Structuring Venture Capital, Private Equity, and Entrepreneurial Transactions

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1 NEW 2018 Editio of Structurig Veture Capital, Private Equity, ad Etrepreeurial Trasactios W e are proud to eclose the 2018 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 Federal icome tax rates for 2018 ad thereafter l C corp icome tax rate. The C corp federal icome tax rate for 2018 ad thereafter (o both OI ad LTCG) has bee reduced to 21%, while the approximately 3 percetage poit reductio o qualified U.S. productio busiess et icome has bee repealed. l Idividual icome tax rates. The idividual top federal icome tax rates for 2018 ad thereafter (which also apply to partership, LLC, ad S corp icome flowig through to a idividual equity ower) are as follows: For OI, the top rate has bee reduced to 37%, 5 with a possible further reductio of the top rate to 29.7% for qualified busiess OI flowig through a partership, LLC, S corp, or proprietorship to a idividual (as discussed i more detail below), 5 but the approximately 3 percetage poit reductio o qualified U.S. productio busiess et icome has bee repealed. For ormal LTCG, the top rate cotiues at 20%. Copyright 2018 CCH Icorporated. All Rights Reserved. 1 MORE

2 For STCG, the top rate has bee reduced to 37%. For QDI (qualified divided icome), the top rate cotiues at 20% (i.e., the same as for LTCG). For Code 1202 LTCG (from sale of qualified small busiess stock held more tha 5 years), the top rate cotiues at: 5 0% for such stock acquired after 9/27/10, 5 7% for stock acquired betwee 2/18/09 ad 9/27/10, ad 5 14% for stock acquired betwee 8/11/93 ad 2/17/09. l Idividual icome-based Medicare tax (i additio to regular icome tax): O compesatio ad self-employmet icome, the rate cotiues at 3.8%, with (a) 2.9% imposed 50% o a employer ad 50% o a employee or 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. O passive icome (icludig OI, QDI, ad CG) from ivestmets ad busiesses as to which a 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). l With respect to idividual itemized deductio ad persoal exemptio phase-outs which previously reduced idividual icome taxes: The former 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, has bee repealed. Miscellaeous itemized deductios (icludig ivestmet [i.e., o-busiess] expeses other tha iterest), formerly deductible to the extet a idividual s aggregate miscellaeous itemized deductios exceed 2% of AGI, are o loger deductible. Persoal exemptios (ad hece the former phase-out) have bee repealed. See discussio at 107. l Detailed descriptio of reduced idividual OI rate for qualified U.S. busiess icome from flow-through etity. Special 199A icome tax deductio. Code 199A, eacted by the 2017 Tax Act ad effective oly for taxable years 2018 through 2025, provides a special icome tax deductio for a idividual equal to up to 20% of the idividual s qualified [U.S.] busiess icome ( QBI ) flowig to the idividual through a partership, LLC, S corp, or sole proprietorship, thus reducig the idividual s federal icome tax rate 2

3 o QBI by up to 20%, e.g., from 37% to 29.6% 1 for a idividual otherwise taxed at the maximum (37%) federal rate who qualifies for the maximum Code 199A deductio. 2 Uder the statute s covoluted terms, a idividual s Code 199A QBI deductio is equal to: (i) (ii) (iii) (iv) (v) 20% of the idividual s et QBI from a qualifyig flow-through trade or busiess, which geerally takes ito accout all items of such busiess s OI ad OL (but ot CG, CL, or divided icome), 3 l icludig OI from a sale of (x) the flow-through busiess assets or (y) the idividual s owership iterest i the flow-through etity, but oly to the extet such et QBI is effectively coected with a U.S. busiess, thus requirig exclusio or apportiomet of icome ad expese items if (x) the busiess is coducted i whole or i part outside the U.S. or (y) a portio of the activities are ivestmet activities ot effectively coected with a busiess, but such et QBI is reduced by the portio of such idividual s OI from the flow-through busiess that costitutes reasoable compesatio to the idividual for services redered to the qualified busiess, calculated differetly depedig o whether the etity is formed as a partership/llc, a S corp, or a sole proprietorship, ad such QBI deductio is subject to a W-2 wages/asset based limitatio (i.e., a possible formulistic cut back o the QBI deductio) i the case of a higher icome idividual, but such QBI deductio caot exceed (i.e., is subject to a ceilig equal to) 20% of the idividual s overall taxable icome (excludig the idividual s et CG ad QDI taxed at a maximum 20% rate). Calculatio of the QBI deductio is relatively straightforward for (x) a idividual receivig flow-through icome from a sigle busiess activity, (y) coducted etirely i the U.S., (z) whose overall taxable icome from all sources (before takig ito accout the QBI deductio) is below a threshold amout ($315,000 for a joit retur ad $157,500 for a separate retur 4 ). However, i other fact patters, calculatio of the deductio is much more complicated. I particular: 1 37% 80% ¼ 29.6%. 2 The QBI deductio is ot take ito accout i calculatig a idividual s AGI but rather is take ito accout below the AGI lie, without regard to whether the idividual itemizes deductios. 3 Uder special rules, a idividual s REIT divided icome ad qualifyig publicly traded partership icome also costitute QBI eligible for the 20% deductio. 4 All of Code 199A s taxable icome tests are subject to post-2018 iflatio adjustmet. 3 MORE

