COMPENSATION ISSUES FOR THE STARTUP VENTURE

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1 COMPENSATION ISSUES FOR THE STARTUP VENTURE Structuring Partnership/LLC Non-Qualified Deferred Compensation Before and after Enactment of Section 409A Equity Incentive Compensation Considerations for Both Corporations and Partnerships/LLC s White Paper: Year End Tax Planning Considerations for Flow Through Investment Fund Management Companies, Their Principals and Executives PPT Reasonable Compensation by THOMAS J. RIGGS JD, CPA, MAS O Connor Davies, LLP New York, NY 149

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3 Structuring Partnership/LLC Non-Qualified Deferred Compensation Before and after Enactment of Section 409A Thomas J. Riggs JD, CPA, MAS O Connor Davies, LLP Overview of the Taxation of Deferred Compensation Arrangements Before the Enactment of Section 409A: Property Based Plans Deferred compensation plans which give an employee the right to participate in the appreciation in the enterprise value of a firm are often structured in one of two basic formats. The first format is most commonly a written plan which offers key employees the right to purchase corporate stock or partnership/llc interests in the future, according to a pre-determined plan. Under these types of arrangements, employees acquire an actual ownership interest in the granting entity over time, and as such these types of plans represent the present grant of a future interest in property; that property being shares of stock or partnership interests. These plans typically include a vesting period, coupled with either an optional right of exercise or an exercise right granted according to a predetermined schedule, after vesting has occurred. A share of stock or partnership/llc interest is characterized as property by applicable Internal Revenue Code (The Code ) provisions. The grant of any property interest in exchange for services is governed in general by Section 83 of the Code, along with applicable Regulations and related court cases. The traditional concepts of constructive receipt and economic benefit, as delineated in Code section 451, underpin this body of both statutory and case tax law. In the specific case of deferred compensation plans characterized by the granting of corporate stock options, with the right to exercise and purchase shares at stated future intervals, specific provisions contained within Code Sections 421 and 423 provide a safe harbor statutory roadmap for structuring. For example if a plan meets certain statutory requirements as an Incentive Stock option Plan or ISO, neither the original grant of the options, nor the vesting, exercise or purchase of shares will trigger a taxable event. Only upon the ultimate sale of shares which were awarded upon exercise will taxable income be recognized, in an amount by which the exercise value exceeds any cost basis of the Employee in the shares. At that point, the appreciation inherent in the shares which accrued prior to exercise is generally treated as compensation income, with the post exercise appreciation generally treated as capital gain. In the case of non-qualified corporate plans, neither the execution of the plan nor the vesting of the interest will give rise to a taxable event; but at the time of exercise compensation income must be recognized to the extent that the exercise value exceeds the Employees cost basis in any 151

4 shares awarded. At the time the Employee is required to recognize compensation income upon exercise, the employer is entitled to a corresponding payroll expense deduction, subject to the full withholding requirements as specified elsewhere in applicable Code provisions. In the context of a partnership or LLC, no express statutory roadmap yet exists for structuring grants of the future right to purchase partnership or LLC interests. However, IRC Notice provides useful guidance in this area through a fairly extensive set of proposed Regulations. These proposed regulations act to apply the overall tax framework which currently exists in the area of the grant of future rights of corporate stock, to partnerships and LLC s, and although these proposed regulations have yet to be finalized, it is reasonable to assume that they represent the current thinking of the IRS in this area, and can therefore be relied upon for structuring purposes. V Overview of the Taxation of Deferred Compensation Arrangements Before the Enactment of Section 409A: Non-Property Based Plans The second common format for deferred compensation arrangements which allow key employees to participate in growth in the underlying enterprise value of the firm are referred to as Stock Appreciation Rights (SAR) plans, or in the context of a partnership or LLC, Unit Appreciation Rights (UAR) or Partnership Percentage Rights (PPR) plans. These types of plans differ from property based plans as discussed above, in that instead of allowing for the actual purchase of shares or partnership interests during future intervals, SAR and UAR plans provide for key employees to share in equity appreciation through the grant of a phantom stock or partnership interests. These plans, at inception, grant key employees a hypothetical share of equity, expressed either as a hypothetical number of shares or a percentage of the fair market value of the enterprise determined at the inception of the plan. Then at future intervals, as the overall fair market value of the firm presumably grows, the employee is entitled to receive a cash payment equal to the difference between his hypothetical share of the fair market value that existed at the date of the initial grant, and his hypothetical share as determined at the future date of exercise. In other words the key employee never actually owns an equity interest in his company, but is compensated as if he had. One of the primary advantages of an SAR plan over plans which actually grant future ownership interests is that key employees can be compensated on an incentive basis without diluting the equity interest of existing owners. Another advantage is that the compensated employees do not have to come up with funds to purchase the equity interest at the time of exercise. 152

