Structuring Venture Capital, Private Equity, and Entrepreneurial Transactions

Transcription

1 NEW 2015 Editio of Structurig Veture Capital, Private Equity, ad Etrepreeurial Trasactios W e are proud to eclose the 2015 editio of Structurig Veture Capital, Private Equity, ad Etrepreeurial Trasactios by co-authors Jack S. Levi ad Doald E. Rocap, seior parters i the iteratioal law firm of Kirklad & Ellis LLP, i cojuctio with special editors Russell S. Light of Kirklad & Ellis LLP ad the late Marti D. Gisburg of Georgetow Uiversity Law Ceter. Here is a summary, writte by the authors, of major developmets reflected i the ew editio. Highlights of the New Editio l Federal icome tax rates for 2015 ad thereafter C corp icome tax rates. The top federal C corp icome tax rate for 2015 ad thereafter (o both OI ad LTCG) cotiues at 35% (subject to a approximately 3 percetage poit reductio o qualified U.S. productio busiess et icome). See discussio at 107(5) ad (6). Idividual icome tax rates. The top federal idividual icome tax rates for 2015 ad thereafter (which also apply to partership, LLC, or S corp-level icome flowig through to a idividual equity ower) are as follows: 5 O OI ad STCG, the top rate cotiues at 39.6% (subject to a approximately 3 percetage poit reductio o qualified U.S. productio busiess et icome). 5 O ormal LTCG, the top rate cotiues at 20%. 5 O QDI (qualified divided icome), the top rate cotiues at 20% (i.e., the same as LTCG). 5 O Code 1202 LTCG (o qualified small busiess stock held more tha 5 years), the top rate is: Copyright 2015 CCH Icorporated. All Rights Reserved. 1 MORE

2 14% for such stock acquired after 12/31/14 (uless Cogress agai retroactively exteds [to stock acquired i 2015 ad perhaps thereafter] the 0% rate described immediately below, as the Obama admiistratio budget recommeds), 0% for such stock acquired betwee 9/28/10 ad 12/31/14, 7% for stock acquired betwee 2/18/09 ad 9/27/10, ad 14% for stock acquired betwee 8/11/93 ad 2/17/09. See discussio at 107(1) through (3) ad (6). Idividual icome-based Medicare taxes i additio to regular icome tax: 5 O compesatio ad self-employmet icome, the rate cotiues at 3.8%, with (a) 2.9% imposed partly o a employer ad partly o a employee ad 100% o a self-employed perso plus (b) a additioal 0.9% o such icome i excess of a threshold amout ($250,000 for a joit-retur idividual) imposed 100% o a employee or self-employed perso. 5 O passive icome from ivestmets ad busiesses as to which idividual is ot active, the rate cotiues at 3.8%, to the extet the idividual s AGI exceeds a threshold amout ($250,000 for a joit-retur idividual). See discussio at 107(4)(a) through (c). Idividual itemized deductio ad persoal exemptio phase-outs also affect idividual federal icome taxes: 5 A itemized deductio phase-out by 3% of AGI i excess of a threshold amout (approximately $300,000 for a joit-retur idividual), with a maximum phase-out equal to 80% of itemized deductios. 5 A persoal exemptios phase-out as AGI icreases (from approximately $300,000 to $425,000 for a joit-retur idividual). See discussio at 107(4)(d) ad (e). l Securities law chages Newco public sale of stock with abbreviated SEC Reg. A registratio. If a offerig of Portfolio Compay securities does ot qualify for 1933 Act exemptio e.g., as a Reg. D private placemet to ivestors or a Rule 701 private placemet to service providers Portfolio Compay ca evertheless sell securities while avoidig a full-blow SEC 1933 Act registratio by utilizig ewly revised SEC Reg. A, i which case Portfolio Compay is exempt from 1933 Act registratio but is required to file a Reg. A offerig statemet with SEC. SEC Reg. A amedmets effective 6/19/15 substatially icrease the amout of securities Newco ca sell publicly uder Reg. A ad chage may of the pre-existig Reg. A rules: 2

3 (1) The maximum amout of equity (ad/or debt) securities Portfolio Compay ca sell i oe or more Reg. A offerigs durig ay 12-moth period is (a) $20 millio if Portfolio Compay elects to utilize Reg. A s Tier 1 rules or (b) $50 millio if Portfolio Compay elects to utilize Reg. A s Tier 2 rules. For a offerig o greater tha $20 millio, Portfolio Compay ca elect either Tier 1 or 2, while a offerig greater tha $20 millio ca be made oly uder Tier 2. (2) As compared to a full-blow 1933 Act registratio statemet, a Reg. A offerig statemet is geerally far shorter ad less complex, does ot require Newco to respod to SEC commets, ad is geerally less expesive ad time cosumig. However, a Tier 2 Reg. A offerig requires a more extesive offerig statemet tha does a Tier 1 offerig. (3) Portfolio Compay ca use Reg. A oly if Portfolio Compay was created uder the laws of, ad has its pricipal place of busiess i, the U.S. or Caada. I additio, Portfolio Compay caot use Reg. A if it is a 1934 Act reportig compay, a blak check compay, a ivestmet compay required to register uder the ICA, or a BDC. Nor ca Portfolio Compay use Reg. A if it is a PE/VC fud exempt from ICA registratio uder ICA 3(c)(1) or 3(c)(7), sice a Reg. A offerig costitutes a public offerig which would destroy such ICA exemptio. (4) While Portfolio Compay ca sell securities i a Tier 1 offerig to ayoe, it ca sell securities i a Tier 2 offerig oly to (a) a accredited ivestor without limitatio as to amout or (b) a o-accredited ivestor i a limited amout (except that such limitatio o amout does ot apply if the securities will be listed o a atioal securities exchage). The limited amout (i) for a o-accredited idividual ivestor is ot more tha 10% of the greater of such idividual s aual icome or et worth (calculated i the same maer as for makig a accredited ivestor determiatio) ad (ii) for a o-accredited etity ivestor is ot more tha 10% of the greater of such etity s aual reveue or et assets. (5) A Reg. A offerig is a public offerig (ot a Reg. D private offerig). Hece, (a) except for the limitatio o the amout of Tier 2 securities that ca be sold to a o-accredited ivestor i a Tier 2 offerig as described i (4) above, there is o limit o the type of distributio, the umber of offerees or purchasers, or the offerees / purchasers sophisticatio, icome, et worth, or other characteristic ad (b) securities purchased i a Reg. A offerig are ot restricted securities, so that they ca geerally be freely resold. (6) SEC s ormal factually based subjective itegratio doctrie applies i determiig whether a offerig exceeds the Reg. A limits, except that: (a) a offer or sale of Portfolio Compay securities prior to the Reg. A offerig is ot itegrated with the Reg. A offerig, ad 3 MORE

