Day 1 September 17, 2015:

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1 DRAFTING LLC/PARTNERSHIP OPERATING AGREEMENTS, PART 1 & PART 2 First Run Broadcast: June 16 and 17, 2015 Live Replay: September 17 & 18, :00 p.m. E.T./12:00 p.m. C.T./11:00 a.m. M.T./10:00 a.m. P.T. (60 minutes each day) For most LLCs and partnerships, the single most important document they will ever need is their operating agreement. These are complicated documents governing current and future contributions, management rights of members or the authority of managers, distribution rights and policies, and ultimately exit rights. These interlocking provisions also have substantial tax implications that do not always flow logically from the entity s financial results. Operating agreements can also modify the very important (but often overlooked) fiduciary duties of LLC members. Careful planning and drafting is required to ensure the parties get the benefit of their bargain and there are no adverse tax consequences. This program will provide you with a drafter s guide to the most important provisions of LLC and partnership operating agreements. Day 1 September 17, 2015: Framework of provisions contributions/formation, management, distribution policy, and sales/liquidations Understanding the complicated relationship among financial, tax and IRC Section 704(b) books and its practical importance Drafting cash/property distribution and separate tax allocation provisions of operating agreements Capital contributions capital v. services, current contributions v. future capital calls, documenting and valuing contributions Drafting member-managed v. manger-managed LLCs how closely do clients want to track corporate forms of authority? Fiduciary duties of members and imposition of contractual restrictions on seeking related opportunities Day 2 September 18, 2015: Restrictions on transfers baseline restrictions imposed by law & those imposed by agreement Distributions ordinary distributions, minimum tax distributions, waterfall distributions, liquidating distributions How payments to member (not distributions) are treated for financial v. tax purposes Drafting allocation provisions for maximum tax benefit and to secure the safe harbor Rights of first refusal, rights of first offer, buy-sell provisions understanding the alphabet soup of exit alternatives Liquidations of the entity and sale of an individual member s interests Speakers: Leon Andrew Immerman is a partner in the Atlanta office of Alston & Bird, LLP, where he concentrates on federal income tax matters, including domestic and international tax planning

2 and transactional work for joint ventures, partnerships, limited liability companies and corporations. He formerly served as chair of the Committee on Taxation of the ABA Business Law Section and as chair of the Partnership and LLC Committee of the State Bar of Georgia Business Law Section. He is also co-author of Georgia Limited Liability Company Forms and Practice Manual (2d ed. 1999, and annual supplements). Mr. Immerman received his B.A., magna cum laude, from Carleton College, his M.A. from the University of Minnesota, and another M.A. and his Ph.D. from Princeton University, and his J.D. from Yale Law School. Lee Lyman is a shareholder in the Atlanta office of Carlton Fields Jorden Burt, LLP and has more than 20 years experience in corporate and real estate transactions. She provides corporate and transactional advice, with an emphasis on advising clients engaged in ongoing business transactions, including joint ventures, mergers and acquisitions, and business restructurings. She has extensive experience in LLC and partnership law, organization, structure, and operations. She has extensive experience structuring equity and debt financing for the acquisition, development and sale of real estate and in general corporate transactions. Ms. Lyman received her B.S. from Florida State University, her M.A. from the University of Pittsburg, her J.D. from Duke University School of Law.

3 VT Bar Association Continuing Legal Education Registration Form Please complete all of the requested information, print this application, and fax with credit info or mail it with payment to: Vermont Bar Association, PO Box 100, Montpelier, VT Fax: (802) PLEASE USE ONE REGISTRATION FORM PER PERSON. First Name Middle Initial Last Name Firm/Organization Address City State ZIP Code Phone # Fax # Address Drafting LLC/Partnership Operating Agreements, Part 1 Teleseminar September 17, :00PM 2:00PM 1.0 MCLE GENERAL CREDITS VBA Members $75 Non-VBA Members $115 NO REFUNDS AFTER September 10, 2015 PAYMENT METHOD: Check enclosed (made payable to Vermont Bar Association) Amount: Credit Card (American Express, Discover, Visa or Mastercard) Credit Card # Exp. Date Cardholder:

4 VT Bar Association Continuing Legal Education Registration Form Please complete all of the requested information, print this application, and fax with credit info or mail it with payment to: Vermont Bar Association, PO Box 100, Montpelier, VT Fax: (802) PLEASE USE ONE REGISTRATION FORM PER PERSON. First Name Middle Initial Last Name Firm/Organization Address City State ZIP Code Phone # Fax # Address Drafting LLC/Partnership Operating Agreements, Part 2 Teleseminar September 18, :00PM 2:00PM 1.0 MCLE GENERAL CREDITS VBA Members $75 Non-VBA Members $115 NO REFUNDS AFTER September 11, 2015 PAYMENT METHOD: Check enclosed (made payable to Vermont Bar Association) Amount: Credit Card (American Express, Discover, Visa or Mastercard) Credit Card # Exp. Date Cardholder:

5 Vermont Bar Association CERTIFICATE OF ATTENDANCE Please note: This form is for your records in the event you are audited Sponsor: Vermont Bar Association Date: September 17, 2015 Seminar Title: Drafting LLC/Partnership Operating Agreements, Part 1 Location: Credits: Program Minutes: Teleseminar - LIVE 1.0 MCLE General Credit 60 General Luncheon addresses, business meetings, receptions are not to be included in the computation of credit. This form denotes full attendance. If you arrive late or leave prior to the program ending time, it is your responsibility to adjust CLE hours accordingly.

