PRIVATE EQUITY INVESTING: CORPORATION OR LLC?

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1 PRIVATE EQUITY INVESTING: CORPORATION OR LLC? By Bruce Blasnik, CPA and Peter Baum, CPA In this first paper of a two-part series1 we compare a private equity (PE) fund2 investment structured as a limited liability corporation treated as a partnership for income tax purposes (LLC) to an investment structured as a C corporation (C Corp) and explore the tax advantages and disadvantages of each. We use a case study to examine exit transactions from the LLC and the C Corp assuming two alternative C Corp exit strategies: (1) asset sale, and (2) stock sale. We find a higher internal rate of return (IRR) for the LLC over both C Corp scenarios. We offer mitigating strategies to overcome disadvantages associated with the LLC structure and suggest that PE firms should consider the increased IRR of an LLC before favoring only C Corp portfolio investments. LLC VS. C CORP When deciding on business entity type, private businesses often prefer the LLC structure to that of a C Corp primarily due to the flow through nature of and avoidance of double taxation on business income and capital gains upon sale. Furthermore, while both the LLC and C Corp provide limited liability, an LLC generally allows for more flexibility in defining the ownership and management structure of the company without being required to adhere to formalities customarily associated with corporations. Alternatively, when deciding on portfolio investments, many PE firms tend to avoid investments in LLC structures in large part due to actual and perceived disadvantages associated with the flow through of tax attributes to the PE fund. Generally speaking, due to some or all of these pitfalls, discussed later in this document, PE firms often prefer the C Corp structure when adding a particular business to their portfolio. CASE STUDY We use a case study to examine financial results for a PE firm that purchases 55% of a successful professional services business referred to as Newco. The initial investment is structured either as an asset purchase or the purchase of an LLC interest, both of which provide substantially the same starting point. The PE investors benefit from additional amortization resulting from a step up in basis attributable to intangible assets (e.g., customer lists/relationships and goodwill). The pre-money valuation of Newco is $55,000,000. Table 1 displays the other specifics of the investment. 1 2 Part 2 focuses on equity incentive plans. This paper uses PE fund and PE firm interchangeably.

2 CASE STUDY We use a case study to examine financial results for a PE firm that purchases 55% of a successful professional services business referred to as Newco. The initial investment is structured either as an asset purchase or the purchase of an LLC interest, both of which provide substantially the same starting point. The PE investors benefit from additional amortization resulting from a step up in basis attributable to intangible assets (e.g., customer lists/ relationships and goodwill). The pre-money valuation of Newco is $55,000,000. Table 1 displays the other specifics of the investment. TABLE 1 PE Firm Acquisition of 55% Interest in Newco PE firm will hold a $15,250,000 participating preferred equity security in Newco with a cumulative 8% dividend ($1,220,000), payable annually. Upon exit from Newco, PE firm receives a 1X preference on the initial investment plus full participation (55%) on an as if converted basis. PE firm also arranges for outside senior debt of $15,000,000 with a term of 10 years, annual principal payments of $1,500,000 plus 8.25% interest. Additionally, there is a required reduction of principal equal to 50% of the excess earnings, defined as net income minus the 8% dividend on the preferred equity interest and income taxes (or a tax distribution in the case of an LLC). The $30,250,000 proceeds from preferred stock and debt are distributed to the original owners of the business who will continue to hold a 45% interest in Newco after the PE investment. At the end of Year 4, Newco is sold for $120,000,000. We compiled financial results over a 4-year period for Newco (Appendix B). We then compared the exit from Newco under the three case scenarios (including two alternative selling prices for scenario 3) summarized in Table 2. TABLE 2 Case Scenarios Scenario Purchase Structure Exit Structure Selling Price ($ millions) 1 LLC LLC interest or asset sale $120,000 2 C Corp Corporate asset sale $120,000 3A C Corp Corporate stock sale $120,000 3B C Corp Corporate stock sale final selling price is reduced by the estimated present value of the buyer s foregone step up in basis of the assets $104,000