4 (b) a offer or sale of Portfolio Compay securities subsequet to the Reg. A offerig is ot itegrated with the Reg. A offerig where such subsequet sale is: l l l l l made more tha 6 moths after completio of the Reg. A offerig, or registered uder the 1933 Act, or pursuat to Rule 701, or solely to persos ot residet i the U.S. i compliace with SEC Reg. S i a offshore trasactio with o directed sellig efforts ito the U.S. market with respect to such securities ad the securities are restricted from resale to a U.S. residet for a specified period (oe year for Portfolio Compay equity securities ad 40 days for Portfolio Compay debt securities), or pursuat to 1933 Act 4(a)(6) crowdfudig rules. (7) After makig a Tier 2 offerig Portfolio Compay is geerally ot required to become a 1934 Act reportig compay, but is required to file periodic SEC Reg. A reports (e.g., disclosig its fiacial results), although ot as may or as extesive as the filigs required for a 1934 Act reportig compay. (8) If Portfolio Compay were sellig securities i a full-blow 1933 Act registered public offerig, Portfolio Compay could geerally ot (because of the SEC gujumpig rules) commuicate with potetial purchasers regardig the offerig util filig its full-blow registratio statemet with SEC. However, where Portfolio Compay is plaig a Reg. A offerig, Portfolio Compay ca test the waters before preparig the Reg. A offerig circular. By filig a simple statemet with SEC, Portfolio Compay ca commuicate with potetial purchasers orally, i writig, or by advertisig (i ewspapers, o radio or TV, or by mail) to determie whether they have ay iterest i purchasig Portfolio Compay securities. If there is ot sufficiet iterest, Portfolio Compay ca drop the idea of a Reg. A offerig without icurrig the expese of preparig ad filig a Reg. A offerig statemet. (9) Reg. A preempts state securities law registratio ad qualificatio requiremets. See discussio at l Purchase or sale of a busiess, icludig leveraged buyout (LBO) Two-step acquisitio of publicly traded Target avoidig Target shareholder vote. Where BuyerCo (possibly fiaced by PE/VC fud) is acquirig publicly traded Target by (1) first purchasig a portio of Target s stock either i a teder offer or i oe or more egotiated purchases ad (2) the squeezig out Target s remaiig 4

5 (miority) shareholders by a merger (betwee Target ad either BuyerCo or its subsidiary), BuyerCo geerally prefers to avoid a vote of Target s shareholders, e.g., because Target, as a 1934 Act reportig compay, would be required to comply with SEC s proxy rules which geerally would result i substatial delay before completig the merger. There are two circumstaces, however, where a vote of Target s shareholders ca be avoided: First, uder a log-stadig exemptio (Delaware Geeral Corporatio Law 253) where BuyerCo (orgaized as a corporatio, partership, or LLC) ows 90% or more of Target (orgaized as a corporatio) whether acquired by BuyerCo i a teder offer for Target s stock or otherwise ad both BuyerCo ad Target are formed i Delaware (or i aother state permittig a similar short-form merger), Target eed ot secure a shareholder vote o the squeeze-out merger ad hece (where Target is a 1934 Act reportig compay) o proxy statemet is ecessary for Target s shareholders. I additio, where the BuyerCo-Target acquisitio is friedly ad Target has adequate authorized but uissued stock, Target might grat BuyerCo a top-up optio before BuyerCo commeces its teder offer for Target s stock, givig BuyerCo the oetime right (ad perhaps the obligatio) to purchase from Target (typically for a ote) that umber of ew Target shares which, whe combied with the Target shares acquired by BuyerCo i the teder offer or the egotiated purchases, will be sufficiet to meet the state law threshold for a short-form merger (e.g., 90% i Delaware). Secod, uder a 2013 additio to Delaware law (as further ameded i 2014) Delaware Geeral Corporatio Law 251(h) a vote of Target s shareholders (ad hece a 1934 Act proxy statemet) o a forward or reverse merger of Target ad BuyerCo (or a BuyerCo subsidiary), ca be avoided where: (a) (b) (c) (d) (e) Target (orgaized as a corporatio) has more tha 2,000 shareholders or is exchage traded immediately prior to executig the merger agreemet, BuyerCo or its subsidiary (orgaized as a corporatio) ( AcquirigCorp ) makes a first-step teder or exchage offer for ay ad all Target stock, after such first step, AcquirigCorp ows sufficiet Target stock to approve the secod-step squeeze-out merger (uder Delaware law ad Target s charter), geerally more tha 50%, all o-tederig Target shareholders receive i the merger the same cosideratio as the tederig Target shareholders received i the teder offer, i.e., cash where the teder offer cosideratio was cash, Target is icorporated i Delaware, ad 5 MORE