5 With regard to the tax framework applicable to SAR and UAR plans, they fall under the general category of non-qualified deferred compensation, and since they do not grant actual ownership interests or property in exchange for services, the express provisions of Section 83 do not apply. Instead, the traditional doctrines of constructive receipt and economic benefit are controlling. The result is generally that there are no tax consequences, to either the granting entity or to the employee, upon either the initial grant or the vesting of the interest, as long as the amount of the employees entitlement remains subject to a substantial risk of forfeiture. Only after vesting and ultimate exercise occur, and the employee thereby has access to the remuneration, does the amount of the award generally become taxable as compensation. It should again be noted that as in the case of property based plans, at the time the employee is required to recognize compensation income upon exercise the employer is entitled to a corresponding payroll expense deduction, subject to the full withholding requirements as specified elsewhere in the Code. VI The Enactment of Code Section 409A in 2004 Code Section 409A was enacted in 2004, and applicable Regulations which were proposed in 2005 became final in Section 409A overlays the existing body of law governing the taxation of nonqualified deferred compensation in general; it does not specifically replace that body of law. The basic thrust of Section 409A is to place additional restrictions on non-qualified deferred compensation plans placed into effect after January 1 st, Where a non-qualified deferred compensation plan is subject to 409A but is not in compliance, the result is the immediate recognition of otherwise deferred income, as well potentially triggering certain 20% penalty and related interest provisions. VII The Applicability of Code Section 409A to Partnerships and LLC s: The issuance of options or UARs on partnership or LLC interests is not addressed in Section 409A or in the subsequent proposed and adopted regulations. The Internal Revenue service has stated its intent to issue regulations specific to the issuance of such interests in pass-through entities, pursuant to rules comparable to those set forth with respect to options and SARs in the corporate context, but to date such regulations have not been issued. We must conclude therefore that for purposes of structuring deferred compensation plans for partnerships and/or LLC s, one must apply not only the Code and related case law regarding such non-qualified deferred compensation plans, but the principles of the Section 409A overlay as well. 153

6 Section 409A states that a number of non-qualified deferred compensation arrangements shall be exempt from its provisions. With regard to SAR plans in the corporate context, the regulations specifically exempt such plans as long as three conditions are met by the plan as originally drafted and implemented: - Deferred compensation payable pursuant to the plan cannot be greater than the difference between the fair market value of the phantom interest at inception over the amount of the interest at the date of exercise. - The exercise price of the SAR interest can never be less than the fair market value of the interest at inception. - The SAR plan does not include any feature for the deferral of compensation other than the deferral provided up to and until the date of exercise. By meeting the above requirements, a corporate SAR plan should expressly avoid the strictures imposed by 409A, and thus be subject only to the traditional tax framework in place for such deferred compensation plans in general. Further, even though Section 409A does not specifically address its application in the context of a partnership or LLC, the final regulations specify that the exemption requirements for corporate appreciation rights plans would be consistent with those for partnership or LLC based plans. As such it is reasonable to conclude that compliance with the three conditions stated above would exempt a partnership or LLC plan from the strictures of the 409A overlay as well. Thomas J. Riggs JD CPA MST 154

7 Equity Incentive Compensation Considerations for Both Corporations and Partnerships/LLC s Thomas Riggs JD, CPA, MST Bruce Blasnik CPA O Connor Davies, LLP Plans for Corporations Employee Stock Option Plans Employee stock option plans (SOPs) are a popular form of equity incentive within the corporate setting. With the typical SOP, employees are granted options to purchase a stated number of shares of the company's common stock at a predetermined exercise price, generally equal to the fair value of a share of the issuing company s stock on the date of grant. The options will vest based on time, performance parameters or some combination of the two. The employee will generally have up to ten years from the date of grant to exercise the options as long as the employee remains employed by the Company. If employment is terminated, the terminated employee will generally have up to 90 days after the termination date to exercise the options that have vested. Under the tax code, employee stock options may be designated as either qualified incentive stock options (ISO s) or non-qualified stock options (NQSO s). ISO s provide a potential benefit to the employees, as the difference between the exercise price and fair value of the stock on the date of exercise will not be subject to ordinary income tax as long as the stock is held by the employee for at least one year after exercise 1 ( otherwise there would be a disqualifying disposition). With an ISO, however, the issuing company does not get a tax deduction at the time of issuance or at the time of exercise, but may get a deduction if there is a disqualifying disposition. With NQSO s, the difference between the exercise price of the option and the fair value of the stock on the date of exercise is treated as ordinary income to the employee, subject to income tax withholding and employment taxes. The Company, however, receives a full deduction for the amount includable in the employee s wages. With both ISO s and NSQO s, 1 However, the difference between the fair value of the stock on the exercise date and the exercise price is subject to the alternative minimum tax (AMT). Employees with high earnings or those that exercise a large number of shares within a calendar year may have to pay the AMT

