Tax Issues Every Person Working With Start-Ups Should Know October 10, 2016

Transcription

1 Tax Issues Every Person Working With Start-Ups Should Know October 10, 2016 Saba Ashraf Ballard Spahr LLP (215)

2 Choice of Entity 2

3 Choice of Entity THE BASICS 3

4 Tax Rates

5 Tax Rates - Individuals Type of Income: Ordinary Income 39.6% Long-Term Capital Gains 23.8% Short-Term Capital Gains 43.4% Dividends 23.8% Interest, Rents, Royalties, Annuities Current Tax Rate:* 43.4% *These rates include the Net Investment Income Tax (also somtimes called the Medicare tax) of 3.8% on investment income of individuals that have adjusted gross income of over $200,000, and $250,000 for married taxpayers filing jointly. 5

6 New Medicare Tax on Unearned Income For the first time, since 2013, there is a a Medicare tax on unearned (i.e., investment) income of individuals. Tax is 3.8% of modified adjusted gross income above a threshold: - $250,000 (joint return or surviving spouse). - $125,000 (married filing separate). - $200,000 (other cases). 6

7 New Medicare Tax on Unearned Income Unearned income includes active business income of a partnership if the partner does not actively participate in the business. - Incorporates concepts from passive activity loss rules. Same rule for S corporation shareholders. 7

8 Tax Rates - Individuals Individuals To get favorable capital gains tax rate, must be long-term. Long-term means more than 1 year. Holding period begins the day after the property is acquired and ends on the date of disposition. Some exceptions: - Depreciation recapture: ordinary rates (35% maximum (currently). - Unrecaptured section 1250 gain (gain on the sale of depreciable real property that is not recaptured as ordinary income): 25% maximum. - Collectibles (art work, rugs, antiques, metals, gems, stamps, coins, alcoholic beverages): 28% maximum. - Gain on qualified small business stock (QSBS) held for five years (Code Section 1202). 8

9 Capital Gains Rates Other Entities Pass-through entities S Corps, partnerships, most LLCs pass through capital gains. So, an individual partner will pay tax at the maximum 20% (currently) rate on his or her share of the partnership s long-term capital gain. However, REIT dividends still generally taxed at ordinary rates (35% maximum). - Exceptions: REIT capital gain dividends; REIT dividends attributable to dividends the REIT itself receives from C Corps; Dividends to the extent the REIT pays corporate-level tax. 9

10 Capital Gains Rates What is a Capital Gain? Capital asset is defined negatively: it s any property, with 5 exceptions. Code Section Generally, it is property held for investment Exception 1: Stock in Trade - No capital gains if the property is stock in trade of the taxpayer or other property of a kind which would properly be included in the inventory of the taxpayer if on hand at the close of the taxable year, or property held by the taxpayer primarily for sale to customers in the ordinary course of his trade or business. - Vague multi-factor analysis (used especially for real estate): Frequency and continuity of sales Purpose for which the property was acquired and held (investment?) Efforts to subdivide, develop, improve Sales efforts (including ads, use of agents) Time between acquisition and sale Taxpayer s other real estate activities and income - one of the key questions in determining whether property is for investment or not is whether the increase in its value was attributable to market factors, rather than to the work performed. 10

11 Capital Gains Rates What is a Capital Gain Exception 2: Depreciable Business Property - Depreciable property, or real property used in a trade or business. - Under Code Section 1231, this can be better than a capital asset. Such property used in a trade or business yields: - Capital gains if there are net gains (subject to possible recapture). - Ordinary losses if there are net losses. (Ordinary losses are 100% deductible while capital losses are subject to an annual deduction limitation of $3,000 for individuals.) - Depreciation deductions (other than land). - Includes buildings, machinery, land, timber, and other natural resources, unharvested crops, cattle, livestock and leaseholds that are at least a year old. 11

12 Capital Gains Rates What is a Capital Gain Other Exceptions: - Self-created copyrights, compositions, memoranda, and the like. - Accounts or notes receivables acquired in the ordinary course of trade or business for services rendered or from the sale of property described in the first exception. - Certain U.S. government publications. Related Party Rules: - No capital gains on sale of depreciable assets between related taxpayers. Code Section No capital gains on a sale to a controlled partnership. Code Section 707(b)(2). 12

13 Tax Rates - Corporations Type of Income: Ordinary Income 35% Capital Gains 35% Dividends Current Tax Rate: 35% (unless qualify for dividends received deduction) 13

14 Tax Rates - Corporations Regular C Corps No capital gains preference for regular C Corps. C Corps still may need to worry about capital gains. A C Corp cannot deduct any capital losses except against capital gains. 14

15 Choice of Entity C Corporation - Computes taxable income separate from that of its shareholders. Unless and until the corporation makes a distribution to the shareholders, the shareholders should not have taxable income. - A corporation s losses are separate from that of its shareholders. Shareholders cannot use the corporation s losses. Losses carryover with it even if it is sold (subject to exceptions). - Example: In 2016, a corporation has $100 of income and has a 35% federal tax rate. The corporation distributes $65 of income to its shareholders (after paying tax of $35). If the distribution is a dividend, the shareholders receive net proceeds of $49.53 ($65 x 23.8% = $15.47 of tax) 15