6 (f) the merger agreemet expressly permits this procedure ad states that the short-form merger shall be effected as soo as practicable after the teder offer closes. Where BuyerCo is a ewly formed etity (perhaps formed by PE/VC fud to acquire Target i a LBO), BuyerCo may offer Target s executives a opportuity to exchage their (low tax basis) Target shares for BuyerCo shares tax free (with carryover low tax basis), as part of BuyerCo s Code 351 formatio ad its buyout of Target, without recogizig the CG iheret i their Target shares. However, if BuyerCo is usig Delaware 251(h) (discussed i Secod above) rather tha Delaware 253 ad similar provisios i other states (discussed i First above) to squeeze out Target s o-tederig shareholders, BuyerCo will ot be able to offer Target s key executives this tax-free rollover opportuity because: (i) (ii) the federal teder offer rules (x) require BuyerCo to offer each Target shareholder the highest cosideratio [BuyerCo] pay[s] to ay other security holder for [Target] securities tedered i the teder offer ad (y) prohibit BuyerCo from purchasig (or agreeig to purchase) Target shares outside the teder offer oce the teder offer has commeced ad prior to its expiratio ad after the teder offer s expiratio Delaware 251(h) requires all o-tederig Target shareholders (here Target s key executives) to receive the same merger cosideratio as the tederig Target shareholders received i the merger here cash where the teder offer cosideratio was cash. The solutio would be to avoid a Target shareholder vote o the secod-step merger by ivokig the log-stadig Delaware 90% exemptio (or comparable exemptio i may other states) discussed i First above, supplemeted by a top-up optio (should the teder offer aloe ot achieve Delaware 253 s 90% threshold) ad forsakig use of Delaware 251(h). See discussio at Target board s fiduciary duty. Uder state corporate law, busiess judgmets reached by Target corporatio s directors are geerally accorded deferece if the board acted o a iformed basis, i good faith, ad i the hoest belief that the actio was take i the best iterests of the corporatio ad its shareholders. I order for the board to claim the beefit of this judicial busiess judgmet rule, the board must be able to demostrate that it acted with due care after thorough study ad coscietious deliberatio. 1 However, whe Target corp s board is cosiderig a trasactio i which Target s shareholders give up cotrol i.e., (1) a cash sale of Target (geerally the case where a 1 While Delaware law is clear o the board s fiduciary duty ad some other states laws are less clear, all states are likely to agree o the priciples euciated i text. 6

7 PE/VC fud sposors BuyerCo s LBO acquisitio of Target) or (2) a combiatio of Target ad BuyerCo, with Target s shareholders receivig BuyerCo stock but with the combied BuyerCo-Target eterprise cotrolled by oe or a group of BuyerCo shareholders actig i cocert Target s directors have a ehaced duty to protect the iterests of Target s shareholders ad obtai the highest price for their shares reasoably attaiable (the so-called Revlo duty), ad courts typically subject the directors coduct to ehaced scrutiy to esure that they have acted reasoably to achieve these goals. As protectio agaist a Target shareholder s breach of fiduciary duty claim (seekig a ijuctio agaist the acquisitio or damages after the acquisitio s cosummatio 2 ), Target s board, especially where Target is a public corporatio, may utilize some or all of the followig measures: (1) appoit a idepedet board committee whose members have o iterest (e.g., stock owership or aticipated favorable employmet) i BuyerCo, which committee i tur selects idepedet legal cousel ad a idepedet ivestmet baker to represet ad advise the committee, (2) empower the idepedet committee to egage i a auctio process, solicitig other bidders for Target, or at least performig a more limited market check, (3) authorize the idepedet committee to obtai a ivestmet baker fairess opiio, ad/or (4) permit or require the idepedet committee to seek a majority vote of Target s disiterested directors ad/or a majority vote of Target s disiterested shareholders. I a trasactio ivolvig related parties (e.g., directors or cotrollig shareholders sittig o both sides of the trasactio), a etire fairess stadard applies, uder which Target s board must demostrate that it (1) achieved a fair price for Target s shareholders ad (2) egaged i a fair process. Thus, whe some board members have a iterest i the trasactio differet from the iterest of Target s shareholders geerally e.g., i a LBO where BuyerCo or its PE/VC fud sposor offers Target s maagemet the opportuity to cotiue as post-acquisitio BuyerCo/Target executives, perhaps with icreased compesatio, ad/or to ivest i BuyerCo by buyig, or receivig optios to buy, BuyerCo commo stock there is a coflict betwee such Target directors /maagemet s (1) duty to obtai the highest price for Target s public shareholders ad (2) atural desire for 2 A corporatio icorporated i Delaware or some other states ca elimiate director moetary liability for certai types of fiduciary duty breaches through a charter provisio. 7 MORE

8 BuyerCo (which will be partly owed by, ad/or pay ehaced compesatio to, such Target directors/maagemet) to purchase Target at the lowest possible price. I such case, it is advisable to form a committee of Target idepedet directors (composed of Target directors with o iterest i BuyerCo) to foster a arm s legth egotiatio betwee BuyerCo ad Target. Target s idepedet committee must be fully iformed ad must have freedom to egotiate with BuyerCo at arm s legth. Target s idepedet committee typically selects its ow idepedet ivestmet baker ad idepedet legal cousel ad geerally has authority to seek other buyers for Target. Such a idepedet committee acts as both a procedural ad a substative measure to esure a fair process. I additio, if Target subjects the trasactio to a o-waivable coditio that a majority of disiterested shareholders approve the acquisitio, this provides further evidece that the trasactio was etirely fair to Target s public shareholders. I fact, if a trasactio ivolvig related parties has the beefit of both a empowered, disiterested Target board committee ad a o-waivable majority of the miority shareholder approval coditio, the i Delaware the etire fairess stadard does ot apply ad Target s board ca regai the beefit of the busiess judgmet rule. A ivestmet baker fairess opiio ad/or some form of (pre- or post-agreemet) auctio or market check helps to demostrate that Target s board (or idepedet committee) acted i a iformed ad reasoable maer. However, courts look carefully at ivestmet baker fairess opiios, particularly whe competig bids are beig cosidered. See discussio at LBO fraudulet coveyace risk. Where BuyerCo acquires Target i a LBO, the trasactio is frequetly structured so that Target s pre-acquisitio creditors are prejudiced geerally because the proceeds from the acquisitio debt are paid out to Target s old shareholders while the acquisitio leders acquire a claim agaist Target s old assets which (if such claim is secured by Target s assets) is superior to Target s old usecured creditors or (if ot so secured) is pari passu with Target s old usecured creditors. If the BuyerCo-Target LBO is so structured ad the BuyerCo-Target eterprise goes bakrupt reasoably soo after the LBO, Target s old creditors (ad i some circumstaces Target s ew trade ad geeral creditors) may have a fraudulet coveyace claim agaist (a) the acquisitio leders, (b) Target s old shareholders who received the LBO proceeds, ad (c) the LBO s private equity sposors. Such a claim would be based o the collapse (or step-trasactio) doctrie employed by courts i umerous fraudulet coveyace cases, uder which the loas from the acquisitio leders, the acquisitio of Target s assets ad liabilities, ad the paymets to Target s old shareholders ca be treated by a court as a sigle trasactio. I this case, BuyerCo 8