6 Vermont Bar Association CERTIFICATE OF ATTENDANCE Please note: This form is for your records in the event you are audited Sponsor: Vermont Bar Association Date: September 18, 2015 Seminar Title: Drafting LLC/Partnership Operating Agreements, Part 2 Location: Credits: Program Minutes: Teleseminar - LIVE 1.0 MCLE General Credit 60 General Luncheon addresses, business meetings, receptions are not to be included in the computation of credit. This form denotes full attendance. If you arrive late or leave prior to the program ending time, it is your responsibility to adjust CLE hours accordingly.

7 Drafting LLC Operating Agreements Lee Lyman Carlton Fields Jorden Burt (404) L. Andrew Immerman Alston & Bird LLP (404) # v1

8 "DEVELOPMENT COMPANY, LLC" Development Company, LLC Limited Liability Company Agreement June 16, 2015 This presentation discusses the LLC Operating Agreement of "Development Company, LLC," a Delaware LLC (with occasional references to "Corporate Company, LLC"). This is a fairly typical but simple LLC Agreement. This Agreement reflects a very common pattern, traditionally found in limited partnerships: the LLC brings together capital ("Investor") and services ("Developer"). Assumes the LLC is taxed as a partnership. 2

9 "DEVELOPMENT COMPANY, LLC" Sample Provision We ve provided a separate abridged form of an Operating Agreement or Limited Liability Company Agreement (as it is referred to in Delaware) Blue boxes on slides show selected provisions from the Operating Agreement. 3

10 THE BASICS An Operating Agreement or Limited Liability Agreement is a contract and governed by principles of contract law Basic components: What goes in (contributions) How it runs (allocations; governance; restrictions; exit strategies) What comes out (distributions) How it ends (sales; liquidation) 4

11 CONTRIBUTIONS Section 2.3 Capital Contributions Member's Capital Contribution. Each Member's initial Capital Contribution is set forth on Exhibit B. Your Operating Agreement should recite: the contributions of each party obligations to make future contributions consequences of failing to meet future contribution obligations 5

12 DOCUMENTING THE CONTRIBUTION Member's Capital Contribution. Each Member's initial Capital Contribution is set forth on Exhibit B. Exhibit B shows: $2,000 capital contribution by Investor. $0 capital contribution by Developer. Some advisors recommend that Developer put in at least some capital. In any case, services are not capital. 6

13 "CAPITAL CONTRIBUTION" Capital Contributions include cash and the Gross Asset Value of property contributed. However, the amount of liabilities that the property is subject to is debited from the Capital Account, so that the contributor only gets Capital Account credit for the net value. Sometimes there will be a separate "Contribution Agreement," with representations and warranties as in a sale. "Capital Contributions" means, with respect to any Member, the amount of money and the initial Gross Asset Value of any property (other than money) contributed to the Company with respect to the Percentage Interest held by such Member. 7

14 DOCUMENTING THE CONTRIBUTION EXHIBIT B DEVELOPMENT COMPANY, LLC LIMITED LIABILITY COMPANY OPERATING AGREEMENT Members' Names and Addresses Initial Capital Contribution Percentage Interest Investor: Developer: $2, % $ % 8

15 TAX FOLLOWS BOOK With some exceptions, the Regulations say: Tax income follows from "book" income. Once you know what allocations are made on the "books" of the LLC, you generally know what taxable income each member of the LLC has. 9

16 HOW MANY BOOKS DO YOU NEED? An LLC may have to keep three or more kinds of books: Tax. Financial reporting (GAAP, IFRS or other). "704(b)" (defined by Regulations under Section 704(b) of the Code). Most LLC agreements require the LLC to keep 704(b) books. 10

17 704(b) BOOKS VS. TAX BOOKS 704(b) books are not tax books. For the most part, the allocation provisions in LLC agreements that tax advisors typically want to see are technically 704(b) "book" allocations and not tax allocations. 704(b) books start from taxable income, but make significant adjustments. 704(b) books represent, in effect, the IRS's version of the real economics of the deal. The theory is that the real economics should determine the tax consequences. For example, if you will be entitled to a distribution of profits, you should be taxable when those profits are earned. In many situations you cannot figure out the tax consequences without first thinking about the 704(b) books. When tax can't follow book, there are special "704(c)" rules for reconciling the two. 11

18 CONNECTING THE PIECES The 704(b) Regulations link together the principal tax and economic provisions of the LLC agreement: 1. Contributions. 2. Allocations. 3. Distributions. 4. Capital Accounts. Economic terms and tax terms are interrelated. There are other tax-related provisions but these four concepts are fundamental and are the ones we focus on. In a sense, the Capital Accounts summarize the other three concepts. Capital Accounts are essential to LLC agreements and partnership tax. 12