16 Choice of Entity Partnership or LLC with two or more members - Partnerships do not pay income tax. Rather, items of partnership income flow-through to the partners. Similarly, if a partnership has losses, those losses flow through to the partners and the partners are able to use them against their income from other sources (subject to various limitations). - The character of income (ordinary income v. capital gains) is determined at the partnership level. However, the tax is actually paid by the partners themselves based on the type of taxable person the partner is. For example, if the partner is an individual and the character of the income he receives from the partnership is capital gain, he will pay tax on it at the 20% rate. - When the partnership has taxable income, each partner reports that income. When the partnership actually distributes the income to its partners, the partners should not have additional tax. This means that partners will have income even if the partnership does not make a distribution of its earnings. - Can elect to be taxed as a corporation, but default rule is taxation as partnership. 16

17 Choice of Entity S Corporation - Generally do not pay income tax. Instead, similarly to partnerships, the items of income flow-through to the S corporation shareholders. - When the S corporation has taxable income, each shareholder reports that income. When the S corporation actually distributes the income to its shareholders, the shareholders should not have additional tax. This means that shareholders will have income even if the S corporation does not make a distribution of its earnings. - The character of the income (ordinary income v. capital gains) is determined at the S corporation level. - Confirm that S corporation election is valid. It s easy to fail to comply with the numerous procedural requirements. (100 shareholders, no non- U.S. shareholders, only single class of stock, timely filed election). 17

18 Choice of Entity Single Member LLC - An LLC with only one member is disregarded for U.S. federal income tax purposes. - This means that a transaction that an owner conducts with a single member LLC has no income tax consequences. 18

19 Comparison of Entities

20 LLC/Partnership S Corporation C Corporation Limited Liability Generally yes for all members (with LLCs, LLPs, and LLLPs). Yes for all shareholders. Yes for all shareholders. Levels of Federal Income Tax One Generally one, unless it was formerly a C corporation. Two. Number of Owners At least two. May be taxable as a corporation if publicly traded, or treated as a tax nothing if only one member. One to 100. No restrictions. 20

21 LLC/Partnership S Corporation C Corporation Tax Rates No U.S. federal income tax imposed Generally, no U.S. federal income tax imposed. However, in circumstances where it is imposed, it is currently 35% Currently 35%. Historically, C corporations had rate advantage as compared with individuals. Now equal. Capital Gains Tax Rate Capital gains flow through to owners, so if owner is individual, lower CG rate applies. Capital gains flow through to owners, so if owners is individual, lower CG rate applies. No tax break for capital gains of a C corporation. 21

22 LLC/Partnership S Corporation C Corporation Tax-Related Transfer Restrictions Generally no. May be taxable as a corporation if publicly traded. Technical "termination" on certain transfers. Yes. Transfer to an ineligible shareholder terminates S status. Cannot exceed 100 shareholders. No Tax Restrictions on Converting to Other Form Generally can convert tax free. Generally can convert tax free only to C corporation. Generally can convert tax free only to S corporation (if eligible). 22

23 LLC/Partnership S Corporation C Corporation Participation in Tax-Free Corporate Mergers/ Acquisitions No Yes Yes Employment Tax on Owner/ Employee Self-employment tax on share of business income to general partners, and to limited partners on guaranteed pay for services. Unclear treatment of LLC members. Owner-employees are subject to FICA/FUTA on compensation, but not on other distributions. Owner-employees are subject to FICA/FUTA on compensation, but not on other distributions. 23

24 LLC/Partnership S Corporation C Corporation Issue Equity Interest to Service Provider Without Current Tax to Recipient Generally, can issue a profits interest without current tax. Proposed legislation may change that. No. May be able to defer tax on receipt of it. No. May be able to defer tax on receipt of it. May be able to argue a low value, especially if different class. Allow new member/ shareholder coming in to contribute appreciated property tax-free Generally, yes. Generally, only if new person, along with other shareholders that are contributing property at such time will own 80%+ of corporation. Generally, only if new person, along with other shareholders that are contributing property at such time will own 80%+ of corporation. 24

25 LLC/Partnership S Corporation C Corporation Allow a purchaser of an equity interest to receive a stepped-up tax basis with respect to the assets of the entity. Yes, by making a Section 754 election. Yes, but only if a purchaser purchases 80%+ of stock of S corporation and makes a Section 338(h)(10) election. Yes, but only if a purchaser purchases 80%+ of stock of corporation and makes a Section 338(h)(10) election, which may only be made if corporation being purchased is a subsidiary of another corporation. 25

26 LLC/Partnership S Corporation C Corporation Special Considerations for Non-U.S. Investors -Non-U.S. partner or member s share of taxable income will be withheld on. -Non-U.S. person that is not otherwise subject to U.S. tax may become subject to U.S. tax, as it may be deemed to be engaged in U.S. trade or business. -May be subject to branch profits tax if corporate investor. Cannot have any non-u.s. investors, as it would terminate S status. Non-U.S holders not subject to tax additional tax unless and until the U.S. corporation makes a distribution to them. -Liquidating distributions, and gains on sales of stock of corporation generally not subject to withholding tax. 26

27 Choice of Entity DEEPER DIVE 27

28 State Law LLCs Taxed As S Corporations

29 State Law LLCs Taxed As S Corporations In the past few years, entities that are formed as state law LLCs, but that elect to be taxed as S corporations, are became more and more common. Non-tax benefits put forth for having a state LLC: - Operational ease, from a corporate law perspective - LLCs are not required to have formal meetings and keep minutes. - Fewer restrictions on profit-sharing within an LLC as members distribute profit 29