4 (a) (b) (c) where a idividual receives flow-through icome from multiple busiesses or from a busiess partially withi ad partially outside the U.S., complicated icome ad expese allocatio issues arise, where a idividual s taxable icome exceeds the threshold amout (a higher icome idividual ), certai types of service busiesses are treated as ot qualified, although may of the rules for determiig the busiess activities to be so treated are ambiguous, ad for a higher icome idividual, the QDI deductio is subject to a formulistic ceilig based o the idividual s allocable share of each busiess W-2 wages ad/or uadjusted tagible asset basis. Qualified busiess. A Qualified Busiess is ay trade or busiess other tha (a) the trade or busiess of performig services as a employee ad (b) i the case of a higher icome idividual, a specified service trade or busiess (a SSB ). For a idividual with overall taxable icome from all sources (icludig, e.g., both CG ad QDI ad before subtractig the QBI deductio) exceedig a threshold amout ($415,000 for a joit retur taxpayer ad $207,500 for a separate retur taxpayer), a SSB does ot costitute a Qualified Busiess so that such a higher icome idividual is ot etitled to ay QBI deductio with respect to icome flowig through from such a SSB. For a idividual with overall taxable icome withi a phase-out rage (more tha $315,000 but ot above $415,000 for a joit retur ad more tha $157,500 but ot above $207,500 for a separate retur), the QBI deductio with respect to a SSB is ratably phased out over the phase-out rage so that such idividual is etitled to a QBI deductio with respect to oly part of the icome from the SSB. Each of the followig is a taited SSB: Exclusio (i) Exclusio (ii) ay... busiess ivolvig the performace of services i the fields of health, law, accoutig, actuarial sciece, performig arts, cosultig, athletics, fiacial services, brokerage services, or ay... busiess where the pricipal asset of such... busiess is the reputatio or skill of 1 or more of its employees or owers, or 4

5 Exclusio (iii) ay... busiess which ivolves the performace of services that cosist of ivestig or ivestmet maagemet, tradig, or dealig i securities (defied i Code 475(c)(2) [as meaig corporate stock, partership iterest i a widely held or publicly traded partership, evidece of idebtedess, otioal pricipal cotract, or derivative thereof]), partership iterests, or commodities proposed IRS regulatios iterpret several of these exclusios arrowly. 5 For example, the proposed regulatios iterpret exclusio (ii) as ecompassig oly a busiess where a perso receives fees for (x) edorsig products or services, (y) allowig use of the perso s ame, image, or trademark, or (z) appearig at a evet or o radio, televisio, or aother media. With respect to exclusio (i) the 2018 proposed regulatios adopt a taxpayerfavorable arrow iterpretatio that performace of services: 5 i the field of health meas provisio of medical services by... health care professioals... directly to a patiet, ad does ot iclude operatio of health clubs or health spas..., research, testig, ad maufacture ad/or sales of pharmaceuticals or medical devices, 5 i the field of law meas performace of services by... lawyers, paralegals, legal arbitrators, mediators, ad similar professioals, ad does ot iclude... priters, delivery services, or steography services, 5 i the field of accoutig meas services by... accoutats, erolled agets, retur preparers, fiacial auditors, ad similar professioals, icludig tax retur ad bookkeepig services, 5 i the field of cosultig meas professioal advice ad cousel to cliets to assist the cliet i achievig goals ad solvig problems (e.g., with a govermetal agecy or legislator), ad does ot iclude services other tha advice ad cousel, 5 i the field of fiacial services meas services provided by fiacial advisers [ad] ivestmet bakers to cliets icludig maagig wealth, advisig cliets with respect to fiaces, developig retiremet plas [or]... wealth trasitio plas, [providig]... advisory... services regardig valuatios, mergers, 5 The proposed regulatios state that taxpayers may rely o them pedig issuace of fial regulatios. 5 MORE

6 acquisitios, dispositios, restructurigs,... ad raisig fiacial capital, ad does ot iclude takig deposits or makig loas, 5 i the field of brokerage services, icludes a perso who arrages trasactios betwee a buyer ad seller with respect to securities (as defied i Code 475(c)(2) [quoted i exclusio (iii) above]) for a commissio or fee, thus coverig stock brokers ad other similar professioals, but does ot iclude services provided by real estate agets ad brokers, or isurace agets ad brokers. However, with respect to exclusio (iii), the 2018 proposed regulatios adopt a taxpayer-ufavorable broader iterpretatio of ivestig ad ivestmet maagemet services which, ulike brokerage services i exclusio (i), does ot limit taited ivestig ad ivestmet maagemet services to services with respect to securities. Rather, this category covers a busiess ivolvig the receipt of fees for providig ivestig, asset maagemet, or ivestmet maagemet services, icludig providig advice with respect to buyig ad sellig ivestmets, apparetly icludig securities, real estate, or ay other property. But maitaiig the theme of treatig real estate as a favored idustry, the regulatios state that this category does ot iclude directly maagig real property. With respect to tradig or dealig i securities (geerally defied by Code 199A as stock, debt istrumets, partership iterests, otioal pricipal cotracts, ad commodities), the 2018 proposed regulatios state that this exceptio covers regularly purchasig... ad sellig securities... i the ordiary course of a... busiess o behalf of customers or for the perso s ow accout. Based o the statute ad proposed regulatios, it appears that: 5 for a PE/VC fud which ivests i stocks, debt istrumets, ad/or partership iterests, maagemet fees eared by the fud s GP etity or maagemet compay fall withi the SSB exclusio, 5 for a real estate fud, the result for the fud s GP etity or maagemet compay are the same except that fees [eared by the fud s GP etity or maagemet compay] for directly maagig the fud s real property do ot fall withi the SSB exclusio, 5 whether OI flowig through to a fud s GP ad LPs from busiess activities coducted by the fud (or by a flow-through portfolio compay owed by the fud) fall withi the SSB exclusio depeds o the ature of the uderlyig busiess activities. Applicatio of 199A to multiple related busiesses. The 2018 proposed regulatios provide several rules to address a SSB coducted i cojuctio with a o-taited busiess: 6