19 CONNECTING THE PIECES In the text of this Agreement, the most crucial tax-related sections are: Article 4 (Distributions and Allocations). Section 1.4.2(e) (Liquidating Distributions). Section 2.3 (Capital Contributions). However, the text relies heavily on Exhibit A ("Definitions"). Some of the most important and surprising provisions are in the definitions rather than the text. Do not neglect the definitions, especially not the definition of "Capital Account" and the other terms used in maintaining the Capital Account. 13

20 CONTRIBUTIONS + ALLOCATIONS = DISTRIBUTIONS This formula is not a secret but: It is not made explicit in LLC agreements. It is only occasionally made explicit in discussions about drafting or understanding LLC agreements. It tends to get buried under the details (especially details about debt-financed deductions or distributions). However, this Agreement and most others are designed to satisfy the formula over the lifetime of the LLC. 14

21 LIFETIME PERSPECTIVE In partnership tax, focus on the entire lifetime of the partnership. In particular, always ask: What would happen on a complete liquidation at "book value"? Nowadays many LLCs are intended to last indefinitely, just like corporations, but partnership tax was not designed with indefinite life in mind. 15

22 FORMATION AND INITIAL CONTRIBUTIONS Investor owns two parcels of raw land: WHITEACRE BLACKACRE Fair Market Value: $1,000 $1,000 Basis: $1,000 0 Investor contributes the land to Development Company LLC. Developer agrees to develop the land and receive a share of the proceeds from any increase in value. The business deal is that Investor gets back the first $2,000 of cash flow. Any proceeds above the first $2,000 are divided 80% to Investor and 20% to Developer. 16

23 OPENING BALANCE SHEET Assets Liabilities and Capital Cash $ 0.00 Debt $ 0.00 Land Capital Whiteacre $1, Investor $2, Blackacre 1, Developer 0.00 Total Assets $2, Total Liabilities and Capital $2, Investor's capital account is $2,000. Developer's capital account is zero. 17

24 LIQUIDATING DISTRIBUTION Assets Liabilities and Capital Cash $0.00 Debt $0.00 Land Capital Whiteacre $0.00 Investor $0.00 Blackacre 0.00 Developer 0.00 Total Assets $0.00 Total Liabilities and Capital $0.00 A liquidating sale and distribution to Investor at book value brings all capital accounts to zero. 18

25 HOW DOES THE LLC KEEP TRACK OF THE FORMULA? The Capital Account (with some adjustments) is like a snapshot of the amount, at any given time, that the members would receive on a liquidation at "book value." Contributions + Allocations - Distributions Capital Account Allocations may be positive (income or gain) or negative (deduction or loss). This presentation deals mostly with positive allocations. 19

26 CAPITAL ACCOUNTS: AVOID COMMON MISCONCEPTIONS The Capital Account is not simply Contributions less Distributions. Allocations of Profits and Losses must be shown in the Capital Account. Some LLC Agreements define a concept such as "Unreturned Capital" consisting of: Capital Contributions, less Certain Distributions (those Distributions treated as return of capital rather than as a share of profit). Do not assume that Capital Account corresponds to Unreturned Capital. 20

27 CAPITAL ACCOUNTS: AVOID COMMON MISCONCEPTIONS Using terms like LLC "Units" or "Shares" does not necessarily make Capital Accounts less crucial. LLCs are very different from corporations, even if corporate terminology is used. The Capital Account does not include debt. Capital Account reflects an equity interest. However, the basis of a member in the LLC will include the member's share of the LLC's debt almost (but not exactly) as if the member incurred the debt himself. 21

28 CAPITAL ACCOUNTS Capital Accounts should equal zero after the LLC liquidates: Contributions + Allocations Distributions = Capital Account = 0 22

29 "CAPITAL ACCOUNT": CREDITS Credit Capital Account With Contributions and Profit Allocations (a) To each Member's Capital Account there shall be credited such Member's Capital Contributions, such Member's distributive share of Profits and any items in the nature of income or gain that are allocated pursuant to Section 4.2 hereof, and the amount of any Company liabilities assumed by such Member or that are secured by any Property distributed to such Member; 23

30 "CAPITAL ACCOUNT": DEBITS Debit Capital Account for Distributions and Loss Allocations (b) To each Member's Capital Account there shall be debited the amount of cash and the Gross Asset Value of any Property distributed to such Member pursuant to any provision of this Agreement, such Member's distributive share of Losses and any items in the nature of expenses or losses are allocated pursuant to Section 4.2 hereof, and the amount of any liabilities of such Member assumed by the Company or that are secured by any property contributed by such Member to the Company; 24

31 "CAPITAL ACCOUNT": LIABILITIES If the Member assumes liabilities of the Company, the Member is treated as making a capital contribution. If the Company assumes liabilities of the Member, the Member is treated as receiving a distribution. (d) In determining the amount of any liability for purposes of clauses (a) and (b) of this definition, there shall be taken into account Section 752(c) of the Code and any other applicable provisions of the Code and Regulations. 25

32 "CAPITAL ACCOUNT": LIABILITIES Capital Accounts are affected by liabilities that the Member assumes or that the LLC assumes from the Member. Capital Accounts are not affected by the Member's "share" of the Company's liabilities, even though the Member's "share" of liabilities is included in the Member's basis. In many instances, if the Member's tax basis is higher than the Member's Capital Account, the reason is that the tax basis but not Capital Account includes a share of the Company's 26 liabilities.