9 would be viewed for fraudulet coveyace purposes as ot havig received adequate cosideratio from the acquisitio leders i exchage for issuig them debt istrumets (ad possibly security iterests), because the amout borrowed from the acquisitio leders was promptly paid out to Target s shareholders (rather tha used to pay Target s creditors or to acquire additioal assets for Target). Thus the LBO may be held to violate the fraudulet coveyace laws where BuyerCo/Target violates ay oe of three fiacial tests immediately after the LBO solvecy (asset FV greater tha liabilities), adequate capital, ad ability to pay obligatios as they mature i the ordiary course of busiess. Traditioal sources of law dealig with such fraudulet coveyace issues iclude the Uiform Fraudulet Trasfer Act ( UFTA ) adopted by most states, the Uiform Fraudulet Coveyace Act ( UFCA ) adopted by a few states, ad the Bakruptcy Code applicable throughout the U.S. I 7/14 the Uiform Law Commissio approved a umber of amedmets to the UFTA, icludig reamig the ew act the Uiform Voidable Trasactios Act ( UVTA ). The retitlig of the Act is a attempt to elimiate the cofusio surroudig the use of the word fraud throughout the UFTA, i.e., whe a trasfer is subject to avoidace based upo actual fraud ad whe a trasfer is voidable based upo costructive fraud. The UVTA also icludes amedmets relatig to choice of law, burde of proof allocatio, ad the good faith defese. Curretly, seve states (Georgia, Idaho, Ketucky, Miesota, New Mexico, North Carolia, ad North Dakota) have adopted the UVTA, ad it has bee itroduced i several other state legislatures. Ultimately, the UVTA may be adopted by all states that have adopted the origial UFTA. See discussio at BuyerCo resposibility for Target liabilities ot explicitly assumed i a asset purchase. I a acquisitio structured as a asset purchase, uder various versios of the bulk sales act adopted by various states, a buyer of Target s assets i bulk geerally becomes liable for Target s liabilities (up to the FV of the Target ivetory ad equipmet purchased) uless the buyer has give otice to all of Target s creditors at least a specified period before the asset sale ad has followed other specified procedures. Although most states at oe time eacted a bulk sales act, i recet years all but two states (Marylad ad Califoria) have repealed their bulk sales statutory provisios. Nevertheless, some courts have held the buyer of a busiess resposible for some Target liabilities (especially tort liabilities for defective products, uderfuded pesio liabilities, ad evirometal liabilities) uder the vague commo law doctries of de facto merger ad successor liability whe Target s busiess is trasferred to buyer as a goig cocer ad Target goes out of existece, especially (but ot exclusively) where 9 MORE

10 Target s owers receive a substatial equity iterest i buyer. See discussio at HSR filig for acquisitio aual iflatio adjustmet. A Hart-Scott-Rodio filig with FTC/DOJ is required if the size of BuyerCo s purchase price for acquirig Target (ad, i certai cases, the size of the parties to the trasactio) exceeds specified tests. The authors have updated the etire HSR discussio to reflect the 2/15 aual iflatio adjustmet of all the HSR tests, thresholds, ad filig fees. See discussio at GAAP accoutig for a acquisitio, as substatially revised by FASB i 11/14. 5 Accoutig at the BuyerCo level. Whe BuyerCo acquires Target, the accoutig carryig value of Target s assets o BuyerCo s cosolidated fiacial statemets are uder the purchase accoutig rules geerally writte up to the amout BuyerCo paid (i cash, BuyerCo stock, BuyerCo otes, ad iherited Target liabilities) to acquire Target, regardless of the trasactio form (e.g., stock purchase, asset purchase, or merger). Such purchase accoutig book value write-up for Target s assets o BuyerCo s cosolidated fiacials geerally icreases BuyerCo s post-acquisitio (a) GAAP depreciatio/amortizatio for the old Target assets (both tagible ad itagible) ad (b) potetial future GAAP impairmet write-dows if the purchased Target goodwill declies i value, thus reducig BuyerCo s post-acquisitio accoutig et icome. 3 5 Accoutig at the Target level. For a acquisitio before 11/19/14, where Target cotiued to exist as a BuyerCo subsidiary, Target was geerally required to apply (i.e., push dow i accoutig parlace) BuyerCo s purchase accoutig o its stad-aloe fiacial statemets, such that the accoutig carryig value of Target s assets (o Target s stad-aloe fiacial statemets) was geerally writte up to the amout BuyerCo paid to acquire Target as described above. 4 However, for a acquisitio o or after 11/19/14, the accoutig rules have chaged substatially such that Target may geerally elect whether to (a) apply 3 These accoutig rules are ot the same as the icome tax rules ad hece the accoutig rules may result i reduced accoutig icome without ay reductio i taxable icome. 4 I limited circumstaces uder the old pre-11/19/14 accoutig rules, Target could avoid pushdow purchase accoutig (ad thus retai its old accoutig carryig values o its stad-aloe fiacial statemets) by structurig the acquisitio as a recapitalizatio where (i) Target survived ad (ii) old (or i some cases ew) Target shareholders who were ot part of a collaborative group with BuyerCo owed a sigificat stake i Target s commo equity (geerally at least 6% but i some cases at least 20%) after the acquisitio. Qualificatio for this ow obsolete recapitalizatio accoutig exceptio to pushdow purchase accoutig for Target was complex ad at times ucertai. 10