7 First, if less tha 5% of a busiess s gross receipts (10% for a busiess with $25 millio or less aual gross receipts) are attributable to the SSB, the busiess is ot treated as a SSB. Secod, a busiess that would ot otherwise be a SSB is so treated if (i) it provides 80% or more of its property or services to a SSB ad (ii) there is 50% or more commo owership of the two busiesses. Third, a busiess that would ot otherwise be a SSB is treated as part of a larger SSB if it (i) has 50% or greater commo owership with a SSB, (ii) has shared expeses with the SSB, ad (iii) o a stad-aloe basis has gross receipts represetig o more tha 5% of the total combied gross receipts of the two busiesses. Applicatio of SSB exclusio to higher icome idividual. For a idividual with overall taxable icome (icludig CG ad QDI ad before subtractig the QBI deductio) exceedig $415,000 for a joit retur taxpayer or $207,500 for a separate retur taxpayer, a SSB is ot a Qualified Busiess. For a idividual with overall taxable icome withi a phase-out rage (more tha $315,000 but ot above $415,000 for a joit retur ad more tha $157,500 but ot above $207,500 for a separate retur), the QBI deductio ratably phases out over such rage. Taxpayer with more tha 1 qualified busiess. A idividual s QBI deductio is the sum of the QBI amouts determied as set forth above for each of the taxpayer s qualified trades or busiesses, i.e., 20% of the idividual s QBI with respect to each such Qualified Busiess for the taxable year but subject, for a higher icome idividual, to a W-2 wages/uadjusted asset basis limitatio (as discussed below). Reductio of QBI for taxpayer s reasoable compesatio for services redered to flow-through etity. While the QBI reduced rate does ot apply to compesatio received by the idividual taxpayer for services redered to the flow-through etity, the amout of such compesatio-related exclusio (subtractio) from the idividual s QBI ca vary substatially, depedig o the busiess orgaizatioal form: 5 Partership or LLC. Where the Qualified Busiess is a partership or LLC ad the idividual service provider is a parter or member, parter status trumps employee status, so ay amout the parter receives that is determied without regard to the [etity s] icome (emphasis added) is treated as a Code 707(c) guarateed paymet, thus ot qualifyig for Code 199A s reduced icome tax rate ad hece (for Code 199A purposes) is subtracted from the parter s K-1 icome. However, there is o obligatio for the etity to pay reasoable (or ay other) amouts of guarateed paymets to a parter/service provider. 7 MORE

8 5 Sole proprietorship. Where a idividual operates a Qualified Busiess as a sole proprietorship, o icome of the sole proprietorship is excluded from QBI because the idividual is a service provider. 5 S corp. Where a Qualified Busiess is owed through a S corp ad a shareholder provides services to the S corp, the S corp must pay (or if it does ot, IRS ca impute) reasoable compesatio to the idividual as a service provider. This reasoable compesatio from the S corp to its shareholder/service provider (whether actually paid or merely imputed) does ot qualify for (i.e., must be subtracted from) the shareholder/service provider s S corp icome to which the reduced Code 199A rate applies. W-2 wages ad asset basis limitatio for higher icome idividual. For a idividual with overall taxable icome (before applyig the QBI deductio) above a threshold amout ($415,000 for a joit retur ad $207,500 for a separate retur), the QBI deductio from each Qualified Busiess is limited to the greater of: 5 50% of the idividual s allocable share of W-2 wages paid by such Qualified Busiess ad properly allocable to QBI or 5 the sum of (i) 25% of the idividual s allocable share of such W-2 wages paid by such Qualified Busiess plus (ii) 2.5% of the idividual s allocable share of such Qualified Busiess s uadjusted basis immediately after acquisitio of all qualified property. This W-2/asset basis limitatio does ot apply to a idividual whose taxable icome (before applyig the QBI deductio) does ot exceed $315,000 for a joit retur or $157,500 for a separate retur. For a idividual whose icome (before applyig the QBI deductio) falls withi the phase-out rage (more tha $315,000 but ot more tha $415,000 for a joit retur ad more tha $157,500 but ot more tha $207,500 for a separate retur), the QBI deductio from each Qualified Busiess is limited to the greater of (i) the QBI deductio amout determied without applicatio of the W-2/asset basis limitatio, but with such amout ratably phased out over the phase-out rage, or (ii) the QBI deductio determied with applicatio of the W-2/asset basis limitatio. 5 W-2 wages. I the case of a busiess coducted by a partership (icludig a LLC) or S corp, each parter (or member) or S corp shareholder is treated as payig W-2 wages i a amout equal to such perso s allocable share of the etity s W-2 wages. Where a partership or LLC s parters/members are also service providers, IRS takes the positio that parter/member status trumps employee status, so o 8

9 compesatio for services performed by such perso couts toward the W-2 wage-based limitatio. Similarly, a idividual caot receive W-2 wages from his or her ow sole proprietorship. The W-2 wage-based limitatio makes the amout of the QBI deductio highly depedet o the techical form of legal relatioship betwee a Qualified Busiess ad its service providers. 5 Qualified property. Qualified property meas tagible depreciable property (icludig depreciable real estate) (i) which is held by, ad available for use i, the qualified busiess at the close of the taxable year, (ii) which is used at ay poit durig the taxable year i the productio of qualified busiess icome, ad (iii) for which the depreciable period has ot eded before the close of the taxable year. For this purpose, the depreciable period for a item of qualified property eds o the later of (i) 10 years after the property was first placed i service by the taxpayer ad (ii) the ed of the last full year i the property s Code 168 depreciatio period. The uadjusted basis of such property should mea its tax basis before takig ito accout ay depreciatio deductios, icludig the 100% deductio for certai tagible property allowed i taxable years. Each parter, LLC member, or S corp shareholder is treated as havig uadjusted asset basis i a amout equal to such parter s or S corp shareholder s allocable share of the partership s or S corp s uadjusted asset basis. Nettig of icome ad losses from multiple qualified busiesses. Where a idividual ows iterests i multiple Qualified Busiesses, some geeratig profits ad others losses, egative QBI from a Qualified Busiess is etted agaist positive QBI from other Qualified Busiesses, ad if the sum of all QBI Amouts is egative, such egative amout is carried forward to subsequet years (as a offset agaist subsequet years positive QBI amouts). Oe busiess or multiple busiesses. Whether a idividual is egaged i a sigle busiess or i multiple busiesses affects several parts of the Code 199A aalysis: First, whether certai activities costitute a SSB may hige o whether the activities are combied with or separated from other busiess activities of the idividual. 9 MORE