3 Table 3 shows the initial investment (cash outflow), the net cash inflows over the four-year period and the overall IRR. Net cash inflows include preferred dividends, tax distributions in the case of an LLC, proceeds from exit, and payment of federal and state taxes at the investor level. Detailed, annual results supporting the cash flows and IRR are provided in Appendix A. TABLE 3 Summary of Investment Results (In $ millions) Scenario Initial Investment Net Cash Inflows (After Tax) IRR 1 LLC $15,200 $65, % 2 C Corp asset sale $15,200 $46, % 3 C Corp stock sale $15,200 $60, % 4 C Corp stock sale $15,200 $53, % (lower selling price) DISCUSSION The LLC structure yields an IRR of 45.1% due to the pass through of income to owners and the avoidance of double taxation on the annual income, preferred dividends, and capital gain upon exit, which is considerably higher than any of the C Corp scenarios. When comparing the C Corp scenarios, the highest IRR is achieved in Scenario 3A, which is structured as a corporate stock sale with the selling price set at the same level as the asset sale. This may not be realistic, as one would expect the selling price to be lower in a stock sale when compared to an asset sale since, with a stock sale, the buyer cannot take advantage of a stepped up basis in the underlying assets and the additional tax advantages thereof. Scenario 3B reflects a stock sale with a reduced selling price consistent with what is seen in practice relative to an asset sale and is probably the best benchmark for comparing relative IRRs. The lowest IRR is achieved in Scenario 2, which is structured as a corporate asset sale. The reduced IRR between Scenario 2 and Scenario 3A and 3B results from the gain on sale in Scenario 2 being taxed at both the corporate level and the investor level. The double taxation on the capital gain at exit is avoided with a corporate stock sale. 3 Including pension funds, foundations and other tax-exempt organizations. LLC PITFALLS AND STRATEGIES Although the LLC results in the highest IRR, the flow through nature of its income brings with it a number of issues/disadvantages that don t exist in the C Corp structure: Income tax filing delays for the PE fund resulting from the LLC s often extended income tax filing dates. Additional state income tax returns for the PE fund and/or the PE fund s LPs. Unrelated business taxable income (UBTI) for domestic tax-exempt investors. 3 Effectively connected income (ECI) for foreign investors requiring foreign investors to file U.S. income tax returns. Problems regarding extended income tax filing dates are inherent to the LLC, and may be unavoidable to the PE firm and its investors. The issue of additional state income tax returns can be mitigated to the extent the LLC is permitted to file state composite returns (i.e., a return on behalf of its owners). However, the composite filing rules are complex, vary by state, and often don t work well with tiered ownership structures. If the LLC operates in only one or a few states, additional state income tax returns should not be a significant issue.

4 Tax-exempt organizations such as charities, universities, and pension plans are not required to pay taxes on income related to their tax-exempt purpose, but they are required to pay income tax on UBTI. The regular activities of an operating business are UBTI, and this income flows through to the PE fund investors. The tax-exempt investors are therefore forced to report and pay income tax on this UBTI. This is not the case with respect to interest, dividend and capital gains income received by tax-exempt investors. Similarly, foreign investors are generally not required to file U.S. income tax returns unless they have ECI derived from the active conduct of a trade or business in the U.S. Passive investment in a corporation does not give rise to ECI for a foreign investor. However, members in a LLC taxed as a partnership are treated as though they are engaged in whatever business the LLC itself is engaged in, which means that a foreign investor in an LLC will generally be forced to file a U.S. income tax return. Problems associated with the flow through of UBTI to tax-exempt investors and/or ECI to foreign investors may be avoided, at least in part, through the use of various onshore or offshore blocker corporations. The use of blocker corporations is complex and there are numerous considerations that must be taken into account, including the types of flow-through income, U.S. withholding requirements, the domicile of the taxpayers and tax treaty provisions, among others. These matters are beyond the scope of this paper. Finally, while not common in practice, there are some structures that may allow PE firms to take advantage of the more efficient tax structure of an LLC while avoiding many of the pitfalls a best of both worlds situation. One alternative is an LLC with two types of interests: income interests and capital interests. Ordinary income can be allocated solely to the income interests. Upon a sale of the company (or change in control transaction), the cumulative preferred return is paid out to the capital interest holders and the remaining gain can be allocated to the capital interests, as well as to the income interests, as provided for in the LLC operating agreement. To compensate for the deferral of cash returns to the capital interest holders, the preferred yields might need to be increased. CONCLUSION The choice of entity for a PE firm s portfolio investments is an important decision that can have a significant impact on the firm s IRR as well as other factors. While every scenario is different and the structure of each portfolio investment should be analyzed prior to making a decision, PE firms should not automatically default to investing in C Corps without first considering the financial benefits of more creative structures. In addition to sacrificing the potential for higher IRR, offhandedly dismissing LLC structures may limit the investment opportunities for PE fund managers. About PKF O Connor Davies PKF O Connor Davies, LLP is a full-service certified public accounting and advisory firm with a long history of serving clients both domestically and internationally. With roots tracing to 1891, ten offices in New York, New Jersey, Connecticut and Maryland, and more than 600 professionals led by 100 partners, the Firm provides a complete range of accounting, auditing, tax and management advisory services. PKF O Connor Davies is ranked number 29 on INSIDE Public Accounting s 2015 Top 100 Firms list and is recognized as one of the Top 10 Fastest- Growing Firms. PKF O Connor Davies is also recognized as a Leader in Audit and Accounting and is ranked among the Top Firms in the Mid-Atlantic, by Accounting Today. In 2016, PKF O Connor Davies was named one of the 50 best accounting employers to work for in North America, by Vault. The Firm is the 11th largest accounting firm in the New York Metropolitan area, according to Crain s New York Business. For more information on this article please contact: Bruce Blasnik, CPA Partner (203) bblasnik@pkfod.com Peter Baum, CPA Partner (914) pbaum@pkfod.com