11 l S corp tax issues pushdow accoutig (i.e., apply BuyerCo s purchase accoutig [as described above] o Target s stad-aloe fiacial statemets) or (b) retai (uchaged) Target s old accoutig carryig values for Target s assets (i.e., ot push dow BuyerCo s purchase accoutig). Cosequetly, where Target cotiues to exist for accoutig purposes post-acquisitio as a BuyerCo subsidiary ad does ot elect to push dow BuyerCo s purchase accoutig, Target cotiues (o its separate post-acquisitio fiacials) to use its pre-acquisitio asset book values uchaged such that Target s post-acquisitio GAAP depreciatio/amortizatio ad/or goodwill impairmet charges do ot icrease as a result of the buyout (as they would if pushdow accoutig had applied). See discussio at 504. Avoidig corporate-level icome tax o sale of S corp assets. A S corp is a flow-through etity for tax purposes ad hece ormally pays o federal icome tax at the etity level, i.e., icome of a S corp is subject to oly oe level of icome tax (imposed at the shareholder level). However, Code 1374 subjects a S corp to a corporate-level pealty tax o asset-sale gai (so that the S corp s asset-sale gai is subject to double tax) uder two circumstaces: (1) where the S corp was formerly a C corp but switched to S corp status or (2) where the S corp (although always a S corp) acquired assets tax-free with carryover basis from a C corp. I either such case Code 1374 has log subjected the S corp s asset-sale gai (which accrued before the S electio or the tax-free-carryover-basis asset acquisitio) to double tax if such assets were sold (a) withi 10 years after the coversio from C to S corp or (b) withi 10 years after the S corp s tax-free acquisitio of COB assets from a C corp. However, begiig i 2009, legislatio reduced this 10-year pealty period first to 7 years ad the to 5 years. For such a S corp asset sale durig 2014 the period was 5 years, but such legislatio shorteig the 10-year pealty period expired 12/31/14. Hece begiig 1/1/15 the pealty period for such a S corp is agai 10 years, uless Cogress reduces the 10-year period (retroactively) for such a 2015 S corp asset sale to 5 years or 7 years. See discussio at Avoidig restrictios o S corp shareholders. A corporatio ca elect to be a S corp (subject to S corp flow-through tax rules rather tha C corp double tax rules) oly if it meets certai arbitrary rules relatig to its stock ad its shareholders, icludig: 5 all of the corporatio s outstadig shares of stock are idetical from a ecoomic stadpoit (although ot ecessarily from a votig power stadpoit) ad 11 MORE

12 5 each of its shareholders is a idividual (or the estate of a idividual) who is a U.S. citize or residet, i.e., o shareholder ca be a corporatio, partership, LLC, or idividual o-u.s. citize/residet. 5 However, oe techique for miimizig the impact of these arbitrary rules ad achievig similar ecoomics to (1) a secod class of stock (e.g., gratig oe or more shareholders a seior equity positio or a complex profit sharig ratio or both) or (2) a etity or a o-u.s. idividual shareholder especially useful where a existig S corp is raisig ew moey from a PE/VC fud is for: (a) such S corp to drop its existig busiess ad assets (i a tax-free Code 721 trasactio) dow to a ewly formed partership or LLC ( lower-tier operatig etity ) ad (b) PE/VC fud either to make a ivestmet i lower-tier operatig etity (rather tha i S corp) or to purchase a iterest i lower-tier operatig etity from S corp. S corp s old busiess is the owed ad operated by lower-tier partership or LLC etity a form of orgaizatio ot subject to the S corp arbitrary rules discussed above which is i tur owed i part by S corp ad i part by PE/VC: U.S. idividuals 100% S corp PE/VC fud ad/or other ew equity owers Drop dow S corp s assets ad busiess Juior or formula equity claim Cash Seior or formula equity claim New Partership or LLC (lower-tier operatig etity) I situatios where a actual trasfer of S corp assets to a lower-tier operatig etity (as described above) is ot desirable (e.g., because of the eed for third-party cosets), the same result ca be achieved utilizig the etity coversio mechaism 5 Uder limited circumstaces a trust for a U.S. idividual or a oe-member LLC owed by a U.S. idividual or a TEO ca also be a S corp shareholder. 12

13 available uder most state laws. Uder this alterative, (1) the existig S corp shareholders cotribute all their S corp shares to a ew S corp ( Holdco S corp ), (2) the old S corp elects uder state law to covert ito a partership or LLC, ad (3) the ew ivestors ivest i the ewly coverted partership/llc or purchase a portio of such partership/llc s equity from Holdco S corp. Steps (1) ad (2), take together, are treated, for federal icome tax purposes, as a tax-free F reorgaizatio, which views Holdco S corp as a cotiuatio of old S corp, while step (2) (old S corp s state-law electio to become a partership/llc) is ot treated for state law purposes as a asset trasfer, so that the state law drawbacks of a actual asset trasfer (e.g., retitlig of assets ad possible eed for third-party cosets) ca typically be avoided. See discussio at ad l PE/VC fud qualifies as SBIC icrease i size stadards for SBIC ivestmet i Portfolio Compay. Where PE/VC fud is a SBIC, PE/VC fud ca geerally ivest i Portfolio Compay oly if Portfolio Compay is a small busiess, i.e., meets at least oe of the followig two size stadards : (a) (b) tagible book et worth ot i excess of $19.5 millio (recetly icreased from $18 millio) ad average et icome for prior 2 complete fiscal years ot i excess of $6.5 millio (recetly icreased from $6 millio) or certai employee or reveue stadards published by SBA from time to time for the idustry i which Portfolio Compay is pricipally egaged. See discussio at l Reduced tax rate for gai o sale of Code 1202 qualified small busiess stock. Code 1202 grats a reduced LTCG tax rate (ad a reduced Medicare tax rate) for a idividual s gai from sale of a C corp s stock which has bee held more tha 5 years ad meets several other requiremets. The extet of the tax rate reductio turs o whe the taxpayer acquired the stock: Date stock acquired Reduced LTCG tax rate Portio of LTCG subject to 3.8% Medicare tax 8/11/93 thru 2/17/09 14% 50% 2/18/09 thru 9/27/10 7% 25% 9/28/10 thru 12/31/14 0% 0% 1/1/15 ad thereafter 14% 50% uless Cogress retroactively exteds (to 2015 or perhaps thereafter) the 0% rate as the Obama budget recommeds ad as Cogress has previously doe year by year. 13 MORE