33 "CAPITAL ACCOUNT": COMPLYING WITH REGULATIONS This Agreement says that the definition of "Capital Accounts" is intended to comply with certain provisions in the Regulations. Some LLC agreements define Capital Accounts by simply incorporating the Regulations by reference omitting all the details. The foregoing provisions and the other provisions of this Agreement relating to the maintenance of Capital Accounts are intended to comply with Regulations Section (b), and shall be interpreted and applied in a manner consistent with such Regulations. 27

34 "CAPITAL ACCOUNT": COMPLYING WITH REGULATIONS LLC agreements sometimes give managers authority to modify Capital Account computations to comply with the Regulations, although it is hard to know what these provisions really mean. The Managers may modify the definition of Capital Accounts contained in this Agreement to the extent the Managers reasonably determine that such modification is necessary to comply with such Regulations, provided that such modification is not likely to have a material effect on the amounts distributable to a Member hereunder upon the dissolution of the Company in accordance with Section

35 "CAPITAL ACCOUNT": TRANSFERS Transferee Succeeds to Capital Account of Transferor (c) Subject to the provisions of this Agreement, in the event any interest in the Company is transferred in accordance with the terms of this Agreement, the transferee shall succeed to the Capital Account of the transferor to the extent it relates to the transferred interest. 29

36 "GROSS ASSET VALUE" The value of property reflected in Capital Accounts is often defined, as in this Agreement, as "Gross Asset Value." Crucial substantive features of the Capital Accounts are built into this definition. "Gross Asset Value" means, with respect to any asset, the asset's adjusted basis for federal income tax purposes, except as follows: 30

37 "GROSS ASSET VALUE" Focus on who gets to make the decision about what the Gross Asset Value of an asset is, especially after the initial contribution. Initial Gross Asset Value is usually a mutual decision between the Company and the contributor. (a) The initial Gross Asset Value of any asset contributed by a Member to the Company shall be the fair market value of such asset, as determined by the contributing Member and the Company; 31

38 "BOOKING UP" Booking up Capital Accounts means reflecting new fair market values for the LLC's assets, and adjusting Capital Accounts accordingly. The Managers may be delegated the authority to decide on new values, but other procedures for determining new values are possible. (b) The Gross Asset Values of each item of Property shall be adjusted to equal its gross fair market value, as determined by the Managers, as of the following times: 32

39 "BOOKING UP" Gross Asset Value of all existing property is typically "booked up" when an additional interest is issued to a new or existing Member (other than de minimis interests). (i) the acquisition of an additional interest in the Company by any new or existing Member in exchange for more than a de minimis Capital Contribution or in connection with the grant of more than a de minimis interest in the Company as consideration for the provision of services to or for the benefit of the Company; 33

40 "BOOKING UP" Example: Suppose that the LLC needs extra cash and New Investor agrees to contribute $2,000. If the net assets of the LLC at the time have increased in value to $4,000 (rather than the $2,000 original book value), New Investor's contribution will represent $2,000 out of the total $6,000 value. New Investor should be credited with owning only 1/3 of the capital -- not ½. 34

41 "BOOKING UP" The $2,000 increase in value that accrued before the new investment should be credited to the Capital Accounts of Investor and Developer, as if the assets had been sold. This increase in Capital Accounts is not taxable to Investor and Developer, but creates built-in gain that can eventually come back to haunt them almost as if Investor and Developer had contributed appreciated property to a new partnership with New Investor. 35

42 "BOOKING UP" Gross Asset Value also may be booked up on a distribution of property (whether or not in liquidation). (ii) the distribution by the Company to a Member of more than a de minimis amount of Property; and (iii) the liquidation of the Company within the meaning of Regulations Section (b)(2)(ii)(g); 36

43 "BOOKING UP" In this agreement and many others a book-up on liquidation is mandatory. Book-ups on other events may or may not be needed. adjustments pursuant to clauses (i) and (ii) above shall be made only if the Managers reasonably determine that such adjustments are necessary or appropriate to reflect the relative economic interests of the Members in the Company; 37

44 WHAT IS DEVELOPER'S INTEREST Capital: $0.00 Profits: 20% IN THE LLC? Developer contributes no capital and initially has a zero Capital Account. However, she receives a 20% interest in profits. Exhibit B shows that Developer has a 20% "Percentage Interest," which reflects her share of profits. However, her initial Capital Account is zero. It is misleading to define her interest as a single number. How many "units" does Developer have? The question is meaningless. This LLC Agreement does not use the term "units." 38

45 PROFITS INTEREST FOR SERVICES Section explains that Developer received a profits interest for services -- which generally is nontaxable to her Interest for Services. The Percentage Interest of any Member in excess of such Member's percentage of the Capital Contributions made by all Members shall be deemed to be a profits interest received in exchange for services rendered or to be rendered to or for the benefit of the Company. 39