30 State Law LLCs Taxed As S Corporations (Cont.) Benefits put forth for being taxed as an S corporation: - Retain flow-through tax status of entity, similar to partnerships (though different in some key respects) - Generally, an owner of an LLC (taxed as a partnership) is considered to be self-employed and must pay self-employment taxes with respect to LLC income. - In contrast, a shareholder of an LLC must pay payroll taxes with respect to his/her reasonable compensation. However, distributions that are not compensatory are not subject to employment taxes. - Employment taxes are generally 15.3%. For 2016, for income above $118,500, only the Medicare portion is levied at 2.9%. An additional 0.9% applies and raises the 2.9% to 3.8% for individuals with income above $200,000 ($250,000 for joint filers). 30

31 State Law LLCs Taxed As S Corporations (Cont.) Treas. Reg (c)(v)(C) provides: An eligible entity that timely elects to be an S corporation under section 1362(a)(1) is treated as having made an election under this section to be classified as an association, provided that (as of the effective date of the election under section 1362(a)(1)) the entity meets all other requirements to qualify as a small business corporation under section 1361(b). Subject to (c)(1)(iv), the deemed election to be classified as an association will apply as of the effective date of the S corporation election and will remain in effect until the entity makes a valid election, under (c)(1)(i), to be classified as other than an association. Thus, a state law LLC may elect to be taxed as an S corporation by timely filing a completed IRS Form 2553 (assuming it meets the other requirements to qualify as a small business corporation). The LLC need not undertake two steps to be taxed as an S corporation: (1) file IRS Form 8832 to be taxed as a corporation, and (2) file IRS Form 2553 to make an S election for such corporation. 31

32 State Law LLCs Taxed As S Corporations: Potential Issues Unreasonable compensation. The IRS may recharacterize S corporation distribution as wages subject to employment taxes, when the compensation is less than reasonable. The IRS seems to be stepping up enforcement activity in this area and often successfully challenges. See David E. Watson, P.C., 668 F.3d 1008 (8th Cir. 2012) Recent high-profile examples of uses of S corporations to avoid selfemployment taxes: Former House Speaker Newt Gingrich, Senator John Edwards. There have also been legislative proposals to treat an S corporation s distributive share of income from an S corporation engaged in a personal service business as self-employment income, for employment tax purposes. 32

33 State Law LLCs Taxed As S Corporations: Potential Issues (Cont.) S corporation carries certain restrictions: - Under partnership taxation, profits and losses can be allocated with some flexibility, but all S corporation profit and loss distributions must be made pro-rata by shares. - S corporations are limited to 100 shareholders, whereas partnerships do not have tax-related limitations on the number of owners. - S corporation shareholders must be individual U.S. citizens or certain trusts, whereas members of LLCs taxed as corporations may include corporations, other LLCs and alien members. 33

34 State Law LLCs Taxed As S Corporations: Potential Issues (Cont.) Most LLC operating agreements are drafted to reflect partnership taxation principles. Accordingly, conflicts can easily arise between the governing documents and the actual tax election. Biggest issue is whether there is more than one class of stock. While S corporations shares may have differences in voting rights, they must carry identical rights to distributions and liquidation proceeds. If the LLC operating agreement provides for varying rights as to distributions or liquidation proceeds at any time, the one-class-of-stock requirement likely is violated. 34

35 State Law LLCs Taxed As S Corporations (Cont.) How is a state law LLC taxed, if its election to be taxed as an S corporation is invalid for some reason? - As a C corporation? - As a partnership? What if the initial election is valid, but later there is failure to meet one of the requirements to continue to qualify as an S corporation? 35

36 Qualified Small Business Stock

37 Qualified Small Business Stock Qualified Small Business Stock ( QSBS ) - 100% of the gain from the sale of QSBS stock can be excluded from income in the case of stock acquired after September 27, In addition, unlike previous years, the excluded gain is not an item of preference for AMT purposes. - There are several key requirements that must be met in order for the gain to be excludible. - Amount of gain that can be excluded by each taxpayer is the greater of (i) 10x the taxpayer s basis in the stock, or (ii) $10 million. 37

38 Qualified Small Business Stock 1. Corporation must be a qualified small business : C Corporation. Section 1202(c)(1). Eligible Corporation (not a DISC, RIC, REMIC, FASIT) The benefits of Section 1202 do not apply to equity interests acquired and held in pass-through entities 38

39 Qualified Small Business Stock 2. The stock must have been directly acquired via an original issuance from the U.S. C corporation. Section 1202(c)(1)(B). Purchasing stock from another shareholder will not qualify. Stock must be acquired in exchange for money or other property, or as compensation for services performed for such corporation (other than underwriting services. Incorporation of a partnership. Section 1202(h)(1) provides that in the case of a transfer from a partnership to a partner of stock with respect to which the requirements of Section 1202 stock (without regarding to the 5- year holding period requirement) are met, that the transferee (partner) shall be treated as (i) having acquired the stock in the same manner as the transferor, and (ii) having held such stock during any continuous period immediately preceding the transfer. Legislative history to Section 1202 makes it clear that stock acquired through the exercise of options or warrants, or through the conversion of convertible debt, is also treated as acquired at original issuance. 39