8 the employee s holding period for capital gain treatment begins on the exercise date (unless there is a disqualifying disposition of the ISO shares, in which case there is no capital gain treatment available). For ISO s, the employee s basis is the exercise price, whereas with NSQO s the employee s basis is the fair value at the time of exercise. While still quite popular, SOPs are not nearly as valuable a benefit to employees of private companies as they once were. Prior to 2005, the regulatory and accounting environment for private company SOPs was much different than it is today. Private companies were able to issue NQSOs to employees with a very low exercise price, often $.01, generally without negative tax consequences. 2 This all ended in 2005 when Internal Revenue Code section (IRC) 409A took effect. With the advent of IRC 409A, SOPs became subjected to the relatively harsh rules thereunder governing deferred compensation unless the exercise price on the date of grant is at least equal to the fair value of the underlying stock on the date of grant. As a result, substantially all options issued by private companies since IRC 409A became effective have an exercise price equal to the fair value of the stock on the date of grant. Just one year after IRC 409A became effective, Financial Accounting Standard No. (FAS) 123R, Accounting for Stock-Based Compensation, became effective for private companies, further clouding the landscape for private company stock option plans. As a result of FAS 123R, private companies were no longer allowed to use the intrinsic value method 3 to determine stock-based compensation expense and the disclosure requirements became much more complex. Despite the lingering popularity of private company SOPs, the now decade old changes in the regulatory and financial reporting landscape create several issues that should be considered: In order to comply with both IRC 409A and FAS 123R (now ASC 718) private companies are required to periodically value their stock. Given the complexity of capital structures and option valuation models, it is advisable for those valuations to be performed by a qualified independent valuation professional. Depending on how quickly 2 The Internal Revenue Code provided at the time that as long as the underlying stock did not have a readily determinable fair market value, the granting of a stock option was not a taxable event. 3 Under the intrinsic value method, the expense to be recognized for accounting purposes was equal to the difference between the exercise price of the option and the fair value of the stock on the option grant date

9 a company is growing, such a valuation might have to be performed each time stock options are issued to employees; although most companies can get away with performing these valuations annually, or in some cases every other year. In addition to being expensive, having a valuation performed takes time away from other tasks. The accounting and disclosure requirements for employee stock option plans under generally accepted accounting principles in the United States of America (USGAAP) are quite complex. Under USGAAP, the issuing company must recognize an expense on their books equal to the fair value of the options on the date of grant. The Black-Scholes pricing model 4 is the most common model used to value the options on the grant date, but other, more complex models, might be more appropriate in certain circumstances. This expense is recognized over the vesting period, which can be particularly challenging to determine when vesting is wholly or partially based on performance parameters. Beyond computing the expense associated with the issuance of employee stock options and determining the period over which to recognize the expense, there are a number of detailed disclosures including weighted average exercise price, weighted average vesting periods and expiration dates which are tedious and time consuming to compute each reporting period. And perhaps most significant, within the private company setting, there is often little, if any advantage to either the issuing company or the employees of a SOP over much simpler forms of incentive compensation. This has primarily to do with the fact that there is no market for the private company stock held by employees once an option grant is exercised. The employee has to pay the cash purchase price to exercise the options and perhaps additional cash to pay the taxes where there is a difference between the exercise price and the stock s fair value upon exercise. Yet, unless or until the issuing company is sold, there is generally no way to benefit from the increase in the stock s value over time. For this reason, most options are not exercised until a company is sold. At that point, the stock received is immediately sold for cash, making the entire difference between the exercise price and the cash received by the employee taxable as ordinary income subject to withholding and employment taxes. 4 Under the Black-Scholes pricing model, options are priced using a formula that takes into account a number of factors, the most complex of which is the stock s volatility or a surrogate based on the volatility of a relevant stock index or basket of public company stocks

10 Stock Appreciation Rights Although not as common, stock appreciation rights (SARs) are another equity-based incentive plan alternative for private company s to consider. SARs can provide for the payment of cash or, in the alternative, the issuance of stock upon exercise by the employee. Where the SAR plan provides for the payment of cash, it essentially acts as a deferred bonus arrangement. Cash payout SARs may present an attractive alternative to the founders where they wish to attract and retain key employees but would prefer not to disperse their voting rights or increase the number of actual shares outstanding. However, cash payment SARs may not be appropriate for many private-equity portfolio companies where cash is needed to repay debt and fuel growth. SARs that payout in stock may be better suited for these companies. SARs that provide for the issuance of stock are similar to NSQO s except that, rather than paying an exercise price to receive the shares of stock, the employee receives shares equal in value to the increase in the value of the stock between the grant date and the exercise date. It is the equivalent of a cashless exercise of stock options. The advantage to the employee is that they do not have to pay cash to exercise their options; however, they will end up owning fewer shares. The advantage to the company is that there is less dilution to existing shareholders because they are issuing fewer shares