46 PROFITS INTEREST FOR SERVICES Some LLC agreements recite that the Members received their interests solely for capital which is not true here. We noted under the definition of "Gross Asset Value" that this Agreement permits booking up Capital Accounts on the issuance of a profits interest. The regulations now expressly authorize booking up on issuing a profits interest, but formerly did not. 40

47 FUTURE CONTRIBUTIONS Section provides for the possibility of later capital contributions. An LLC agreement will often require unanimous approval of Members before additional capital can be required, but some LLC agreements do not. 41

48 FUTURE CONTRIBUTIONS Section permits vague penalties for default on making a required capital contribution. It is unlikely this penalty provision would have to be used here, since a Member is not required to contribute capital unless the Member agrees to it. In deals where future capital contributions may be required without unanimous consent, a penalty for default may be more important. 42

49 MANAGEMENT/GOVERNANCE Under most states law, LLCs are either member or manager managed. The basic roles, duties and responsibilities of each are defined by state statutes, but can be modified by a written operating agreement. 43

50 GOVERNANCE STRUCTURE Development Company, LLC Partnership like structure Managing Member = General Partner Investment Member(s) = Limited Partners Representatives Corporate Company, LLC Corporation like structure Manager(s) = Board of Directors Members = Shareholders Delegation to Officers 44

51 CORPORATE COMPANY, LLC Articles of Organization and/or Operating Agreement must stipulate that the Company is manager managed. Manager(s) have full authority to manage the Company. Member rights to governance and voting must be expressly reserved (except certain rights reserved by statute). 45

52 CORPORATE COMPANY, LLC Members typically have rights to vote to: Amend the LLC Agreement Admit new Members Remove, replace or elect Managers Merge the Company or sell its assets Dissolve the Company 46

53 VOTING Beware of the state statutory default rules! Georgia Per capita voting default rule One member = one vote Delaware Default rule voting based on capital contributions More contributions = more voting power Always make voting provisions (percentages or units) clear in your operating agreement 47

54 DEVELOPMENT COMPANY, LLC What is a Managing Member? Not really a manager, but not entirely a member either. LLC Agreement must set forth in detail authority and restrictions of a Managing Member In absence of a Manager, a Managing Member has all the power of a member as an agent of the Company, but so do the non- Managing Members 48

55 DEVELOPMENT COMPANY, LLC Section 8.03 Management. (a) The Managing Member, as agent for the Members, shall have responsibility for supervising, directing and overseeing the policies and operating procedures of the Company and managing the business and affairs of the Company. A Managing Member typically has day to day operational authority to run the Company Similar to General Partner in a limited partnership. 49

56 DEVELOPMENT COMPANY, LLC Major Decisions will require the consent of the Investment Member(s): Operating Budget or Business Plan Significant Capital Expenditures New Indebtedness, Financing or Refinancings Business Combinations Sale of any portion of Company Property Change in Business Dissolution Note: Ownership percentages have no relevance for voting and decision making in this format 50

57 RESTRICTIONS ON MEMBERS Fiduciary Duties: May be defined in state statutes. May be based on common law principles (Delaware). Duty of loyalty and duty of care. Typically fiduciary duties in LLC context may be reduced or even eliminated. In Delaware can be eliminated except for the contractual covenant of good faith and fair dealing. Effect of fiduciary standards is to place restrictions on activities of both Managers and Members. Fiduciary provisions, and any limitations, should be carefully addressed in the Operating Agreement. 51

58 RESTRICTIONS ON MEMBERS Managers are not required to devote full time to the performance of such duties and may have other business interests or engage in other business activities, whether or not competitive with the Company. Neither the Company nor any Member has any right, by virtue of this Agreement, to share or participate in such other investments or activities of the Managers. The Managers will not incur any liability to the Company or to any Member as a result of engaging in any other business or venture. 52

59 RESTRICTIONS ON MEMBERS Other Restrictive Covenants: Non-competition provisions Non-solicitation provisions Confidentiality 53

60 RESTRICTIONS ON TRANSFER Restriction on Transfers. Except as otherwise permitted by this Agreement, no Member may Transfer all or any portion of such Member's Membership Interest. Most LLC Agreements will restrict the ability of Members to freely transfer their interests. Be aware that the state UCC provisions (Sections 9-406(d) and 9-408) may raise a question as to the enforceability of these restrictions to the extent LLC interests constitute "payment intangibles" or "general intangibles." 54

61 PERMITTED TRANSFERS Certain transfers may be permitted: After obtaining specified consent. Transfers to family members, or for estate planning purposes. Transfers to affiliated entities. Transfers that have been subject to a right of first refusal or similar mechanism. 55

62 PROHIBITED TRANSFERS Some transfers are specifically limited: Preserving the partnership tax status No technical tax terminations No transfers that would trigger withholding No transfers that violate ERISA limitations 56