14 To be eligible for Code 1202 s reduced idividual LTCG tax rate, the trasactio must meet all the requiremets described i (1) through (8) below, some relatig to the C corp issuer of the stock ( Portfolio Compay ), some relatig to the sellig shareholder, ad some relatig to the ature of the trasactio i which the sellig shareholder acquired the stock. The authors have expaded their aalysis of Code 1202 s applicability vel o to a umber of factual patters outside the ormal sale by a idividual of C corp stock purchased for cash ad held more tha 5 years before sale. (1) Gai must be taxable to a idividual. To qualify for 1202 treatmet the CG must be taxable to a idividual, trust, or estate (hereiafter referred to as a idividual), ot to a C corporatio. If the gai is recogized by a flow-through etity such as a PE/VC fud (i.e., a partership, LLC, or S corp), the reduced rate is available to a idividual equity ower o his/her share of the flow-through etity s gai, to the extet such equity ower s iterest i the etity is ot greater tha whe the etity acquired the Portfolio Compay stock ad such equity iterest has bee held cotiuously sice the etity acquired the Portfolio Compay stock. Where a S corp distributes to its shareholders either o the S corp s liquidatio or as a divided, both of which costitute a taxable evet to the S corp qualified 1202 stock i Portfolio Compay held by the S corp for more tha 5 years before such shareholder distributio, the appreciatio i the qualified stock at the time of its distributio to shareholders is recogized by the S corp ad costitutes 1202 gai allocable (o a flow-through basis) to the S corp s idividual shareholders. However, the Portfolio Compay stock ceases to be qualified 1202 stock whe received by the S corp s shareholders ad thus does ot costitute qualified stock whe later sold by the shareholders, because the Portfolio Compay stock was ot acquired by the S corp s shareholders at origial issuace as required by (2) below. (2) Stock acquired at origial issuace ad post-8/10/93. The idividual reportig the gai (or the flow-through etity i which the idividual reportig the gai holds a equity iterest) must have acquired the stock at its origial issue (directly or through a uderwriter). Thus, the shares must be purchased i a primary offerig from Portfolio Compay (or from Portfolio Compay s uderwriter), ot from a third party i a secodary offerig. It is ot, however, ecessary that the shareholder purchase the Portfolio Compay shares whe Portfolio Compay is first formed ad first issues shares. The Portfolio Compay stock must also have bee origially issued after 8/10/93, whe Code 1202 was first eacted. Where a idividual receives Portfolio Compay stock by gift or at death from a idividual who held the qualified stock, the stock cotiues to qualify i the trasferee s 14

15 hads (so log as the trasferee is a qualified shareholder or a flow-through etity to the extet owed by a qualified shareholder). Whe a partership or LLC holdig qualified stock distributes such stock to its equity owers, the stock received by a equity ower who is a qualified shareholder (i.e., a idividual) cotiues to be qualified stock if the additioal requiremets described i (1) above are satisfied. There is, however, o such favorable carryover treatmet for (a) Portfolio Compay stock held by a S corp ad distributed by the S corp to its shareholders or (b) Portfolio Compay stock held by a idividual ad cotributed by the idividual to a partership, LLC, or S corp. If a qualified shareholder holds qualified stock i corp #1 but exchages such corp #1 stock for corp #2 stock i a tax-free Code 351 icorporatio or 368 reorgaizatio, the corp #2 stock received i exchage cotiues to be qualified stock with a tacked holdig period from the corp #1 stock. However, if corp #2 is ot a qualified corporatio at the time of the exchage (e.g., because corp #2 has more tha $50 millio of assets, as described i (6) below), gai o the qualified shareholder s subsequet dispositio of the corp #2 stock qualifies for 1202 treatmet oly to the extet of the built-i appreciatio iheret i the corp #1 stock at the time such stock was exchaged for corp #2 stock. (3) 5-year holdig period. The shareholder must hold the Portfolio Compay stock for more tha 5 years. However, there is tackig for (a) a stock trasfer by gift or at death or by partership or LLC distributio to its equity owers (to the extet a equity ower s iterest i the etity is ot greater tha whe the etity acquired the Portfolio Compay stock ad such equity iterest has bee held cotiuously sice the etity acquired the Portfolio Compay stock), (b) o a coversio of covertible preferred stock (but ot covertible debt) ito (e.g.) commo stock, (c) o a coversio of o-votig ito votig stock, or (d) o a rollover of old 1202 stock for ew 1202 stock (pursuat to a Code 1045 sale of the old 1202 stock coupled with a purchase of ew 1202 stock withi 60 days thereafter). Where Portfolio Compay covertible debt is coverted ito stock, the holdig period starts aew at the time of the debt coversio ad the measuremet of whether Portfolio Compay qualifies for 1202 (e.g., satisfies the $50 millio or less asset test) is made at the time of the debt coversio. Moreover, the gai which qualifies for 1202 is limited to appreciatio i the stock occurrig after the debt coversio. Thus, the 1202 result is sharply differet for covertible debt tha for covertible preferred, where the commo stock received o coversio is treated as merely a cotiuatio of the preferred stock. Where a Portfolio Compay warrat is exercised, the trasactio is treated as a ew purchase of commo stock so (a) the holdig period for the stock starts aew at time of exercise 15 MORE