11 Table 1 NSQO vs SAR Value of stock on grant date (exercise price) $ 2.00 Value of stock on exercise date $ 4.00 No. of shares subject to grant 1,000 NSQO Value of shares on exercise date $ 4,000 Less exercise price (2,000) SAR Appreciation in value $ 2,000 $ 2,000 No. of shares of stock issued 1, Taxable compensation $ 2,000 $ 2,000 Just as with NSQO s, employees who exercise SARs will be taxed at ordinary rates on the difference between the value of the stock on the date of grant and the date of exercise, and the company will receive an ordinary tax deduction for the same amount. The employee may still have to contribute cash to pay the withholding taxes. Any gain from the exercise date forward will be treated as capital gain to the employee (short-term or long-term, depending on how the long the stock is held before it is sold). As with stock options, there is little incentive for an employee of a private company to exercise a SAR unless the company is being sold because the employee may need to come up with cash to pay taxes on phantom income at the time of exercise, while no market exists to provide liquidity for the stock. However, since the cash required to exercise a SAR can be significantly less than the cash required to exercise a stock option (because with an option the employee will need to come up with cash for both the exercise price and the taxes) some employees might be motivated to exercise a SAR in order to lock in long-term capital gains treatment or to avoid having the SAR expire upon termination

12 Restricted Stock Grants Restricted stock grants (RSG s) 5 are generally not suitable for widespread use, but may be appropriate to reward a small number of relatively senior employees. With an RSG, an employee is given shares of stock in a company. This stock generally vests over time; although this is not a requirement. For tax purposes, as long as an employee makes a valid election under IRC 83(b), the fair value of the stock, both vested and unvested, on the date of grant is taxable to the employee as ordinary income subject to withholding and employment taxes. Assuming a valid election under IRC 83(b) 6 is made, the RSG grant date is also the start date for the capital gains holding period. The company receives a current tax deduction equal to the amount taxed to the employee. For financial reporting purposes, the company recognizes the expense over the vesting period, which may result in a deferred tax liability due to the timing difference between when the expense is recognized for tax purposes and when it s recognized for financial reporting purposes. RSG s are particularly useful to help compensate the first few employees of a start-up company. At that time, as long as a valid 83(b) election is made, the tax consequences to the employee are minimal since the stock has little or no value. All future appreciation benefits the employees who also receive favorable capital gain treatment for tax purposes. RSG s are less beneficial to employees of more mature companies (where the stock may have significant value) because of the tax due upon grant. Say, for example, Mary earns $125,000 a year and she receives a RSG worth $75,000 from her employer. Mary will have to come up with about $25,000 to pay the withholding taxes on the grant date and will have to hold the stock until a liquidity event, if and when that occurs, to realize any benefits. In many ways, this has economics similar to exercising a nonqualified stock option. Plans for Partnerships/Limited Liability Companies 5 The term restricted stock grant carries over from the public company setting. In the private company setting all stock is restricted, so these are really just stock grants. 6 Under IRC 83(b) an employee can elect to include the fair value of property received in income on the date of grant even if that property is not yet vested. Without such an election, the value of the property received is included in income when it vests, at which point the value may be significantly higher than it was at the grant date

13 Profits Interests For partnerships or limited liability companies which are treated as partnerships for tax purposes, the profits interest is by far the most common type of equity-based compensation plan in use today 7. A profits interest is very similar to a SAR in that it allows an employee to participate in the future income and growth in value of the awarded interest (often in the form of units). Like SAR plans, profits interests can provide for vesting and for forfeiture upon termination; although neither of these features is required. The tax aspects of profits interests are somewhat complex and more ambiguous than those in the area of stock options, SARs or RSGs. Also, differentiating a profits interest from a capital interest is critical. The distinction is important because a capital interest is generally taxable at the date of grant, whereas a profits interest is not. The proper classification under any particular set of facts may be difficult. Since the wording of the plan itself and/or the underlying operating agreement will be determinative, proper drafting of both is essential. More specifically, a capital interest is defined in the subject Regulations as one in which the recipient or holder would be entitled to a distribution of net cash and/or assets if the company were liquidated on a hypothetical basis, and the above referenced distributions proceeded in accordance with the plan and the underlying operating agreement. The Regulations go on to define a profits interest as any interest which does not constitute a capital interest. Once the threshold issue of profits interest versus capital interest has when dealt with, the issue of vested versus nonvested/contingent interests must be addressed. With respect to a fully vested and noncontingent profits interest ( generally any interest which is not subject to a substantial risk of forfeiture ), Revenue Procedure (Rev. Proc.) provides a safe harbor which renders the grant nontaxable as long as three requirements are met: The grant is made to an individual in his or her capacity of a member of the LLC, or in anticipation of becoming a member of the LLC, in exchange for past or future services. 7 In addition to being used as a type of equity-based incentive for operating partnerships and LLC s, profits interests are typically used by PE and VC funds to incentivize the fund managers. In PE/VC setting the profits interests are generally referred to as carried interests