63 WHAT GETS DISTRIBUTED? Answer: "Net Cash Flow" Net Cash Flow is defined by reference to defined in terms such as "Operating Expense," "Reserves," and "Gross Revenues." In this Agreement, the overall effect of these elaborate cross-referring definitions is that Net Cash Flow means whatever the Managers decide to distribute. Members sometimes want tighter controls over distributions. 57

64 "NET CASH FLOW" Different LLC agreements use different terms for what gets distributed, including: "Net Profits." "Net Income." "Distributable Income." The exact term doesn't matter, but the phrase "Net Cash Flow" is less misleading. Profits and income do not get distributed. Cash (and sometimes property) gets distributed. 58

65 DISTRIBUTIONS Beware of the state statutory default rules! Georgia Per capita distribution default rule Distributions shared equally among Members Delaware Default rule distributions based on agreed value of capital contributions More contributions = more distributions Always make distribution waterfalls clear in your operating agreement 59

66 DOCUMENTING THE DISTRIBUTIONS Section 4.1.1(a) says that Investor first receives a cumulative distribution equal to the initial amount of capital he contributed. So he receives the first $2,000 of distributions. Section 4.1.1(b) says that after Investor receives this first $2,000 of distributions, distributions are made 20% to Developer and 80% to Investor. 60

67 DOCUMENTING THE DISTRIBUTIONS (a) First, 100% to Investor until the cumulative distributions under this Section 4.1.1(a) equal Investor's initial Capital Contribution. (b) Second, twenty percent (20%) to Developer and eighty percent (80%) to Investor. 61

68 YEAR TWO: SALE OF WHITEACRE Assume Whiteacre was sold in Year 2 for $2,000, and there are no other income and expense items, leaving $2,000 Net Cash Flow. Without a minimum tax distribution to Developer, the full $2,000 could be distributed to Investor. 62

69 MINIMUM TAX DISTRIBUTION? As we will see when we discuss allocations, Developer will have $200 of taxable income even if she gets no distribution. A minimum tax distribution provision may say, notwithstanding Investor's preferential distribution, the Company should distribute enough so that the Members can pay their tax. This provision is intended to help the Members Developer in particular cope with "phantom income." 63

70 MINIMUM TAX DISTRIBUTION? Minimum Tax Distribution. Except as otherwise provided in Section 1.4, notwithstanding Section the Company shall make distributions out of Net Cash Flow to the Members at such times and in such amounts as are reasonably estimated by the [Managers] [Members] to be at least sufficient to enable each Member to make timely payments of federal, state and local income taxes, including estimated taxes, attributable to such Member's Percentage Interests. 64

71 MINIMUM TAX DISTRIBUTION? Section only requires the tax distribution to be a reasonable estimate of the amount needed to pay taxes. The estimate may be less than is actually needed. Section only requires the tax distribution to be made out of "Net Cash Flow." For example, the Company does not need to borrow money to make a tax distribution. No matter what the LLC agreement says, there is always some risk that a Member will have phantom income. 65

72 MINIMUM TAX DISTRIBUTION? "Distributions under this Section shall be made twenty percent (20%) to Developer and eighty percent (80%) to Investor. Any amount distributed pursuant to this Section will be deemed to be an advance distribution of amounts otherwise distributable to the Members pursuant to Section 4.1.1(b) and will reduce the amounts that would subsequently otherwise be distributable to the Members pursuant to Section 4.1.1(b) in the order they would otherwise have been distributable." 66

73 MINIMUM TAX DISTRIBUTION? This Agreement says that tax distributions are made 20/80. For example, if Developer needs $20 to pay her taxes, Investor must get $80 -- even if he does not need it to pay his taxes. An LLC agreement need not require tax distributions to be made in the same proportion as profits are shared. However, disproportionate tax distributions tend to increase complexity. 67

74 "PAYMENTS" TO THE MEMBERS Partnership practitioners often distinguish "distributions" from "payments." "Payments" are sometimes set forth outside the LLC agreement, including: "Guaranteed payments" for capital or services. Payment of sales price for property sold to the LLC. 68

75 "PAYMENTS" TO THE MEMBERS However, some "payments" are provided for in vague terms by this Agreement, e.g., Section (interest on loans) and (compensation to Managers) Loans to the Company. The Members may lend money to the Company as approved by the Managers Compensation. Compensation of the Managers will be fixed from time to time by an affirmative vote of a Majority in Interest. 69

76 WHAT IS ALLOCATED? Answer: "Profits" (and "Losses" and other "items"). You can use other terms, but be clear that allocations are accounting entries and not real money. "Net Cash Flow" gets distributed, not allocated. 70

77 "PROFITS" AND "LOSSES" The definition of "Profits" and "Losses" like the definition of "Gross Asset Value" -- starts from taxable income, and then makes adjustments. "Profits" or "Losses" means, for each Allocation Year, an amount equal to the Company's taxable income or loss for such Allocation Year, determined in accordance with Section 703(a) of the Code (for this purpose, all items of income, gain, loss or deduction required to be stated separately pursuant to Section 703(a)(1) of the Code shall be included in taxable income or loss), with the following adjustments: 71