40 Qualified Small Business Stock Stock acquired by gift or by death also treated as acquired at original issuance provided the stock was QSB in the hands of the transferor. Stock Held Through Pass-Through Entities. Where an individual owns an interest in a partnership (including an LLC treated as a partnership), and the partnership owns stock of a QSB, the individual s share of gain attributable to the sale of QSB can be excluded. In order for gain allocated to the individual by the partnership to qualify: - The gain must be attributable to the partnership s sale or exchange of stock which is QSB in the hands of the partnership (i.e., meets all of the requirements to be QSB stock treating the partnership as an individual for this purpose and was held by the partnership for more than 5 years), and - The individual s share of such gain must be attributable to a partnership interest held by such individual on the date on which the partnership acquired the QASB stock and at all times thereafter until the disposition of the QSB stock by the partnership 40

41 Qualified Small Business Stock 3. Gross Asset Test. The aggregate gross assets of the corporation at all times before and immediately after the issuance of the stock do not exceed $50 million. Section 1202(d)(1). The corporation must agree to submit to the IRS and its shareholders any reports that the IRS may require to carry out the purposes of Section To date, the IRS has not promulgated any guidance relating to either the timing or required content of any reporting requirements that may apply. 41

42 Qualified Small Business Stock 4. Active Business Test. At least 80% (by value) of the assets of the corporation must be used by it in the active conduct of qualified trades or businesses. Section 1202(e)(3). The term qualified trade or business means any trade or business other than: - Any trade or business involving the performance of services in the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, or any trade or business where the principal asset of such trade or business is the reputation or skill of 1 or more of its employees, - Any banking, insurance, financing, leasing, investing, or similar business, - Any farming business (including the business of raising or harvesting trees), - Any business involving the production or extraction of products of a character with respect to which a deduction is allowable under section 613 or 613A, and - Any business of operating a hotel, motel, restaurant, or similar business. Note that for purposes of both this requirement and the Gross Asset Test, stock of subsidiares owned more than 50% is looked-through. 42

43 Qualified Small Business Stock 5. Holding Period. - The holding period of QSB stock begins on the date of issuance. - Special tacking rules apply if the QSB is converted into other stock of the same corporation, or if the QSB stock is acquired as a gift, by inheritance, or as a transfer from a partnership. - The holding period also tacks in the case of QSB stock exchanged for stock of another corporation that is treated as QSB stock in a transaction described under Section 351 or Note that a shareholder other than a corporation can rollover the gain on sale of stock held for more than 6 months if proceeds used to purchase QSBS in another company. 43

44 Qualified Small Business Stock When it may make sense: - 5-year holding period expected - Other requirements are met - There is not expected to be a need to extract cash from the corporation (by way of dividends or otherwise) during the operational phase of the business, so that the double corporate level tax is not a significant issue - Expected investor base is non-corporate taxpayers that will benefit. - Expected investor base and/or management engages in diligence to ensure that it is a QSB, and that ongoing requirements, including reporting, are met. - Exit is expected to be a stock sale, and not an asset sale. - The potentially lower purchase paid for stock by the buyer is not greater than the tax savings of the sellers on sale. 44

45 Taking Into Account Tax on Exit

46 Taxation on Exit Aside from the ability of losses to pass through to investors, the tax consequences of a potential exit strategy may be the most significant tax factor in the choice of entity process. In exiting, not only do the seller s tax consequences have to be taken into account, but so do the buyer s. - As a general matter, a buyer will prefer an acquisition structure that results in a stepped-up tax basis to the buyer in the assets of the acquired business. 46

47 Taxation on Exit Seller Considerations - If own interest in a partnership or DRE, then generally, similar tax consequences if assets or interests sold. - However, if own interest in a corporation, very different consequences. - Example, A owns 100% of the stock of a C corporation. A sells the stock of the C corporation for $1,000,000. Generally, 23.8% federal tax of $238,000. After-tax proceeds of $762,

48 Taxation on Exit Seller Considerations continued. If sell assets. Corporation will sell assets for $1,000,000 and pay 35% federal tax on the gain. (Assume basis of 0). After tax proceeds for corporation = $650,000 On receipt of distribution, A will pay additional tax of $154,700 ($650,000 x 3.8%). After-tax proceeds of $495,

49 Taxation on Exit Buyer Considerations: - If a buyer purchases stock of a C corporation, the buyer will have a stepped up tax basis in the stock of the corporation. However, stock is not a depreciable asset, so this results in no immediate tax benefit. - If a buyer purchases assets of a business, the buyer obtains a stepped-up tax basis in the assets of the business. Generally, the assets of an operating business should be depreciable/amortizable, which means that the buyer will have resulting amortization/depreciation tax deduction, which will lower the buyer s or its subsidiaries income. 49

50 Taxation on Exit Example: Buyer purchases a business s assets for $1 million. Assets are mostly goodwill, which is amortizable over a 15 year period for tax purposes. $66,667 of tax deductions per year. Assuming a combined federal and state income tax rate of 40%, this results in tax savings of $26,667 per year. Present value at a discount rate of 6% = $260,000. For this reason, many Buyers will offer less money if purchasing in a structure where they do not obtain this benefit. 50

51 Taxation on Exit Stepped-up tax basis for buyer: - Yes, on purchase of actual assets - Generally, no on purchase of C corporation Section 338(h)(10) election only available generally if buying corporate subsidiary of another corporation. - Generally, no on purchase of S corporation, unless Section 338(h)(10) election is made. Must meet requirements - Yes, on purchase of 100% of interests in a partnership - Generally, yes, on purchase of less than 100% of interest in a partnership. 51