14 The interest cannot relate to a substantially certain and predictable stream of income such as income from high quality debt securities or a high quality net lease. The recipient must not dispose of the profits interest within two years of receipt. Rev. Proc left a certain amount of ambiguity with respect to nonvested and/or contingent interests, and as such the IRS subsequently followed up with Rev. Proc This later Rev. Proc., which essentially contained a separate safe harbor for nonvested and/or contingent interests, provided that neither the granting nor vesting of such interests will be taxable to the recipient as long as the following requirements are met: The recipient of the profits interest is treated as a member of the LLC for tax purposes with respect to the entire interest (both vested and unvested portions) being granted. The LLC does not take a compensation deduction in connection with the granting or vesting of the profits interest. All the other requirements of Rev. Proc have been met. While the tax treatment of profits interests that meet the requirements of either Rev. Proc or may seem clear, in practice many grants of nonvested and/or contingent interests do not fall squarely within the scope of the fact patterns envisioned by the two Rev. Procs. cited above. For example: Individuals receiving profits interests are sometimes treated as W-2 employees for compensation purpose subsequent to receipt of the grant. This can jeopardize the safe harbor requirement that the recipients be treated as partners. Even if the individual is treated as a member for tax reporting purposes, other limitations on the rights and obligations of the individual receiving the profits interest may preclude him or her from being considered a member by the IRS 8. The profits interest may be granted in an entity other than the entity to which the employee/member provided services to (as would be the case in tiered ownership structures). 8 Under Private Letter Ruling it was concluded, among other things, that a mere right to a percentage of a partnership s income does not make someone a partner absent other rights and obligations of a partner such as the ability to exercise control or the obligation to share in losses

15 A note on Section 83(b) Section 83(b provides, among other things, for a taxpayer to elect to treat the receipt of a future or contingent interest in property in exchange for services (where the interest is subject to a substantial risk of forfeiture and therefore not currently taxable) as the grant of a present and currently taxable interest in the property. Although at first blush this might appear to accelerate the recognition of taxable income, as a practical matter the present valuation of such interests is typically zero (for income tax purposes). In such cases the election has the effect of treating future accretion in value as investment return and hence capital gain, at no current tax cost to the recipient. Although the existence of the Rev. Procs. cited above would appear to obviate the specific need for a Section 83(b) election in the context of a profits interest, many practitioners still recommend making the election as a belt and suspenders approach. Presumably in that case, the election could act to preserve the tax benefits afforded by Rev. Procs and/or even if one of the safe harbor requirements therein were not met. One final point with respect to the Section 83(b) election bears mention here. Some practitioners believe that a profits interest, being a mere promise to receive something in the future, does not meet the statutory definition of property as defined within Section 83. In fact, Regulation Section (e) specifically states that property does not include either money or an unfunded and unsecured promise to pay money or property in the future. The IRS attempted to address this issue in 2005 by issuing proposed regulations that make it clear that partnership interests (both capital interests and profits interests) qualify as property for purposes of section 83(b). Although those proposed regulations, which contain a host of other requirements, have not yet been finalized, most practitioners remain comfortable that the proposed regulations provide the requisite insight into the thinking of the IRS on the topic. A Note on Section 409A This comprehensive statute was enacted in 2004 as part of the American Jobs Creation Act, and it generally provides that any amount of compensation deferred under nonqualified deferred 9 163

16 compensation plans is currently includible in gross income to the extent that the deferred compensation is not subject to a substantial risk of forfeiture and was not previously included in income. However the statute specifically reserved guidance with respect to transactions between partnerships and partners providing services. IRS Notice provided a degree of interim guidance regarding the application of Section 409A to arrangements between partnerships and partners, providing that taxpayers may treat an issuance of a profits interest in connection with the performance of services that is properly treated under other applicable provisions as not resulting in inclusion of income by the service provider at the time of issuance, and thus does not result in deferred compensation as defined in Section 409A. However, the deferral of guaranteed payment compensation owed to partners, as opposed to future returns as contemplated by a profits interest, is still widely believed to come under the strictures of Section 490A. Accounting Requirements Under US GAAP, the accounting for profits interests is similar to the accounting for NSQOs and SARs. The fair value of the profits interest is recognized as an expense over the vesting period (requisite service period). Some have argued that because a profits interest has no current (intrinsic) value at the time of grant there should not be any expense. But using that argument, the same would be true for NSQOs and SARs, which is not the case under USGAAP. And, clearly, there is some value in issuing a profits interest or companies would not bother. Options Granted on Partnership and/or LLC interests Partnerships, or LLCs treated as partnerships, can issue options to purchase units, similar to corporation option plans. The general view is that a Section 83(b) election is not be available to the recipient of an option on a partnership or LLC interest, since the regulations treat the granting of an option for property as a non-event for tax purposes. More specifically, and in the case of