16 ad (b) determiatio whether the Portfolio Compay qualifies for 1202 is made at time of exercise. However, i a cashless warrat exercise (where the warrat is exchaged for stock with a FV equal to the appreciatio i the warrat ad the warrat holder makes o cash paymet), the built-i appreciatio iheret i the stock at issuace does ot qualify for Stock received by a service provider i coectio with the performace of services is treated as issued whe the resultig compesatio icome, if ay, is icluded i the service provider s icome i accordace with the rules of Code 83 (i.e., (a) at issuace where the stock is vested at issuace, (b) at issuace where the stock is subject to vestig but the service provider makes a timely 83(b) electio, or (c) at vestig where the stock is subject to vestig ad the service provider does ot make a timely 83(b) electio). As described i (2) above, if a qualified shareholder exchages qualified stock i corp #1 for stock i corp #2 i a tax-free Code 351 icorporatio or 368 reorgaizatio, corp #2 s stock received i the exchage is qualified stock, but if corp #2 is ot a qualified corporatio at the time of the exchage (e.g., because corp #2 has more tha $50 millio of assets, as described i (6) below), gai o the qualified shareholder s subsequet dispositio of the corp #2 stock qualifies for 1202 treatmet oly to the extet of the built-i appreciatio iheret i the corp #1 stock at the time such corp #1 stock was exchaged for corp #2 stock. (4) Stock must be acquired for cash or other qualified cosideratio. The Portfolio Compay stock must have bee acquired i exchage for: (a) (b) (c) cash, property other tha stock, or services. However, as discussed i (2) above, if a qualified shareholder exchages qualified stock i corp #1 for stock i corp #2 i a tax-free Code 351 icorporatio or 368 reorgaizatio, corp #2 s stock received i the exchage is qualified stock, because the corp #1 stock was issued for qualified cosideratio (eve though the corp #2 stock was ot), but if corp #2 is ot a qualified corp at the time of the exchage (e.g., because corp #2 has more tha $50 millio of assets), gai o the qualified shareholder s subsequet dispositio of the corp #2 stock qualifies for 1202 treatmet oly to the extet of the built-i appreciatio iheret i the corp #1 stock at the time such corp #1 stock was exchaged for corp #2 stock. (5) U.S. C corp issuer. The Portfolio Compay stock must have bee issued by a U.S. C corp. Hece, stock i a S corp, stock i a o-u.s. corp, ad equity iterests i a partership or LLC do ot qualify (although stock i a U.S. C corp idirectly owed by a qualified shareholder through a flow-through etity does qualify). 16

17 (6) $50 millio maximum assets at issuace. Gross asset measuremet. The aggregate gross assets of [Portfolio Compay] (or ay predecessor thereof) (icludig itagible assets) must ot exceed $50 millio at ay time o or after 8/10/93 util immediately after the shareholder acquires the stock. 6 Portfolio Compay s assets are measured by their adjusted tax basis, except that a asset cotributed to Portfolio Compay with carryover basis is measured by its FV at cotributio. This $50 millio calculatio is made after takig ito accout the amout received by Portfolio Compay i the stock issuace beig tested for 1202 qualificatio. For purposes of the $50 millio test, Portfolio Compay s assets geerally iclude 100% of the assets of ay 50%-or-more corporate paret ad ay 50%-or-more direct or idirect corporate subsidiary measured by vote or value (igorig certai o-votig plai vailla preferred stock). Step-trasactio doctrie. The statute does ot defie the term immediately after the shareholder acquires the stock (which is whe Portfolio Compay s assets are measured). Thus, taxpayers may take the positio that the term should be iterpreted literally to refer to the state of affairs at the istat immediately followig the issuace of stock, disregardig all subsequet evets, icludig future pre-plaed stock issuaces. However, i iterpretig other Code provisios IRS ad the courts, applyig the steptrasactio doctrie, have frequetly iterpreted the term immediately after to iclude preplaed future evets. Hece it is uclear whether a first ivestor or ivestor group i Portfolio Compay (whose ivestmet does ot icrease Portfolio Compay s gross assets above $50 millio) qualifies for Code 1202 treatmet where there is a precoceived pla (ultimately carried out) to raise additioal fiacig from a differet or eve the same ivestor or ivestor group that does icrease Portfolio Compay s gross assets to more tha $50 millio shortly thereafter. However, the legislative history of 1202 s eactmet ca be read as rejectig a 1202 step-trasactio doctrie ad istead adoptig a bright-lie ed-of-the-day test, by statig that If a corporatio satisfies the gross assets test as of the date of issuace but subsequetly exceeds the $50 millio threshold, stock that otherwise costitutes qualified small busiess stock would ot lose that characterizatio solely as a result of that subsequet evet (emphasis added). Applicatio of $50 millio test i LBO cotext. Where Portfolio Compay is a ew corporatio ( Newco ) formed for the purpose of acquirig Target s assets (e.g., i a 6 Portfolio Compay s liabilities are ot relevat to this calculatio. 17 MORE