52 Minimizing Employment Taxes for Owners 52

53 Minimizing Employment Taxes For Owners THE BASICS 53

54 Partners Cannot be Employees

55 Partners Cannot be Employees The IRS s point of view was expressed in 1969: Bona fide members of a partnership are not employees of the partnership within the meaning of [the Code]. Such a partner who devotes his time and energies in the conduct of the trade or business of the partnership or in providing services to the partnership as an independent contractor, is, in either event, a self-employed individual.... Rev Rul , CB 256 IRS still holds this view. 55

56 Partners Cannot be Employees The law is reasonably well-settled that for tax purposes partners are not considered employees of their own partnership Instead, partners who work for their partnerships are considered self-employed Of course the same is true for LLC members Partners receive a Schedule K-1 each year and not a Form W-2 56

57 Withholding Federal Insurance Contributions Act ( FICA ) and income taxes are withheld from employees paychecks - Employee generally does not file quarterly estimated income tax - FICA is not paid with annual Form For FICA taxes, the employee pays ½ of the tax while the employer pays the other ½ There is no payroll tax withholding on partners - Partner typically files quarterly estimated income tax and annual Form Self-Employment Contributions Act ( SECA ) is also paid through quarterly tax and on annual Form Partner pays 100% of SECA 57

58 SECA Compared to FICA SECA and FICA are equal: - Both comprise: Old-age, survivor and disability insurance ( OASDI ) or social security component, plus Hospital insurance or Medicare component - SECA rates: OASDI rate of 12.4%, on the first $118,500 of wages (in 2016), plus Medicare rate of 2.9% on all amounts -- no ceiling - Plus starting in 2013 an additional 0.9% Partners are allowed a deduction for ½ of the self-employment tax paid. 164(f) (but not for the 0.9% Medicare)* SECA equals combined rate of employer's and employee's share of FICA 58

59 Income Subject to SECA Self-employment tax is payable on net earnings from self-employment. 1402(a) Generally includes all business income Does not include: Dividends Rental from real property Capital gain Interest on any bond, debenture, note, certificate, or other evidence of indebtedness, issued with interest coupons or in registered form. 1402(a)(10) payments to retired partners 59

60 Comparing SECA and FICA - Since partner pays 100% of SECA, but employee pays only 50% of FICA, a partner in a service partnership will pay more on a given amount of net earnings from self-employment than an employee will pay on the same amount of wages - Should a partner be paid more than a comparable employee, to take SECA into account? 60

61 SECA and Limited Partners Limited Partners are subject to SECA only on guaranteed payments for services. Code 1402(a)(13) Are LLC members general partners or limited partners? Proposed regulations from 1997 would have provided guidance on when LLC members (and also partners in partnerships) would be treated as limited partners for purposes of selfemployment tax. Prop Reg (a)-2 The proposed regulations became a political hot potato; they won t be finalized without direction from Congress 61

62 LLC Members as Limited Partners Under the 1997 Proposed Regulations, a partner is not treated as a limited partner if the partner: - Has personal liability for the debts of or claims against the partnership by reason of being a partner; - Has authority to contract on behalf of the partnership under the statute or law pursuant to which the partnership is organized; or - Participates in the partnership's trade or business for more than 500 hours during the taxable year However, for service partnerships (in health, law, engineering, architecture, accounting, actuarial science, or consulting), any individual who provides services as part of the partnership s trade or business will not be considered a limited partner 62

63 Other Differences Between Being Employee and Partner

64 Deduction of Business Expenses One potentially significant benefit of partnership treatment is that a partner is entitled to deduct business expenses. 162 An employee may only deduct business expenses to the extent they -- along with other miscellaneous itemized deductions -- exceed 2% of adjusted gross income. 67 (and alternative minimum tax is a problem also) 64

65 Phantom Income Employees are generally not taxed on amounts they don t receive. However, - Some non-cash compensation may be taxable - Sometimes deferred compensation may be taxable before it is received Partners are taxed on their distributive share of partnership income, whether or not received - The risk of phantom income (taxable income without a corresponding payment to the partner) can be reduced but never entirely eliminated 65

66 State Tax An employee is only taxable where the employee lives and/or works A partner may be taxable in every state in which the partnership does business Tax credits in the partner s home state can greatly reduce the financial burden, but do not necessarily eliminate it If the home state has no income tax, the tax the partner pays to other states is a pure cost (no offsetting benefit at home) Composite returns, filed by the partnership on behalf of nonresident partners, can greatly reduce the compliance burden, but sometimes increase the amount of tax payable 66

67 Minimizing Employment Taxes DEEPER DIVE 67

68 Converting Partners to Employees?

69 Single Member LLC as Employer Partners A and B receive interests in LLC Holdco, but are employees of LLC, which is wholly owned by LLC Holdco. A B Other Owners LLC Holdco LLC 69

70 Single-Member LLC as Employer Treas. Reg. Section (c)(2)(iv)(B) provides that a disregarded entity is a corporation for purposes of employment taxes. - Therefore, the DRE, rather than the owner is considered to be the employer oft he DRE s employees for purposes of employment taxes. At the same time Treas. Reg. Section (c)(2)(iv)(C)(2) provides that for self-employment tax purposes, the above rule does not apply. The regs went on to illustrate the application of this rule by including an example that says that where an individual owns 100% of an LLC that is a DRE, the DRE is subject to employment tax with respect to the employees of the LLC, but the individual owner, however, is subject to self-employment taxes on the NESE resulting from the DRE s activities. 70