10 Secod, the W-2/asset basis limitatio is calculated separately for each Qualified Busiess. Calculatio of this limitatio chages depedig o whether certai busiess activities are combied with or separated from other busiess activities. The 2018 proposed regulatios permit aggregatio of busiesses oly if the taxpayer ca demostrate that: 5 The same perso or group of persos directly or idirectly ows 50% or more of the busiesses to be aggregated, 5 Such owership exists for a majority of the applicable taxable year, 5 The aggregated items of taxable icome or deductio are reported o returs usig the same taxable years, 5 Noe of the busiesses is a SSB, ad 5 The busiesses to be aggregated satisfy at least 2 of the followig 3 factors: (i) (ii) (iii) they provide products ad services that are the same or customarily offered together, they share facilities or share sigificat cetralized busiess elemets, ad they are operated i coordiatio with, or i reliace upo, oe or more of the busiesses i the aggregated group (for example, supply chai iterdepedecies). See discussio at Formatio ad operatio of PE/VC fud l Post year holdig period requiremet for PE/VC fud s idividual GP to qualify for reduced LTCG tax rate o carried iterest CG. A idividual ivestmet professioal (icludig a PE/VC fud s GP) holdig a carried iterest i a ivestmet partership (i.e., a share of partership profits disproportioate to cotributed capital) has log bee etitled to the LTCG tax rate (which is lower tha the OI rate) for his or her allocable share of carried iterest CG o assets held by the fud more tha 1 year. New Code 1061, effective for taxable years begiig after 12/31/17, imposes a special 3-year holdig period requiremet i order for such a ivestmet professioal s carried iterest gai to achieve LTCG status. The relevat holdig period for 1061 is the holdig period of the asset that is sold ad produces gai recogized by the holder of the applicable partership iterest. Thus, where a ivestmet fud sells a asset at a gai (e.g., stock i a portfolio compay), 1061 focuses o 10

11 the fud s holdig period i such asset, rather tha the ivestmet professioal s holdig period i the partership iterest with respect to which he or she is allocated such gai. Specifically, if a applicable partership iterest is held (directly or idirectly) by a idividual, LTCG that would otherwise be recogized by the idividual with respect to that iterest is recharacterized as STCG (ad hece taxable at the higher OI rate) to the extet such et LTCG exceeds the et LTCG that would have bee recogized if the LTCG holdig period was more tha 3 years, rather tha more tha 1 year. A applicable partership iterest is ay partership iterest which, directly or idirectly, is trasferred to (or is held by) the [idividual] taxpayer i coectio with the performace of substatial services by the taxpayer, or ay related perso, i ay applicable trade or busiess. A applicable trade or busiess is a activity coducted through oe or more etities that cosists, i whole or i part of... (A) raisig or returig capital ad (B) either (i) ivestig i (or disposig of) specified assets (or idetifyig specified assets for such ivestig or dispositio), or (ii) developig specified assets. Specified assets iclude corporate stock, debt istrumets, equity iterests i widely held parterships, ad real estate held for retal or ivestmet. The applicable partership iterest defiitio is aimed at a partership iterest held by a ivestmet professioal of a private equity, veture capital, debt, or hedge fud who: (a) (b) (c) shares i fud carried iterest or icetive allocatio through partership iterests i the fud s GP etity, acquires or holds such GP iterest i coectio with performace of substatial services for the GP etity or for a affiliated maagemet compay etity, ad performs activities (through a GP or maagemet compay etity) which icludes raisig ad/or returig capital as well as ivestig i, disposig of, idetifyig, ad/or developig specified assets for the fud. The statute provides three specific exceptios from the defiitio of applicable partership iterest. First, Code 1061(c)(1) excepts a iterest held by a perso... employed by aother etity... coductig a trade or busiess (other tha a applicable trade or busiess) [who]... oly provides services to such other etity. This exceptio appears iteded to exclude from 1061 a employee of a operatig busiess (e.g., a maufacturig corporatio) who might ow a partership iterest i a holdig partership that i tur ows the operatig corporatio s stock. Secod, Code 1061(c)(4)(B) excepts ay capital iterest i the partership which provides the taxpayer with a right to share i partership capital commesurate with... the amout of capital cotributed, which should apply where a ivestmet professioal 11 MORE