17 the grant of an option on a capital interest in exchange for an exercise price, the treatment should be similar to a NSQO, may subject to the strictures of Section 409A and would generate ordinary income to the holder upon exercise equal to the difference between the fair value of the interest on the date of exercise and the exercise price. Keeping It Simple Can Avoid Problems ISOs, NSQOs, RSGs and profit interests are valuable incentives that allow employees to share in the growth and success of a company. However, the tax and accounting rules affecting the most commonly designed plans are complex, and complying with those rules can be costly. By taking away one feature from these typical plans, many of the headaches and costs can be avoided. That one feature is vesting. As discussed above, owning equity or the right to purchase equity in a private company generally has little value until the company is actually sold or liquidated (unless an individual owns a significant interest, there are annual dividends or distributions or the company has an equity buyback plan). And most employees don t exercise their rights to receive equity until an exit occurs. A right to equity that vests only upon the occurrence of an event not certain to occur (contingent vesting) is not taxable until the contingency is removed, nor is the expense associated with that right recognizable under USGAAP, until and unless the contingent event becomes probable of occurrence. IRC 409A is not applicable, annual external valuations of the Company are not required, and many of the complex accounting disclosures are not relevant. At the time the Company is sold, the employees right to a portion of the proceeds vests. Those proceeds are taxable as ordinary income, subject to employment taxes and withholding, just as it would be with a NSQO or a disqualifying disposition of an ISO. While a non-vesting or contingently vesting equity incentive plan may not be appropriate for the most senior people in a company, it would likely work for everyone else. Conclusion The tax and financial reporting rules covering equity incentive plans for both corporations and LLCs are quite complex. Additionally, other rules relating to the issuance of equity securities not discussed above, such as Regulation D and state securities laws, also need to be considered and appropriately dealt with. Before establishing an equity incentive plan, owners and

18 management should give careful consideration to the benefits and costs of such a plan and what they are hoping to achieve by instituting it. Often, the most popular answer is not the best answer

19 White Paper: Year End Tax Planning Considerations for Flow Through Investment Fund Management Companies, Their Principals and Executives. I. The Interrelationship Between Entity and Owner: With the ever increasing demands placed on hedge fund and private equity principals and executives (which include raising capital, managing portfolio(s), dealing with regulators, etc.) it is not uncommon for personal income and estate planning opportunities to be overlooked. These lost opportunities can occur throughout the life cycle of the entity, but at inception or launch the problem is particularly acute. The unique interplay between management companies and their principles and executives gives rise to significant year end income and estate tax planning opportunities. In this article we will explore several of those opportunities; some of which may be familiar to you, and some which may not. Tax Impact of Your Current Fund Structure Prior to year end is always a good time to reconsider your overall fund structure. Is it the most tax efficient structure for you and your investors? One potential savings opportunity arises by virtue of the interplay between the 3.8% Medicare surtax (i.e., Net Investment Income Tax), the self employment (SE) tax. The legal/tax structure of your fund will typically dictate which, if either of these taxes will apply. Tax savings can sometimes be achieved by converting an existing incentive allocation into an incentive fee. This is particularly true where a fund s trading strategy generates mostly short term capital gains and where an IRC Sec. 475 election is in place. Tax Impact of Your Current Management Company Structure. In a typical fund structure, the management company is set up as a flow through entity; i.e. a limited liability company (LLC), limited partnership (LP), or a Subchapter S Corporation ( Sub S Corp ). These are not tax paying entities at the Federal level in and of themselves, but are instead conduits, meaning that all items of income, expense, gain or loss, along with tax classifications and/or attributes at the entity level, pass through directly to their owners, who ultimately pay the tax on their allocable share(s). It becomes readily apparent, therefore, that tax efficiency in a flow through environment should be analyzed holistically, viewing the entity and its owners essentially as one. For example, anticipated results at the management company level can and should be considered when making tax based decisions at the owner(s) personal level. In a year where a management company s net income is anticipated to be low, certain owners may wish to accelerate personable taxable income from other sources, for example through implementation of a Roth IRA Conversion. In years where net income at the entity level is expected to be high, deferral of income or creating deductions at the personal level is typically paramount. In this latter situation, particular owners may want to consider strategies such as creation of a charitable lead trust or contributions to a personal foundation. 167