71 Single-Member LLC as Employer It came to the attention of the Treasury Dept and the IRS that some taxpayers were reading the current regulations to allow for the taking of a position that A and B are employees of the single-member LLC. They were also permitted partners (A and B) to participate in certain employee benefit plans. IRS issued regulations on May 4, 2016 shutting this down. This was never their intent. Regulations clarify that partners in a partnership that owns a DRE are subject to self-employment taxes in exactly the same way that partners in a partnership that does not own a DRE. 71

72 Single-Member LLC as Employer Effective Date: - Later of: August 1, 2016 or The first day of the latest-starting plan year of an affected plan sponsored by an entity that is a DRE. 72

73 Single-Member LLC as Employer While these temporary regulations provide that a disregarded entity owned by a partnership is not treated as a corporation for purposes of employing any partner of the partnership, these regulations do not address the application of Rev. Rul in tiered partnership situations. 73

74 LLC Holdco as Employer Partners A and B receive interests in LLC Holdco, but are employees of LLC. A B LLC Holdco Other Owners LLC Since A and B are no longer partners in LLC, can they be employees of LLC? 74

75 S Corp Shareholder as Employer Partners A and B contribute LLC interests to S Corp. A B S Corp Other Owners LLC Since A and B are no longer partners in LLC, can they be employees of LLC (or of S Corp)? 75

76 Granting Equity To Employees in a Tax- Efficient Way 76

77 Granting Equity Interests in a Tax-Efficient Way THE BASICS 77

78 Profits Interest versus Fee versus Stock

79 Profits Interest versus Fee or Compensation 1st key benefit of a profits interest: - Can result in capital gain instead of ordinary income 79

80 Profits Interest versus Fee or Compensation X, an LLC, really values C, an employee X gives C a $100 bonus C has ordinary income of $100. C generally, has to be pay tax of $

81 Profits Interest versus Fee or Compensation Instead of a bonus, C is issued a profits interest in X X sells assets it owns (real estate, stock, securities) and has capital gain $100 of the capital gain is flows through to C C has $100 of capital gain X C 81

82 Equity for Services: Corp vs. LLC 2 nd key benefit of a profits interest: - No taxable income on receipt by the employee 82

83 Equity for Services: Corp vs. LLC An employee or other service provider is taxable on the receipt of C Corp or S Corp stock as compensation for services By contrast, a service provider is generally not taxable on receipt of a vested or unvested profits interest in an LLC as compensation for services to or for the LLC 83

84 Example: Equity for Services A and B have a corporation, X X owns property with a fair market value of $1,000 and the stock of X is worth $1,000 C is an employee and will perform services for X A and B want to give C 1/10 th of the stock of X to provide incentive for him to work for X FMV = $1,000 A B X C services 84

85 Equity for Services: X is a Corp If X is a corporation: - C has taxable ordinary income equal to $100 (assumed to be the value of his interest in X) - This is regardless of whether X is an S corporation or a C corporation 85

86 Equity for Services: X is an LLC If X is an LLC and X is issued a profits interest: - C has no taxable income on the receipt of the profits interest 86

87 Equity for Services: X is an LLC If X is an LLC and X is issued a capital interest: - C has taxable income of $100 (same as if s/he d received stock in a corporation) 87

88 Difference Between Profits Interest/Capital Interest/Stock of Corporation

89 Difference Between Profits Interest, Stock of Corporation and Capital Interest Assume a corporation has only 1 class of stock. Each share of stock entitles its owner to a horizontal slice of: - (i) the corporation s current value (the capital interest ); and - (ii) the corporation s future value which includes (a) future appreciation beyond the date of the acquisition of the interest, and (b) future income (the profits interest ) If 100 shares are outstanding, one share will entitle the owner of 1 share to: 1. 1/100 of the future income (i.e. dividends) of the corporation; 2. 1/100 of the current value of the corporation (if corporation were sold now, such owner would get 1/100 th of value) 3. 1/100 of the future appreciation in value 89

90 Difference Between Profits Interest, Stock of Corporation and Capital Interest By contrast, a unit or interest in an LLC does not entitle its owner to a horizontal slice of everything An LLC Operating Agreement is a contract between the members as to how they are going to share all items 90

91 Difference Between Profits Interest, Stock of Corporation and Capital Interest Pursuant to the contract (the operating agreement) they decide how to share these 3 economic items: 1. Existing value of LLC (Capital Interest represented by distributions if liquidation) 2. Future income of LLC (Profits Interest) 3. Future appreciation in value of LLC (Profits Interest) 91

92 Granting Equity Interests in a Tax-Efficient Way DEEPER DIVE 92

93 Identifying Profits Interest

94 Identifying Profits Interests A, B and C form an LLC. A and B contribute $100 each, and C contributes services. Each of A, B and C gets 100 units. Distribution: - To each of A, B, and C in proportion to their units Is this a profits interest? A $100 B $100 C services 94

95 Identifying Profits Interests A, B and C form an LLC. A and B contribute $100 each, and C contributes services. Each of A, B and C gets 100 units. Distribution: - First return of capital contributions - Second to be shared by A, B, C, in proportion to their units A B $100 C Is this a profits interest? $100 services 95

96 Identifying Profits Interests Same as before, but this time, C comes along a few years after formation of the LLC. By the time C comes along, the LLC is worth $400. Distribution: - First return of capital contributions - Second to be shared by A, B, C, in proportion to their units A B $100 C Is this a profits interest? $100 services 96