12 ivests capital i the fud (directly or through the GP etity) at the same time, ad i exchage for the same iterest i partership capital, as passive fud ivestors. Third, Code 1061(c)(4)(B) excepts ay iterest i a partership directly or idirectly held by a corporatio. This exceptio appears broader tha likely iteded. It is sesible to except a C corp from Code 1061 because C corps do ot beefit from a reduced tax rate o LTCG. However, because a S corp does pass through the character of LTCG, Treasury/IRS quickly aouced i Notice its itetio to issue regulatios (retroactive to 1/1/18) providig that this statutory exemptio for partership iterests held by a corporatio does ot apply to a partership iterest held by a S corp. Although legal authority for Notice ad the iteded regulatios is questioable, they reach a sesible result, hece we doubt may taxpayers will feel comfortable takig a cotrary positio. Code 1061(b) cotais a fourth exceptio To the extet provided by the Secretary,... [for] icome or gai attributable to ay asset ot held for portfolio ivestmet o behalf of third party ivestors. This exceptio appears iteded to exempt from 1061 recharacterizatio gais attributable to a PE fud s eterprise value (as distict from value attributable to carried iterest i assets held by the PE fud), although the beefit of this exceptio may be limited if it requires effectuatig Treasury regulatios. Nettig 1061-taited gais ad losses. Uder 1061 s formula, where a taxpayer is allocated 1061-taited CG (i.e., gai from a applicable partership iterest with respect to assets meetig the ormal 1-year holdig period but ot the year holdig period), the amout of such taited gai is reduced by both: (i) (ii) ay 1061-taited CL allocated to the taxpayer (from applicable partership iterests with respect to assets meetig the ormal 1-year holdig period but ot the 3-year holdig period) ad ay et LTCL allocated to the taxpayer from applicable partership iterests with respect to assets meetig the full 3-year holdig period. Techiques to maximize satisfactio of 1061 s 3-year holdig period. Where PE fud makes multiple ivestmets i a sigle portfolio compay (for example, to fud a add-o acquisitio or other busiess expasio), PE fud will have differet holdig periods for each of its ivestmets i such portfolio compay, so that 1061 s 3-year requiremet may be satisfied with respect to the fud s first ivestmet but ot its subsequet ivestmet(s). PE fud should (where possible) structure follow-o ivestmets i a portfolio compay to miimize risks of creatig 1061 STCG. For example, where portfolio compay is a corporatio, all of its shareholders could cotribute capital to the corporate portfolio compay i proportio to their existig shareholdigs without 12

13 acquirig ay ew shares of stock. Uder curret law, the ew ivestmet should merely icrease the tax basis of the existig stock, ot start a ew holdig period (although a proposed regulatio, if fialized, would apparetly chage this result by creatig a deemed issuace of additioal stock). However, where ot all the corporate portfolio compay s shareholders participate pro rata i the follow-o ivestmet, a simple capital cotributio is ot attractive, as a ecoomic matter, to those shareholders providig the additioal capital, sice their capital cotributios would beefit all shareholders, eve those ot participatig pro rata i the follow-o ivestmet. I such case, the participatig shareholders could provide the additioal capital i exchage for the corporate portfolio compay s iterest-bearig ote or fixed-yield preferred stock, so the participatig shareholders are etitled to a priority retur of their follow-o capital ivestmet plus a fixed yield, but ufortuately their potetial for appreciatio i the ew iterest would the be lower tha if they had received additioal commo stock. Where the portfolio compay is a partership/llc, rather tha a corporatio, either a capital cotributio or a preferred equity ivestmet ito the partership portfolio compay would achieve the desired tax result because IRS regulatios bifurcate a parter s equity iterest ito two pieces oe equity piece with the origial holdig period ad a secod equity piece with a ew holdig period startig o the date of the ew ivestmet, with the proportios based o the relative FV of the ew ivestmet ad the old partership iterest (valued immediately prior to the ew ivestmet). Moreover, a portio of ay gai iheret i the old partership iterest at the time of the ew ivestmet is allocated to the ew partership iterest with the ew holdig period, ad if oly a portio of the partership iterest is later sold, o separate idetificatio ca be made to sell the portio of the partership iterest with the loger holdig period first. However, it may be feasible to structure a follow-o ivestmet i a partership or LLC portfolio compay without startig a ew holdig period i the etity s commo iterests by purchasig (a) a debt istrumet rather tha equity or (b) a preferred partership iterest which is held by a separate etity (likely a partership or LLC) owed by the participatig parters. I additio, eve if the parters desire, e.g., for busiess reasos, to make the follow-o ivestmet through a additioal commo iterest i the partership, they ca do so through a separate etity (e.g., a ew partership/llc owed oly by the parters who are participatig i the ew ivestmet), i.e., the ew ivestmet would ot be made by the participatig parters directly ito the partership. This approach avoids taitig a portio of the existig built-i gai i the existig partership iterests (if ay) with a ew holdig period. It also allows the participatig parters, 13 MORE

14 i a partial exit sceario, to sell the commo iterests with the loger holdig period first, retaiig the commo iterests with the shorter holdig period, e.g., util they have achieved a 3-year holdig period. Oe potetially useful structure to accommodate follow-o ivestmets i a corporate portfolio compay is for PE fud ad the other ivestors to form at the outset a holdig partership or LLC to ow 100% of the corporate portfolio compay s stock. Whe a follow-o ivestmet is subsequetly made, (a) the ivestors buy ew commo or preferred equity uits i the holdig partership, with each ivestor receivig such additioal ecoomic rights i the holdig partership as are egotiated by the parties ad (b) the holdig partership the cotributes the additioal cash (received from PE fud ad the other ivestors) to the portfolio corporatio as a capital cotributio with respect to the holdig partership s pre-existig commo stock ivestmet i the portfolio corporatio. I this sceario PE fud ad the other ivestors take a partial ew holdig period with respect to their iterests i holdig partership based o the follow-o ivestmet. However, uder existig rules, the holdig partership should ot have a ew holdig period i ay of its corporate portfolio compay stock (although a proposed regulatio, if fialized, would apparetly chage this result by creatig a deemed issuace of additioal stock). A later sale of corporate portfolio compay would be structured as holdig partership s sale of corporate portfolio compay s stock, ot as the ivestors sale of their partership equity. The 1061 holdig period (for gai from holdig partership s sale of its portfolio corporatio stock) would begi at the time of holdig partership s iitial purchase of portfolio corporatio s commo stock, hopefully more tha 3 years before holdig partership s ultimate sale of portfolio corporatio s commo stock. Where PE fud ows portfolio compay stock some or all of which has a moretha-1-year but less-tha-3-year holdig period ad PE fud wats to realize some or all of its FV with respect to the ivestmet while avoidig 1061 recharacterizatio, several approaches may be helpful, depedig o the facts: First, if PE fud ows multiple lots of portfolio corporatio stock with differet holdig periods a fact patter most likely where PE fud made multiple ivestmets i portfolio corporatio which later had a IPO prior to PE fud s sales of portfolio compay s stock PE fud ca sell stock first from ay lot with a 3-year holdig period, retaiig other lots util they have achieved a 3-year holdig period. Secod, PE fud may realize a portio of its value i portfolio corporatio by causig portfolio corporatio to make a divided distributio that would be taxed as QDI, sice QDI is taxed at the LTCG rate for a ivestmet professioal without regard to whether PE fud has a year holdig period i the stock o which the 14