78 "PROFITS" AND "LOSSES" The adjustments bring taxable income and loss into line with "book" income and loss. However, these are the "704(b)" books the books kept under the 704(b) Regulations and not tax books or financial accounting books. (a) Any income of the Company that is exempt from federal income tax and not otherwise taken into account in computing Profits or Losses pursuant to this definition shall be added to such taxable income or loss; 72

79 "PROFITS" AND "LOSSES" Items that must be specially allocated under Section (the "Regulatory Allocations") are allocated before the allocations of Profits and Losses (under Section 4.2.1). (f) Notwithstanding any other provision of this definition, any items that are allocated pursuant to Section hereof shall not be taken into account in computing Profits or Losses. Separating out "Regulatory Allocations" means that losses attributable to nonrecourse debt are not included in "Losses." 73

80 LAYER-CAKE ALLOCATIONS The general rule for allocating Profits appears here as the second level of allocations in the first version of Section 4.2.1(a). (The first level of allocations "charges back" previous Losses.) (ii) Second, after giving effect to the allocations made pursuant to Section 4.2.1(a)(i), Profits shall be allocated twenty percent (20%) to Developer and eighty percent (80%) to Investor. 74

81 "TARGETED" ALLOCATIONS Many LLC agreements nowadays omit detailed allocation provisions, in favor of "targeted" allocations such as the alternative version of Section The targeted capital account provision says: Allocate so that Capital Accounts (with certain adjustments) equal the amounts the members would receive in a liquidating distribution. 75

82 "TARGETED" ALLOCATIONS Instead of following the detailed allocation instructions specified in the LLC agreement (which are sometimes ignored anyway) the LLC's accountants each year have to figure out how to make allocations. This is sometimes called the "forced" allocation approach: allocations are "forced" to correspond to Capital Accounts. 76

83 YEAR THREE: SALE OF BLACKACRE Assume in Year 3 the Company sells Blackacre for $2,000. The Company distributes the proceeds to Investor and Developer in liquidation of the Company. 77

84 YEAR THREE: SALE OF BLACKACRE Assume Investor received the first $2,000 of proceeds in Year Two. The business deal is that all subsequent distributions are made 80/20. So the $2,000 proceeds in Year 3 go: $1,600 to Investor. $400 to Developer. 78

85 LIQUIDATING DISTRIBUTIONS Liquidating distributions are commonly drafted in one of two ways: In accordance with positive Capital Accounts. In accordance with specific distribution provisions. Liquidating in accordance with Capital Accounts may mean that your tax allocations are safer. Liquidating in accordance with distribution provisions may mean that your business deal is safer. 79

86 LIQUIDATING DISTRIBUTIONS Liquidation provisions generally begin by authorizing the Managers to take the steps required by law Liquidation of Property and Application of Proceeds. Upon the dissolution of the Company, the Managers (or, if none, a liquidator appointed by the Personal Representatives of the deceased Members) will wind up the Company's affairs in accordance with the Delaware Act, and will be authorized to take any and all actions contemplated by the Delaware Act as permissible, including, without limitation: 80

87 LIQUIDATING DISTRIBUTIONS The crucial provision on liquidation relates to the distribution of any "residual" (after creditors have been paid off). The residual will be distributed either in accordance with Capital Accounts, or in accordance with a distribution scheme spelled out in the LLC agreement. (e) distributing the proceeds of liquidation and any undisposed Property to the Members in accordance with [their positive Capital Account balances] [Section 4.1.1]. 81

88 LIQUIDATING DISTRIBUTIONS In our example, liquidating in accordance with Capital Accounts or in accordance with Section is exactly the same as it is intended to be and it should be. Especially in complicated deals, parties worry that the Capital Accounts may not work out as anticipated. The drafting trend in recent years is for LLC agreements to say that liquidation will be in accordance with the fixed distribution provision rather than in accordance with Capital Accounts. 82

89 OUR EXAMPLE: YEAR 2 Assume Whiteacre was sold in Year 2. Whiteacre had a tax basis and value of $1,000 when Investor contributed it, so there was $1,000 of income to allocate. The $1,000 income is allocated: $800 to Investor. $200 to Developer. Developer is allocated $200 of income even though she receives no cash (assume no "tax distribution"). 83

90 YEAR THREE: SALE OF BLACKACRE Assume in Year 3 the Company sells Blackacre for $2,000. What is the income of the Company, and how should it be allocated? The book income of the Company is $1,000. Blackacre was booked into the Company at $1,000, and is sold for $2,000, so there is $1,000 of book income. This income of the Company should be allocated 80/20 in Year Three. 84

91 OVER THE LIFE OF THE LLC: CONTRIBUTIONS + ALLOCATIONS = DISTRIBUTIONS The formula works out just right. INVESTOR Year Contributions Allocations Distributions One: $2, Two: 0 $800 $2,000 Three: 0 $800 $1,600 Life of LLC: $2,000 + $1,600 = $3,600 DEVELOPER Year Contributions Allocations Distributions One: Two: 0 $200 0 Three: 0 $200 $400 Life of LLC: 0 + $400 = $400 85