20 Conversely, the owners personal tax situation (s) can be the driver for tax based decisions at the entity level. If an owner(s) projected taxable income for a subject year is anticipated to be high, consideration should be given accelerating expenses or deferring income recognition at the entity level. This approach can take various forms, such as by accelerating executive bonuses or reducing current management fee income through transition to a greater carried interest participation. II. Other Topics: The Carried Interest; What s next? Deferred compensation can be a very powerful tool in attracting, retaining, and incentivizing talent, and in this regard there is no more powerful tool than the carried Interest. If structured properly, a carried interest allows an entity to award equity ownership to employees and/or owners, without requiring a cash investment and without triggering income recognition on the part of the recipient. In certain circumstances, such as where an investment fund generates tax advantaged income in the form of long term capital gains and/or qualified dividend income, it can also act to convert ordinary compensation income into long term capital gain. It has recently become fashionable for politicians on both sides of the aisle to attack the carried interest as give away to rich hedge fund managers, when in reality nothing could be further from the truth. The carried interest remains the primary means by which an entrepreneur with an idea but no capital can start and participate in and grow his business as an owner. Nevertheless, both the Republican and Democratic platforms now specifically call for elimination or at least substantial curtailment of the carried interest. Legislation to repeal the carried interest has languished in Congress for several years. However, the writers anticipate that regardless of which political party captures the White House this November, the effort to repeal the carried interest will gain traction. It is therefore incumbent upon fund managers to implement and grant their carried interest awards as soon as possible. Section 457A: Income Recognition of Manager s Deferred Compensation 2008 Legislation required current income inclusion upon vesting of certain nonqualified deferred compensation paid by "tax indifferent" entities. The legislation effectively capped at 10 years, the maximum deferral of such compensation earned prior to January 1, 2009, meaning that such deferred compensation would be taxable no later than the 2017 tax year. Many fund managers managing offshore funds were caught up in this legislation and may therefore have a significant tax liability accruing in Managers affected by this legislation should be planning now for this looming 2017 income recognition event. Private foundation contributions, charitable lead trusts, and certain life insurance approaches are some of the strategies that can be utilized to mitigate the potential tax consequences to affected managers, but from both an income as well as estate planning perspective the planning can be complex and must be done correctly. Affected managers are therefore urged to address the issue early on so as not to be caught up with time constraints later next year. 168

21 Consider a Tandem Subchapter S/ESOP liquidity Solution At some point in the life cycle of most management companies the principles thoughts turn to exit strategies, succession, and or monetization of their equity. In this context a tandem Subchapter S/ Employee Stock Ownership Plan (ESOP) structure can afford significant wealth creation and tax planning opportunities for both the principals and employees of an existing entity. These benefits can be achieved without the loss of control, and can provide a tax optimized source of funds outside of more traditional approaches such as a complete or partial sale to private equity. The framework can be put into place relatively quickly, with a few months lead time prior to a year end. It is worth noting if the management company is an LLC or an LP, additional structuring may be required. Section 179/Bonus Depreciation As part of the Protecting Americans from Tax Hikes (PATH) Act of 2015, Congress extended bonus depreciation through Within certain criteria, limitations and phase outs which apply, electing or choosing to forego the bonus depreciation election can be a useful tool in maximizing tax efficiencies. Entities often incorrectly assume that electing bonus depreciation is beneficial, however this may not always be the case. Considerations such as rising future income tax rates and current taxable losses at the entity level can dictate foregoing the election entirely. Retirement Plans Another tax efficient way to reduce one s current income tax obligation can be to fund a tax deferred retirement account. Not only do the funds in a retirement account grow tax deferred, or in some cases tax free (in a Roth account), but the growth is not subject to the 3.8% tax on net investment income (IRC Section 1411). In addition, a robust retirement plan can be a way to attract and retain top talent. There are many retirement plan and deferred compensation options available to help fund partners optimize their income taxes. Viable options such as a 401(k), SEP IRA, cash balance and defined benefit plans, each have different requirements and many of them require formation prior to year end, so advance planning is critical. If structured properly, it may be possible for the retirement plan to include an owner s managed fund as an investment option for the retirement plan portfolio. Charitable Contributions and NYC UBT Tax Management companies which are partnerships, conduct their trade or business within New York City, and have total gross income of more than $95,000 are subject to NYC Unincorporated Business Tax ( UBT ) at a rate of 4%. NYC allows a tax deduction for charitable contributions made by the partnership, to the extent contributions would be deductible for Federal income tax purposes. There are certain requirements and limitations, but this is an often overlooked NYC UBT tax deduction at the entity level. 169