15 distributio was made. I additio, such divided reduces the stock s remaiig FV, without reducig PE fud s tax basis i the stock, thus reducig the amout of gai i the stock that could (o PE fud s ultimate sale of such stock) be recharacterized as STCG uder Code Third, Code 1061 does ot trigger gai o assets distributed by PE fud to GP with respect to carried iterest. Thus, if PE fud makes a i-kid distributio of portfolio compay stock to GP etity with respect to its carried iterest (where permitted by the fud s partership agreemet), followed by GP etity s distributio of such stock to its ivestmet pricipals, a ivestmet pricipal (a) could avoid Code 1061 STCG treatmet by waitig to sell the stock util the tacked holdig period (for PE fud ad the pricipal) reaches 3 years ad (b) may be outside the scope of Code 1061 eve if the pricipal sells the stock before reachig a 3-year tacked holdig period (at least where the sale is ot part of a pla that icludes the sale of similar property by PE fud or other parters). Fourth, if PE fud recogizes carried iterest gai from sale of a ivestmet with less tha a 3-year holdig period, the fud s partership agreemet may permit GP to waive its right to carried iterest distributios ad allocatios from such sale ad istead to receive subsequet distributios ad allocatios i a amout equal to the waived carried iterest gai from PE fud s future gai o the sale of a differet PE fud ivestmet that has met Code 1061 s 3-year holdig period. Where properly structured ad permitted by PE fud s partership agreemet, such a waiver should (a) prevet GP from beig allocated carried iterest gai o PE fud s sale of the ivestmet that has ot met Code 1061 s 3-year holdig period (so o gai is recharacterized uder 1061) ad (b) allow GP istead to take a icreased carried iterest gai allocatio o a future sale of a ivestmet that has met Code 1061 s 3-year holdig period. See discussio at (2). l Ivestmet Compay Act of A PE/VC fud would geerally fid it uworkable to operate as a ivestmet compay required to register uder (ad comply with) the excessively complicated Ivestmet Compay Act of However, there have log bee two ICA exemptios available to a PE/VC fud: l l the 100-or-fewer-ivestors exemptio afforded by ICA 3(c)(1) ad the 100% QP exemptio afforded by ICA 3(c)(7). Almost all PE/VC fuds are structured to qualify for either 3(c)(1) or 3(c)(7) exemptio ad hece oly a few have registered uder the ICA, usually as a BDC. A 2018 amedmet to ICA 3(c)(1), while retaiig the 100-or-fewer limitatio for most 3(c)(1) fuds, allows a qualifyig veture capital fud to avoid ICA registratio if 15 MORE

16 it has o more tha 250 (rather tha o more tha 100) beeficial owers. A qualifyig veture capital fud is a fud: (i) (ii) (iii) (iv) (v) with o more tha $10 millio (periodically idexed for iflatio) i aggregate capital cotributios plus ucalled capital commitmets, ad which represets itself to its limited parters (e.g., i its private offerig memoradum) as a veture capital fud, ot as a hedge, private equity, LBO, or multi-strategy fud, ad which makes at least 80% of its ivestmets i equity securities of etities which were ot 1934 Act registered compaies at the time of such ivestmet, ad which does ot offer redemptio or similar rights to its limited parters (or to ay other fud security holders), except for extraordiary circumstaces, icludig those that are foreseeable but uexpected, ad which does ot borrow or icur guaratees exceedig 15% of the fud s aggregate capital cotributios plus ucalled committed capital ad ay such debt or guaratee must satisfy other requiremets. See discussio at ad l Secodary sale of PE/VC fud LP iterest. If a PE/VC fud (formed as a partership or LLC) is treated as egaged i a U.S. trade or busiess (either because of the fud s ow activities or, more ofte, because the fud ows a equity iterest i oe or more portfolio compaies formed as parterships or LLCs ad egaged i U.S. trade or busiess), a o-u.s. LP who sells a iterest i such fud at a gai is taxable i the U.S. o a portio of such gai as icome effectively coected with a U.S. trade or busiess ( ECI ), triggerig a U.S. tax paymet ad tax filig obligatio. Begiig i 2018, if such a o-u.s. LP sells a iterest i a partership (icludig a PE/VC fud) that holds ECI assets, the buyer is geerally required to withhold ad pay over to IRS a amout equal to 10% of the gross amout realized by the sellig o-u.s. LP. This withholdig tax obligatio may substatially exceed ay U.S. tax that the seller would owe (e.g., where oly a small portio of the partership s assets are ECI assets) ad may eve exceed the etire sale proceeds (because the amout realized from sale of a partership iterest icludes the sellig LP s share of partership-level liabilities). If the buyer fails to pay such required withholdig, the partership is itself obligated to withhold the required amouts (plus iterest) from distributios that would thereafter have bee made to the buyer (although IRS has suspeded this secodary withholdig obligatio pedig issuace of further guidace). Uder the statute ad a 2018 IRS otice (which is effective pedig further guidace), a buyer is ot obligated to withhold tax if it receives a certificatio: 16