5 Appendix A PE Firm Investment in Newco Detailed Financial Results and Internal Rates of Return Initial End of Year Outflow Total IRR Scenario 1: Limited Liability Company Preferred dividend $1,220 $1,220 $1,220 $1,220 $4,880 Tax distribution 1,203 1,916 2,757 3,737 9,613 2,423 3,136 3,977 20,207 29,743 Liquidation 61,091 61,092 Total cash inflows 4,846 6,271 7,954 81,298 90,835 Income Tax Payments*: Ordinary (1,752) (2,465) (3,306) (4,286) (11,809) Capital gain (13,816) (13,816) Net Cash $(15,250) $671 $671 $671 $63,196 $65, % Scenario 2: C Corporation Asset Sale Preferred dividends $1,220 $1,220 $1,220 $1,220 $4,880 Capital gain 38,880 38,880 Total 1,220 1,220 1,220 55,350 59,010 Income tax payments* (342) (342) (342) (11,228) (12,253) Net Cash $(15,250) $878 $878 $878 $44,122 $46, % Scenario 3A: C Corporation Stock Sale Preferred dividends $1,220 $1,220 $1,220 $1,220 $4,880 Capital gain 57,613 57,613 Total 1,220 1,220 1,220 74,083 77,743 Income tax payments* (342) (342) (342) (16,473) (17,498) Net Cash $(15,250) $878 $878 $878 $57,610 $60, % Scenario 3B: C Corporation Stock Sale (Selling Price Reduced by Estimated PV of Buyers' Foregone Step Up in Assets) Preferred dividends $1,220 $1,220 $1,220 $1,220 $4,880 Capital gain 48,813 48,813 Total 1,220 1,220 1,220 65,283 68,943 Income tax payments* (342) (342) (342) (14,009) (15,034) Net Cash $(15,250) $878 $878 $878 $51,274 $53, % * See accompany schedule of income taxes.

6 PE Firm Investment in Newco Schedule of Income Taxes Year Scenario 1 (LLC): NI passed through $2,673 $4,257 $6,127 $8,305 Preferred dividends 1,220 1,220 1,220 1,220 Ordinary income 3,893 5,477 7,347 9,525 Rate (Federal and State) Ordinary Tax $1,752 $2,465 $3,306 $4,286 Capital gain $49,342 Rate.28 Capital Gain Tax $13,816 Scenario 2 (C Corp Asset Sale) Preferred dividends $1,220 $1,220 $1,220 $1,220 Capital gain 38,880 Total 1,220 1,220 1,220 40,100 Rate Income tax $342 $342 $342 $11,228 Scenario 3 (C Corp Stock Sale Treated as Asset Sale) Preferred dividends $1,220 $1,220 $1,220 $1,220 Capital gain 57,613 Total 1,220 1,220 1,220 58,833 Rate Income tax $342 $342 $342 $16,473 Scenario 4 (C Corp Stock Sale Selling Price Reduced By Step Up In Assets) Preferred dividends $1,220 $1,220 $1,220 $1,220 Capital gain 48,813 Total 1,220 1,220 1,220 50,033 Rate Income tax $342 $342 $342 $14,009 Note: Income taxes reflect the taxes to be paid by individual limited partners of the PE Fund and include the 3.8% additional tax on investment income.

7 Appendix B Newco Financial Statements NEWCO PROFORMA INCOME STATEMENT Year 0 Year 1 Year 2 Year 3 Year 4 Revenue $70,000 $80,500 $92,600 $106,500 $122,500 Operating expenses: Fixed (11,000) (11,280) (11,560) (11,850) (12,150) Variable (52,400) (60,260) (69,320) (79,720) (91,700) Depreciation (500) (560) (600) (640) (690) Amortization - (1,020) (1,020) (1,020) (1,020) Operating income 6,100 7,380 10,100 13,270 16,940 Interest expense (250) (1,170) (940) (640) (260) EBIT 5,850 6,210 9,160 12,630 16,680 NEWCO PROFORMA BALANCE SHEET End of Year: Current Assets: Cash $3,500 $3,565 $4,400 $6,090 $10,485 Accounts receivable 11,500 13,230 15,210 17,500 20,130 Other Property, Plant, Equip 2,200 2,390 2,540 2,650 2,710 Intangibles, net (15 yr SL) 15,250 14,230 13,210 12,190 11,170 Total Assets $32,950 $33,980 $35,990 $39,125 $45,255 Current Liabilities: AP and accrued expenses $7,350 $8,290 $9,380 $10,620 $12,040 Deferred revenue 1,675 1,930 2,220 2,550 2,930 Current portion of LTD 1,500 1,500 1,500 1,500 - Senior debt 13,500 10,665 7,035 2,470 - Equity: Preferred stock $15,250 $15,250 $15,250 $15,250 Majority interest 1,468 3,811 7,182 11,747 Minority interest (5,124) (3,207) (449) 3,286 Total Equity 8,925 11,595 15,855 21,985 30,285 Total Liabilities & Equity $32,950 $33,980 $35,990 $39,125 $45,255