22 State Income Tax Planning and the AMT Much is written about the Alternative Minimum Tax (AMT), and it frightens many taxpayers. Those living in states with relatively high state and city income and real estate taxes are often subject to this tax. The top AMT rate is 28% versus the current top income tax rate of 39.6%. The interplay between the AMT rate and the ordinary income rate can give rise to planning opportunities, particularly with respect to state income taxes. While a full discussion of the AMT is beyond the scope of this article, AMT planning is relatively complex and warrants careful consideration.. Gifting Start Early The 2016 annual exclusion from transfer tax is currently $14,000 ($28,000 for married couples) per year, per donee. For example, a married couple with 3 children can currently shift $84,000 ($28,000 x 3) out of their estate annually, free of transfer taxes. Appreciation on the assets transferred accrues outside of the donor s estate. In our experience, management company principals overlook this planning opportunity at every phase of the fund lifecycle, from start up to liquidation. III. Conclusion: The cornerstone of sound tax planning for fund managers is an in depth understanding of the tax environment that a management company and its owners face in tandem. After the end of a subject tax year it is often too late to implement strategies or approaches which could have minimized the overall tax burden. We strongly recommend that principals and executives in the investment fund space consult their tax advisors well in advance of the end of the year in order to fully utilize planning opportunities. For more information on our investment fund and management company tax, accounting and advisory services, please contact: Thomas J. Riggs, JD, CPA, MST

23 11/1/2016 Reasonable Compensation Leo Parmegiani Tax Partner, PKF O Connor Davies lparmegiani@odpkf.com November 18, 2016 Unreasonable Compensation Usual context is compensation that is too high and reclassified as a dividend Typical issue if operating through a closely held C Corporation IRS closely scrutinizes owner compensation for reasonableness In S Corp context, IRS argument is turned upside down IRS scrutinizes compensation for being too low since owners would prefer to avoid social security taxes For LLC s, not much of an issue for owners. Social security taxes are due for partnership profits allocation and guaranteed payments alike

24 11/1/2016 Statutory Context IRC Section 162 and Regulations thereunder provide the test of deductibility Two Prong Test 1. Payment is reasonable in relation to services performed and 2. Whether payment was intended to be compensation 3 Paula Construction Case S Corp whose election was retroactively terminated. No salary declared to shareholders because it was believed not necessary. Tax Court acknowledged valuable services were provided. However, Tax Court held Nothing in the records indicate that compensation was paid or intended to be paid. Compensation deduction was disallowed. Tax Court stated It is now settled law that only if payment is made with the intent to compensate is it deductible as compensation. Whether such intent has been demonstrated is a factual question to be decided on the basis of the particular facts and circumstances of the case. Footer

25 11/1/2016 Closely Held Corporation Setting Even if intent exists, payment will not be deductible if substance of payment does not comport with taxpayer s characterization. An ostensible salary will likely be re characterized as a dividend distribution if: The taxpayer corporation is closely held and all the shareholders receive salaries; The salaries are more than what customarily is paid for similar services; and The excessive salaries correspond or bear relationship to the employees stockholdings. Footer 5 Compensatory Intent Heavy judicial reliance on initial characterization Objective criteria such as BOD approval Payroll tax treatment Deducted as salary in books and records Leading case is Paula Construction Co. [58 TC 1055 (1972)] Initial Multi Factor Test Tax Court stated that it is settled law?

26 11/1/2016 Compensatory Intent (con t) Courts more commonly determine reasonable compensation cases under the amount test because it requires a more objective analysis. Regs (b)(3) provides: It is, in general, just to assume that reasonable and true compensation is only such amount as would ordinarily be paid for like services by like enterprise under the circumstances. 7 Reasonableness of Compensation Subjective Criteria & Factors to Consider 1. The employee s qualifications. 2. The nature, extent, and scope of the employee s work. 3. The size and complexities of the business. 4. A comparison of the salaries paid with the gross income and the net income of the business. 5. The prevailing general economic conditions

27 11/1/2016 Reasonableness of Compensation Cont. 6. A comparison of salaries with distributions to stockholders. 7. The prevailing rates of compensation for comparable positions and comparable businesses. 8. The salary policy of the taxpayer for all employees. 9. The compensation paid to the particular. Courts have rejected argument that profitable corporations must use their earnings to pay dividends. Footer 9 Contingent Compensation Arrangements Invite scrutiny because such arrangements normally depend on profitability. However, method of fixing compensation not decisive as to deductibility. If pay is paid pursuant to a free bargain, agreed upon in advance of service and not influenced by other circumstances should be allowed. Not normally possible in closely held setting if single owner but if shareholders bargain among themselves, could be respected. Footer