17 l l l l from the seller that the seller is a U.S. perso, or from the seller that the seller is ot recogizig ay gai from the trasfer, or from the seller that less tha 25% of the seller s allocated icome with respect to the partership iterest for each of the 3 precedig taxable years was ECI, or from the partership that, if the partership were to sell its assets at FV, less tha 25% of the gai realized o such asset sale would be ECI. For a post-2017 sale of a LP iterest, both the fud s GP ad the LP-iterest buyer should esure that appropriate certificatios, represetatios, ad idemities are obtaied to protect the buyer ad the fud from risk of liability for failure to comply with this tax withholdig obligatio. See discussio at l DOL prohibitio o LP ivestmet i PE/VC fud by small beefit pla without sophisticated adviser. I 4/16 DOL promulgated complex ad legthy rules (the 2016 Fiduciary Rule ) that (whe effective) would prevet a PE fud from commuicatig (orally or i writig) with a small beefit pla (icludig a IRA), i.e., oe that does ot have a substatial fiduciary, regardig the possibility of such beefit pla makig a LP ivestmet i the PE fud. DOL repeatedly delayed the 2016 Fiduciary Rule s effective date ad, although the rule became applicable (i part) i 6/17, it was ivalidated i 6/18 whe the Fifth Circuit Court of Appeals vacated the rule o the groud that it was arbitrary, capricious,... ot i accordace with law or i excess of statutory... authority. See discussio at l Taxpayer-adverse chage i deductibility of miscellaeous itemized deductios, icludig PE/VC fud maagemet fee allocable to idividual. I the past a idividual parter i a PE/VC fud was etitled to a miscellaeous itemized [federal icome tax] deductio for his or her share of the fud s maagemet fee which is ot allocable to a busiess activity (to the extet all of such idividual taxpayer s miscellaeous itemized deductios from all sources exceeded 2% of his or her AGI). Effective for 2018 through 2025 a idividual is deied ay deductio for a miscellaeous itemized expese (arisig out of a ivestmet, as opposed to a busiess, activity). After 2025 a idividual ca agai deduct miscellaeous itemized deductios to the extet exceedig (i the aggregate) 2% of AGI. See discussio at (4). Purchase of busiess, icludig LBO l Choice of acquisitio etity after 12/17 Tax Act. Prior to 2018, the top idividual federal tax rate (39.6%) was oly modestly higher tha the top corporate federal tax rate (35%) ad was sigificatly lower tha the 48% effective federal tax rate o icome first eared by a C corp ad the distributed as QDI to (or realized as LTCG by) a idividual (i.e., 35% + (65% 20%)), with this 48% effective rate icreasig if corporate-level state icome taxes 17 MORE

18 were icluded i the calculatio. As a result, it was geerally advatageous for a idividual to coduct icome-geeratig activities through a flow-through etity (such as a partership, LLC, S corp, or sole proprietorship) rather tha a C corp. For 2018 ad later years, the tax advatage of a flow-through etity over a C corp is far less clear. Takig ito accout oly federal icome taxes, the effective rate o icome eared by a C corp ad distributed as QDI to a idividual is ow 36.8% (i.e., 21% + (79% 20%)): (a) (b) which is ow slightly lower tha the 37% top idividual OI rate where idividual owers of a flow-through etity do ot qualify for ay Code 199A flow-through rate reductio, but still higher tha the 29.6% idividual OI rate (where a flow-through etity s earigs do qualify for Code 199A s maximum idividual rate reductio). Moreover, the corporate tax rate advatage i (a) above with respect to curretly distributed corporate icome is typically reversed if the corporatio is subject to state icome tax. But with a C corp structure, the idividual-level QDI or CG tax ca be deferred if the C corp retais its icome ad its shareholders do ot sell their stock (ad would be permaetly avoided if a shareholder holds such stock util death). The immediate 21% C corp federal icome tax rate as compared to the immediate 37% idividual flow-through federal icome tax rate (or eve the 29.6% reduced immediate federal icome tax rate where Code 199A s maximum idividual flow-through rate reductio applies) will likely cause may idividuals to choose to hold icome geeratig activities though a C corp (rather tha through a flow-through etity) where the C corp expects to retai ad reivest its after-tax icome for a substatial period (rather tha to quickly distribute its after-tax icome) ad the C corp s shares are expected to be retaied by the curret owers for a substatial period, especially where its shareholders are elderly. See discussio at There are, however, several reasos the parties might prefer to ow a operatig busiess through a partership/llc: (a) Delaware partership/llc law (if the etity is formed i Delaware) allows the majority owers who cotrol the etity to virtually elimiate fiduciary duty claims by the etity s miority owers as well as from ew miority ivestors who subsequetly ivest i the partership/llc (e.g., if the miority equity owers were to disagree with the majority owers o timig or pricig for a ultimate sale of the busiess). This is a goal they could ot achieve if the busiess was simply formed as a corporatio (where virtually complete waiver of fiduciary duties is ot valid), 18