18 LBO), the $50 millio limitatio for Newco (a) would apparetly be violated where the aggregate amout received by Newco from debt ad equity fiacig exceeds $50 millio ad (b) might be violated (if the step-trasactio doctrie applies) eve where the aggregate amout Newco received from debt ad equity fiacig was below $50 millio but Newco s post-acquisitio tax basis i its ow assets plus the assets acquired from Target (icludig basis created whe Newco iherits Target liabilities as part of the asset acquisitio) exceeds $50 millio. Where Newco is formed to acquire Target s stock, it is uclear whether the $50 millio limitatio is applied (a) by referece to the aggregate debt ad equity fiacig raised by Newco or (b) by referece to Newco s ad Target s post-acquisitio assets (if the steptrasactio doctrie applies) by disregardig Newco s basis i Target s stock ad istead takig cogizace of Target s post-acquisitio tax basis i its assets. (7) Active busiess. The Portfolio Compay must meet a complex active busiess requiremet durig substatially all of the shareholder s holdig period for its stock. (8) No redemptios. Newly issued Portfolio Compay stock is ot eligible for the Code 1202 reduced tax rate if Portfolio Compay has made certai types of stock redemptios. (9) Calculatig amout of gai qualifyig for 1202 reduced tax rate. The maximum amout of a idividual s LTCG from stock of a sigle corporatio eligible for the reduced tax rate is the greater of (a) $10 millio (takig ito accout his or her gai durig the year of the sale ad all prior years) ad (b) 10 times the taxpayer s aggregate basis i such stock disposed of by the taxpayer durig the year of the sale. Where a qualified shareholder acquires qualified Portfolio Compay stock i exchage for appreciated property trasferred to Portfolio Compay (e.g., uder Code 351), the amout of such shareholder s gai o the ultimate sale of such Portfolio Compay stock which qualifies for 1202 s reduced tax rate is reduced by the appreciatio i the property at the time the shareholder trasferred the property to Portfolio Compay i exchage for the qualified stock. See discussio at l Volcker Rule developmets regardig a BHC group s ivestmets (e.g., i PE/VC fuds) ad activities. I additio to restrictig proprietary tradig ad the sposorship of PE/VC fuds by a BHC group (i.e., a bak holdig compay ad its subsidiaries ad affiliates), the Volcker Rule eacted i 2010, but ot fully effective util 7/15 prohibits ivestmets i a covered fud (primarily a PE/VC fud exempt from ICA registratio by 3(c)(1) or 3(c)(7)), uless qualifyig for a exclusio or exemptio. 2/15 Fed publicatio clarifies that the solely outside the U.S. (or the SOTUS) exemptio allows a o-u.s. BHC to ivest i a PE/VC fud offered 18

19 ad sold i the U.S. by the PE/VC fud s sposor. The Volcker Rule s SOTUS exemptio allows a o-u.s. BHC (i.e., a bakig istitutio orgaized i a o-u.s. jurisdictio that is treated as a U.S. bak holdig compay uder the BHCA by virtue of its U.S. bakig exus) to ivest i a PE/VC fud (or a co-ivestmet etity) if: (a) (b) (c) More tha half the o-u.s. BHC group s busiess (o a cosolidated basis) is from outside the U.S., The PE/VC fud has bee offered for sale ad sold pursuat to a offerig that does ot target U.S. residets (as defied i SEC Reg. S), referred to as the SOTUS marketig restrictio, ad The o-u.s. BHC group s ivestmet i the PE/VC fud is made outside the U.S. (i.e., the BHC group s decisio to ivest i the PE/VC fud is made by o-u.s. persoel, the BHC group s ivestmet is ot accouted for by ay U.S. brach or affiliate, ad the BHC group s ivestmet is fuded from a o-u.s. source). Before 2/15, the SOTUS marketig restrictio (discussed i (b) above) was widely iterpreted to mea that o party (icludig the PE/VC sposor) could offer or sell to a U.S. residet iterests i the PE/VC fud iteded to qualify for ivestmet by a o-u.s. BHC uder the SOTUS exemptio. Cosequetly, i order to facilitate a o-u.s. BHC s ivestmet, the PE/VC sposor had to form the SOTUS ivestmet etity (i which o U.S. residet could ivest) as oe of multiple parallel ivestmet etities (i.e., two or more parallel etities formed at approximately the same time by the same GP/maagemet compay/sposor to ivest pro rata i the same portfolio compaies ad deomiated collectively as the same PE/VC fud). I 2/15, however, the Fed published FAQ 13 clarifyig that the SOTUS marketig restrictio prohibitig sales to a U.S. residet applies oly to a o-u.s. BHC s (ad ot a PE/VC sposor s) offer ad sale of iterests i the etity i which the o-u.s. BHC is ivestig i reliace o the SOTUS exemptio. With this guidace, a o-u.s. BHC ca meet the SOTUS exemptio requiremets discussed above (icludig the SOTUS marketig restrictio) ad ivest i a PE/VC fud without the eed for ay special accommodatio (i.e., there is o eed to form a separate etity i which the o-u.s. BHC ivests but i which o U.S. residet ivests). Volcker Rule effective date. The Volcker Rule 12/13 fial implemetig regulatios ad subsequet Fed releases exted the Volcker Rule coformace period: 5 from 7/21/14 to 7/21/15 for all Volcker Rule activities ad ivestmets, with two 1-year extesios i the Fed s discretio ad a additioal extesio of up to 5 years i the Fed s discretio for a illiquid fud ivestmet with respect to which the BHC group had a cotractual obligatio as of 5/1/10, ad 19 MORE

20 5 from 7/21/15 to 7/21/16 for ivestmets i ad relatioships with a covered fud etered ito prior to 12/13, with oe 1-year extesio i the Fed s discretio ad a additioal extesio of up to 5 years i the Fed s discretio for a illiquid fud ivestmet with respect to which the BHC group had a cotractual obligatio as of 5/1/10. However, the Fed s regulatios state that the Fed expects a BHC group to egage i good faith efforts resultig i coformace of its activities to the Volcker Rule by the applicable deadlie ad a BHC group ca make PE/VC fud ivestmets or egage i ew sposorship activities oly to the extet such ivestmets ad activities qualify for a Volcker Rule exclusio or exemptio or otherwise ca be brought ito coformace with the Volcker Rule by the ed of the applicable coformace period. See discussio at ad l... ad much, much more. This publicatio is desiged to provide accurate ad authoritative iformatio i regard to the subject matter covered. It is sold with the uderstadig that the publisher ad the author(s) are ot egaged i rederig legal, accoutig, or other professioal services. If legal advice or other professioal assistace is required, the services of a competet professioal should be sought. From a Declaratio of Priciples joitly adopted by a Committee of the America Bar Associatio ad a Committee of Publishers ad Associatios 20