97 Identifying Profits Interests If this were a profits interest, if the LLC is sold liquidated years later when its value is $1,000, sale or liquidation proceeds would have to be distributed as follows: A B C Remaining Amount Return of Capital $100 $100 $800 Increase in value immediately before issuance to C $100 $100 $600 Remainder $200 $200 $200 $0 Total $400 $400 $200 97

98 Identifying Profits Interests Same as before, but D comes along a year later at a time when the LLC is worth $600. A and B have the Class A units and C and D have the Class B units. A $100 B $100 C D Distribution: - First to Class A holders to return capital contributions - Second to Class A and Class B unit holders in proportion to their units Is D s interest a profits interest? 98

99 Identifying Profits Interests How do you ensure that is a profits interest? You determine value of the LLC immediately before the units are issued to C (the capital interest), and you make sure this value can only be distributed to the pre-existing members and not to C (often called the Threshold Value ). 99

100 Identifying Profits Interests If this is a profits interest, if the LLC is sold liquidated years later when its value is $1,000, sale or liquidation proceeds would have to be distributed as follows: A B C D Remaining Amount Return of Capital $100 $100 $800 $200 Increase in value immediately before issuance to C $300 Increase in value immediately before issuance to D $100 $100 $600 $100 $100 $100 $300 Remainder $75 $75 $75 $75 $0 Total $375 $375 $175 $75 100

101 Threshold Value Key concept in the issuance of profits interests is that a determination of the value of the LLC immediately prior to the issuance of a profits interest has to be made Who will make that determination? What standards will govern how that determination is made? 101

102 Identifying Profits Interests A, B and C form an LLC. A and B contribute $100 each, and C contributes services. Each of A, B and C gets 100 units. A $100 B $100 C services Distribution of Cash from Operations: - To A, B, C, in proportion to their units Distribution of Cash on Liquidation - To A and B to return their capital contributions - Thereafter to A, B, and C in proportion to their units Is this a profits interest? 102

103 Identifying Profits Interests Distributions of Operating Income A B C Year 1 - $300 $100 $100 $100 Year 2 - $300 $100 $100 $100 Year 3 - $300 $100 $100 $100 Total $300 $300 $300 Distributions on Liquidation Year 4 sale of LLC Proceeds = $1100 First, return of capital A B C $100 $100 Remainder $300 $300 $300 Total $400 $400 $

104 Variations of Profits Interests

105 Variations of Profits Interests Simplest Straight Percentage Sharing: - After return of capital to capital partners, all Members (including member holding profits interest) share in all distributions in a straight/fixed percentage of distributions - Ex: First, return of capital to members that contributed capital Next, to all the members in proportion to their percentage interests/units. (See example on slide 21) 105

106 Variations of Profits Interests Suppose A and B contribute $100 each to an LLC, and give C a profits interest. A, B and C will each have have a percentage interest. Return of Capital Percentage Interests A B C Remaining Amount $100 $100 $800 $ $ $ Total $ $ $

107 Variations of Profits Interests Catch-Up: - Intention is to achieve distributions that are similar or equal to the distributions that the capital partners receive - Intended to be similar to a capital interest or corporate stock - Example: First to return capital contributions of A and B Second to C until C has received distributions equal to what each of A and B received Thereafter to all the members in accordance with their percentage interests or units 107

108 Variations of Profits Interests - A and B contribute $100 each to LLC - After return of capital to A and B, distributions are made to C until C is caught up to A and B Return of Capital A B C Remaining Amount $100 $100 $800 Catch-Up $100 $700 Remainder $ $ $ Total $ $ $

109 Variations of Profits Interests Participate only in Distributions from Capital Events or Liquidating Distributions: - Most commonly used in private equity - Profits interest holders do not get any distributions of operating income - They only have a right to distributions from capital events or liquidating distributions - Example: Distributions of operating income: To A and B only. Distributions on liquidation: To A and B until amount equal to value of LLC interest immediately prior to admission of C has been distributed to A and B. Thereafter to the members in proportion to their profits interest/units. 109

110 Variations of Profits Interests - Example: A and B form an LLC contributing $100 each - C is admitted and given a profits interest upon formation - A and B give C a profits interest that entitles C to only participate in distributions on a capital or liquidity event. C s right is to distribution in such proceeds at 10%. - Years 4, LLC is sold 110

111 Variations of Profits Interests Distributions of Operating Income A B C Year 1 - $200 $100 $100 Year 2 - $200 $100 $100 Year 3 - $200 $100 $100 Total $300 $300 Distributions on Liquidation Year 4 sale of LLC Proceeds = $1000 First, return of capital A (45%) B (45%) C (10%) $100 $100 Remainder $360 $360 $80 Total $460 $460 $80 111

112 Variations of Profits Interests Fixed percentage or dilution over time Parties agree that a certain percentage of profits interests should be set aside for issuances to employees. All the recipients are not identified at the time the LLC is formed. Often parties fail to address adequately what will happen to the reserved profits until such time as all the recipients are identified 112

113 Variations of Profits Interests Example: A and B form an LLC, contributing $100 each. At the time of formation, they decide they will bring in C and give C a profits interest. They expect to identify 4 more employees that will receive profits interests over the next few years. They decide they are going to reserve 10% of the units to be issued as profits interest. Key question: Until such time as the remaining 4 recipients are identified, what will C receive? -10% of all profits? -2% of all profits, with the remainder going to A and B? 113