19 (b) (c) (d) without utilizig a partership or LLC as the holdig compay through which the equity owers hold their iterests i the corporate busiess. It is ofte easier to draft a complicated ecoomic arragemet through the provisios of a partership/llc distributio waterfall rather tha i a corporate charter. A partership/llc holdig compay (owig a corporate operatig compay) accommodates a exit structure i which the lower-tier corporate operatig compay is sold by the upper-tier partership/llc so that the partership/llc agreemet cotiues to gover the parties sharig of ay post-sale positive adjustmets (e.g., escrows ad ear-outs) ad egative adjustmets (e.g., idemificatio claims) to the sale proceeds. The busiess s service providers ca receive partership (or LLC) profits iterests i the partership/llc which are subject to Rev. Proc s more pro-serviceprovider-lv approach tha are 83 s FV approach for corporate stock. The parties may be able to obtai most of the tax ad o-tax advatages discussed above by formig the operatig busiess as a C corp owed (wholly or predomiatly) by a partership or LLC, which is i tur owed by the ivestors ad service providers. See discussio at (2), , ad (1). l Utilizig represetatio ad warraty isurace i coectio with the acquisitio of a busiess. Whe BuyerCo is acquirig Target, egotiatig extesive cotractual represetatios ad warraties ( R&W ) regardig Target s assets, liabilities, fiacial statemets, customers, profitability, etc., is ofte highly cotetious, as are the cotractual ceiligs, deductibles, ad time limits for post-closig damage/idemificatio claims. A reasoably recet developmet, which is becomig icreasigly popular, is R&W isurace, i.e., buyig a R&W isurace policy from a isurace compay as a alterative to Target or its equity owers beig liable after the acquisitio has bee cosummated for cotractual R&W breaches. Ofte buyer ad seller work together sharig the premium paid to the R&W isurace compay to buy such a policy with a stated maximum isurace amout ad specified deductibles. Such a R&W isurace policy ca replace all or a large portio of the seller s cotractual R&W idemificatio risk i exchage for a premium, typically 3% to 4% of the amout of isurace coverage. For example, if BuyerCo s acquisitio price for Target is $100 millio, BuyerCo might seek a R&W isurace policy with total coverage betwee 10% ad 50% of the acquisitio purchase price, i.e., betwee $10 millio ad $50 millio of isurace coverage o a $100 millio acquisitio. The premium payable to the isurace 19 MORE

20 compay typically 3% to 4% of the isurace coverage would thus be i the $300,000 to $400,000 rage for $10 millio of isurace coverage or i the $1.5 millio to $2 millio rage for $50 millio of isurace coverage. The R&W isurace policy would typically call for a retetio amout (similar to a deductible) equal to 1% to 1.5% of the acquisitio price, so that o a $100 millio acquisitio BuyerCo ad/or Target (or Target s owers) would bear the first $1 millio to $1.5 millio of R&W losses before the isurace kicks i. Ad the isurace compay would the cover losses (i excess of the retetio amout) up to the policy amout. Although subject to egotiatio betwee BuyerCo ad Target, both the premium ad the retetio amout are ofte split betwee BuyerCo ad Target (or Target s owers), possibly Arragig R&W isurace ofte takes oly 7 to 14 days. See discussio at l Acquisitio debt fiacig ew Code 163(j) limitatio o busiess iterest deductio where busiess etity s et iterest expese exceeds 30% of its EBITDA (or post-2021 exceeds 30% of its EBIT). Code 163(j), as eacted i 12/17, effective for taxable years begiig after 12/31/17, limits the deductibility of busiess iterest expese for all types of taxpayers icurrig busiess iterest expese C corps, S corps, parterships, ad idividuals (icludig sole proprietorships), with exceptios discussed below. C corp. For 2018 ad later years, a C corp s deductio for busiess iterest expese is geerally limited to (a) the C corp s busiess iterest icome plus (b) 30% of its adjusted taxable icome. For taxable years, adjusted taxable icome is based o federal taxable icome, with add-backs for et iterest, depreciatio, ad amortizatio expeses. 6 For 2022 ad later taxable years, the limit becomes more restrictive, as the add-back for depreciatio ad amortizatio expeses is elimiated. 7 Iterest that is o-deductible as a result of this limitatio is carried forward idefiitely by the C corp, treated as busiess iterest expese icurred i each succeedig taxable year, ad subjected to Code 163(j) s 30% limitatio i each such succeedig taxable year. Where the C corp s state icome tax base is affected by the 163(j) iterest deductio limitatio (because the state icome tax calculatio starts with federal taxable icome ad hece is affected by the Code 163(j) rules), a 163(j) disallowace of iterest 6 A modified EBITDA approach, although after subtractio of state ad local icome taxes. 7 A modified EBIT approach, although after subtractio of state ad local icome taxes. 20

21 expese icreases the C corp s state icome tax liability, which reduces the C corp s federal taxable icome ad adjusted taxable icome, which results i additioal 163(j) disallowace of iterest expese i a iterative fashio. If a C corp holds busiess assets ad icurs busiess idebtedess through oe or more parterships, the Code 163(j) rules applicable i determiig the deductibility of partership-level iterest expese must be layered o top of the rules applicable at the C corp level. I the case of a affiliated group of corporatios filig a cosolidated retur, Treasury/IRS has aouced its itet to issue regulatios applyig 163(j) o a cosolidated group basis. 5 Busiess iterest expese ad icome. Busiess iterest expese is iterest paid or accrued o idebtedess allocable to a busiess (ot icludig ivestmet iterest), ad busiess iterest icome is iterest icludible i gross icome allocable to a busiess (ot icludig ivestmet icome), all as defied i Code 163(d). Treasury/IRS has aouced their itetio to issue regulatios clarifyig that, solely for purposes of sectio 163(j),... i the case of a taxpayer that is a C corporatio, all iterest paid or accrued by the C corporatio... will be busiess iterest withi the meaig of sectio , ad all iterest o idebtedess held by the C corporatio that is icludible i the gross icome of such C corporatio will be busiess iterest icome withi the meaig of sectio Adjusted taxable icome. A C corp s adjusted taxable icome for a taxable year is the corp s federal taxable icome for such year computed without regard to several items: l Ay busiess iterest expese ad ay busiess iterest icome are igored. l Ay NOL carryover deductio is igored. l For years begiig after 12/31/17 ad before 1/1/22, ay deductio allowable for depreciatio, amortizatio, or depletio is igored. Applicatio to partership/llc. Where busiess iterest expese is icurred by a partership or a LLC taxed as a partership, Code 163(j) applies first at the partership level ad a secod time at the equity ower level. As with a C corp, subject to exceptios for certai categories of busiesses, a partership s deductio for busiess 21 MORE