Section 465: losses deductible only to the extent of tax basis.

Section 469: Passive losses deductible only against passive

income.

67

IV. Section 409A

Enacted as part of the 2004 American Jobs Creation

Act.

The statute codified common sense and what the courts

had already repeatedly upheld utilizing principles of

constructive receipt and cash equivalency.

Applies primarily to deferred cash or stock grants.

68

IV. Section 409A

Generally, the right to receive deferred

compensation will be taxable immediately where:

a) The recipient has a right to receive something of

value (e.g. the bargain element of stock options), and

b) The right is immediate and is not subject to

forfeiture, and

c) The value is readily ascertainable; i.e. reasonably

subject to current valuation.

69

IV. Section 409A

Specific statutory exemptions exist where the compensation

deferred is/was:

a) Subject to a ‘substantial risk of forfeiture’, or

b) Previously included in income, or

c) Constitutes a mere ‘short term deferral’, defined as

being payable within two and one half months after

date of grant.

70

IV. Section 409A

Section 409A was evidently directed primarily at deferred

cash and/or stock awards.

As it specifically reserved guidance with respect to

transactions between partnerships/LLCs and

partners/members providing services.

Practitioners were left guessing with respect to the

statute’s applicability to carried interest awards.

71

IV. Section 409A

IRS Notice 2005-1 Provided interim guidance, (which has

never been finalized), regarding the application of Section

409A to arrangements between partnerships/LLC and

partners/members.

It was extremely benign, providing that the grant of a ‘profits

interest’ did not constitute deferred compensation as otherwise

defined in Section 409A as long as it:

“is properly treated under other applicable provisions as not

resulting in inclusion of income by the service provider at the

time of issuance”.

72

IV. Section 409A

This language has been accepted to mean that where a

partnership/LLC interest constitutes a ‘profits interest’ under

Rev. Procs. 93-27 & 2001-43, Section 409A should not apply.

73

Section 736 is only three sentences long but stands as a

veritable monument to convoluted statutory drafting. It

contains:

a) A general rule, then

b) exclusions to the general rule, then

c) limitations on the exclusions to the general rule, and

d) finally exceptions from the limitations on the

exclusions to the general rule!

74

V. Early Buyouts and Redemptions:

Section 736

Section 736 governs:

a) The complete termination of a partner or LLC

member interest, or

b) The death of a partner or LLC member.

c) The Section does not apply to partial

redemptions/terminations.

d) Partial redemptions/terminations are treated under

the normal distribution/basis rules of Subchapter K.

75


Section 736

Note: the interest must be completely

terminated pursuant to state law.

a) A partner may be terminated for state law purposes,

but remain a partner/member for tax purposes.

b) Where a partner/member is terminated under state

law but continues to receive a payout under a

termination agreement:

i. Recipient remains a partner for tax purposes until all payments

cease.

ii. Must continue to receive a K-1.

76


Section 736

The Section applies to both lump sum and installment

payouts.

Note: Installment redemption payouts are generally

exempt from the Original Issue Discount (OID) and the

imputed interest rules.

77


Section 736

Section 736 is a ‘categorization’ section.

a) All complete termination/redemption payments are

‘sorted’ into two types, (with the first containing two

sub-types), and

b) once sorted leaves the tax results to other code

sections as applicable.

78


Section 736

The two categories of payments are:

a) Section 736(a) payments, (two types, both ‘earn outs’)

i. Guaranteed payment(s) ii. Allocable share of income

b) Section 736(b) payments, (payment for share of assets)

As a general rule, all payments which do not constitute Section 736(b) payments default to Section 736(a) status.

79


Section 736

The ‘Roadmap’:

A typical Section 736 analysis upon the exit of a partner/member would

proceed as follows:

First, determine whether or not ‘capital is a material income

producing factor’ in the partnership/LLC operations.

Capital generally IS considered a material income producing factor in non-service enterprises, such as manufacturing, real estate, hospitality, etc.

80


Section 736

Capital is generally NOT an income producing factor in service entities including law, accounting, engineering,

consulting, and tech firms (e.g. Facebook, Twitter).

In other words, enterprises where the assets go up and down the elevator every day.

81


Section 736

If capital IS a material income producing factor

(e.g. a manufacturing entity), then:

All termination/redemption payments will generally

constitute Section 736(b) payments, including all

payouts with respect to ‘goodwill’.

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Section 736

If capital is NOT a material income producing factor

(i.e. service entities), and the recipient acts as general partner or

otherwise participates in the business (and typically they will);

The payments will constitute Section 736(a) payments

(treated as an ‘earn out’).

(If recipient does not participate, then

the payment will default back to a 736(b))

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Section 736

One Exception to Section 736(a) treatment even where

capital is not a material income producing factor:

If the operating agreement of the service entity specifically calls

for recognition of and payment for goodwill, the payout will fall

under Section 736(b) to the extent mutually agreed to by the

parties.

This is a drafting issue that should be

addressed in any start-up situation.

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Section 736

Tax Consequences: 736(a)...Guaranteed Payment

If the amount of the 736(a) payment is not contingent upon the net income of the partnership/LLC, then:

a) Tax effect is determined under the provisions of Section

707. b) Typically ordinary compensation income to the recipient

(subject to SE tax), and deductible against income by the partnership/ LLC.

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Section 736

Tax Consequences: 736(a)... Allocable Share of Income

If the amount of the 736(a) payout is contingent upon the net

income of the partnership/LLC, then the:

a) Tax effect(s) are determined under the provisions of Section 702.

b) Results in a pro rata ‘vertical slice’ of partnership/LLC income being allocated to the recipient, character of the income in hands of recipient same as to the partnership/LLC.

c) SE taxes may or may not apply, depending upon the nature of the partnership/LLC activities and the recipient’s ownership status.

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Section 736

Tax Consequences: 736(b) Distribution

a) The payment(s) are deemed to be in exchange for the

recipients share of partnership property.

b) Tax effect(s) are determined under provisions of Sections

731, 741 and 751.

c) Usually results in capital gain or loss to the recipient, is

not subject to SE tax, and is not deductible by the

partnership/LLC.

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Section 736

d) Where ‘inside’ and ‘outside’ basis is the same, the portion

of the payout representing the capital account balance will

typically represent a return of capital to the recipient and

escape taxation.

e) The capital gain recognition is subject to the ordinary

income re-characterization provisions of Section 751.

f) A step up in the ‘inside basis’ of partnership assets should

be available under section 754 to the extent of ‘outside’

capital gain recognition.

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Section 736

Thomas J. Riggs JD, CPA, MAS

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tax implications of choice of entity for startups: an advanced examination for tax...

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