114 Variations of Profits Interests A B C D E Year 1 - $100 $45 $45 $10 Year 2 - $100 $45 $45 $10 Year 3 - $100 $45 $45 $5 $5 Year 4 - $100 $45 $45 $3.33 $3.33 $3.33 Total $180 $180 $28.33 $8.33 $3.33 A B C D E Year 1 - $100 $49 $49 $2 Year 2 - $100 $49 $49 $2 Year 3 - $100 $48 $48 $2 $2 Year 4 - $100 $47 $47 $2 $2 $2 Total $193 $193 $8 $4 $2 114

115 Variations of Profits Interest Surprisingly, this is not addressed in many agreements. Presumably, the parties want it to go to A and B, as otherwise, C would start out with a very high interest, which would get diluted over time not the ideal way to motivate an employee. 115

116 Requirements for Receipt of Profits Interest to be Tax-Free

117 Receipt of Profits Interest IRS will accept that the receipt of a profits interest in exchange for services is not a taxable event for the partnership or the recipient, if: - The interest isn t related to a substantially certain and predictable stream of income from partnership assets - The interest is not disposed of within two years - The interest is not a limited partnership interest in a publicly traded partnership This is set out in Rev. Proc IRS treats 83 as irrelevant for this purpose 117

118 Unvested Profits Interest Under Rev. Proc , if partnership grants an unvested profits, service provider will not be taxed on receipt or vesting if: - Conditions of Rev Proc are met - Partnership and service partner treat and report service partner as tax owner of the interest and service partner includes its distributive share of partnership tax items for tax purposes - Upon grant or vesting of interest, neither partnership nor any partner takes deductions based on the profits interest at grant or vesting 118

119 Safe Harbor vs. Substantive Law Rev Proc and Rev Proc are safe harbors; follow them and the IRS won t challenge you They are not substantive rules of law, but depart from them and you are thrown back to a confusing mass of authorities - For example, 83 seems irrelevant under the two Rev Procs, but how does 83 apply outside of them? 119

120 Practical Difference Between Vested and Unvested Profits Interest In the case of both vested and unvested profits interests, partner and partnership generally will treat person as receiving interest on grant. From the date of grant, the recipient should start getting K- 1s (and would be treated as a partner). If it is desired that this be avoided, then instead of issuing a profits interest as of Year 1, Day 1 which vests on Year 2, Day 1, the parties may agree that the profits interest would be issued on Year 2, Day 1 if certain targets are met. 120

121 When Does It Make Sense To Move Off- Share? 121

122 When Does It Make Sense to Move Offshore THE BASICS 122

123 Moving Offshore - General Recent articles in the Wall Street Journal, Washington Times and other business publications ALL have headlines saying that more and more U.S. companies are managing to avoid or minimize U.S. taxes payable. For example: - A recent Washington Post article states: Experts say the U.S. code has encouraged companies to shift their income overseas, where it is more lightly taxed by the U.S. government. Many firms, in turn, have discovered that just as they can move their manufacturing to other parts of the world, so, too, can they shift their income to far-flung tax havens such as the Cayman Islands. Companies have also found ways to shift their income across national boundaries, roving from country to country in search of the lowest tax burden. 123

124 Moving Offshore This causes many start-up companies to wonder if this is something they should be planning to do at the outset. The truth is that many articles generally make moving income offshore seem much too easy and gloss over the tax and practical issues raised. 124

125 Moving Offshore Moving or starting off-shore will not be a good strategy for every business or start-up. Companies that implementation of business/tax strategies may work for include: - Companies that have or expect to have significant non-u.s. sales. - Companies that have a lot of IP that generates income may benefit from developing and owning that IP outside the U.S. The companies that benefit from strategy should be willing and able to leave their earnings outside the U.S. for the period during which they are seeking to minimize U.S. taxes. If the earnings are needed in the U.S. on a relatively current basis, then deferral will be minimized. 125

126 Moving Offshore Basic Strategy: - 2 Rules/Principles - First, under the U.S. tax system, income tax is imposed on the worldwide earnings of the U.S. taxpayer. - However, the income of subsidiaries of a U.S. company will not be subject to U.S. income taxes until such time as it is distributed to the U.S. shareholders. Exception to this for certain passive income such as rents, royalties, dividends and interest. Subpart F income also includes income from certain related-party sales and services transactions that have the potential for shifting income to low-tax jurisdictions. - Based on this, the general idea is that for companies that have a lot of their revenue outside the U.S., and that do not need the revenue in the U.S. (to fund expansion or pay U.S. expenses or for other reasons), instead of earning their income directly (i.e., through a U.S. company), they form a subsidiary in a low-tax non-u.s. jurisdiction. 126

127 Moving Offshore Revenues by the subsidiary can be generated off-shore by sales of goods and services in non-u.s. jurisdictions by a seller that is not a U.S. person. In addition, income from IP located outside the U.S. can generate non-u.s. income. - This latter type of income is what concerns many U.S. authorities the most, as they worry that this is stateless income and is income that is particularly easy to move from one jurisdiction to another. What is responsible for more of the profits of big U.S. corporations being earned overseas? Big U.S. corporations are in fact selling more products and services in growing foreign markets. But, they are also moving more of their earnings overseas by moving valuable patents and licenses to foreign subsidiaries. 127