92 HOW DOES LLC ACHIEVE THESE RESULTS? Answer: Allocate all Profits 80% to Investor and 20% to Developer (assuming no chargebacks). Distribute the first $2,000 to Investor; all subsequent distributions 80/20. 86

93 THE "SAFE HARBOR" The 704(b) Regulations on "substantial economic effect" include two "safe harbors" for allocations. Allocations that fit in a safe harbor are safe from IRS challenges. One safe harbor requires the members to have an unlimited obligations to restore negative Capital Accounts, which nowadays is almost unheard of. The other safe harbor requires, among other things, layer-cake allocations and liquidation by capital accounts. The rules we have been discussing deal with whether an allocation has "economic effect." There are other rules dealing with whether the economic effect is "substantial," but substantiality is a less mechanical test, and is not reflected as directly in the LLC agreement. 87

94 YEAR THREE: SALE OF BLACKACRE Suppose in Year 3 the Company sells Blackacre for $2,000. The "book value" of Blackacre was $1,000, so the Company has $1,000 of book income. The tax basis of Blackacre was zero, so the Company has $2,000 of tax income. 88

95 RECONCILING BOOK AND TAX INCOME Investor wound up getting total cash distributions of $3,600 from the Company. Investor's initial tax basis in the property contributed to the Company was $1,000. Thus he should have $2,600 of taxable income, and not $1,600. Allocating the extra $1,000 entirely to Investor is fair. 89

96 RECONCILING BOOK AND TAX INCOME Investor is allocated a total $1,800 of taxable income (not "Profits") under "704(c)" in Year Three, consisting of: the entire $1,000 of built-in gain, plus 80% of the $1,000 of gain that arose after the property was contributed to the Company. 90

97 HOW TO RECONCILE TAX AND BOOK There are different "704(c)" methods and they can have wildly different consequences. A member contributing appreciated property may find out that under some methods gain is recognized long before the LLC sells the property. A member contributing cash may find out that under some methods depreciation deductions are less than if the member had bought an equivalent amount property outside the LLC. 91

98 HOW TO RECONCILE TAX AND BOOK Vague instructions to reconcile tax and book may work out in simple cases, but in many situations there are alternative methods, and the choice of method is anything but neutral, innocuous tax boilerplate. Choice of "704(c)" method should be carefully considered and negotiated when a member is contributing appreciated property especially depreciable property. 92

99 SUMMARY OF BOOK/TAX RECONCILIATION INVESTOR: Year Book Tax One: $ 2,000 Contribution $ 1,000 Contribution Two: Allocation Allocation - 2,000 Distribution - 2,000 Distribution $ 800 Book Basis $ 0 Tax Basis* * Since there cannot be negative basis, the distribution of $200 in excess of basis is taxable to Investor. This LLC has no debt, but LLC debt allocated to investor could have increased the Investor's basis and facilitated a $200 nontaxable distribution. 93

100 SUMMARY OF BOOK/TAX RECONCILIATION INVESTOR: Year Book Tax Three: $ 800 Book Basis $ 0 Tax Basis Allocation + 1,800 Allocation $1,600 Book Basis $ 1,800 Tax Basis - 1,600 Distribution - 1,600 Distribution $ 0 Final Book Basis $ 200 Final Tax Basis* * $200 tax basis after the liquidating distribution gives Investor a $200 loss, possibly offsetting $200 of the $1,800 income allocation. 94

101 HOW TO RECONCILE TAX AND BOOK (Section 4.2.6) Tax Allocations. In accordance with Section 704(c) of the Code and the Regulations thereunder and with Section (b)(2)(iv)(f)(4) and (b)(4)(i) of the Regulations, income, gain, loss and deduction with respect to any property contributed to the capital of the Company or property revalued on the Company's books and in the Capital Accounts shall, solely for tax purposes, be allocated among the Members so as to take account, under the [SPECIFY METHOD] as defined by Section of the Regulations, of any variation between the adjusted basis of such property to the Company for federal income tax purposes and its Gross Asset Value. 95

102 THE "REGULATORY ALLOCATIONS" IMPLEMENT THE SECRET FORMULA The secret formula says that over the life of the Company: Contributions + Allocations = Distributions However, certain situations present special challenges when attempting to comply with the secret formula. 96

103 "ADJUSTED CAPITAL ACCOUNT DEFICIT" The special situations tend to involve actual or potential negative (i.e., deficit) Capital Accounts. For example, the secret formula may be violated if a Member receives a distribution in excess of his Capital Account, and is not required to restore the negative balance in the Capital Account. If the Member is not required (and is not deemed to be required) to restore the deficit, the Member has an "Adjusted Capital Account Deficit." 97

104 JUMBLE SOUP: ROFRs, ROFOs, Buy-Sells, Puts and Calls, Tag Alongs, Drag Alongs and other Purchase Rights and Obligations Most LLC Agreements will provide mechanisms to address changes in ownership either by voluntary transactions or through forced repurchases or other types of transfers. Members will generally desire to have some control over who owns the LLC. Mechanisms can also help break deadlocks or ensure cooperation in certain transactions. Members will want to provide for "take out" mechanisms or other exit strategies. 98

105 ROFRs AND ROFOs Right of First Refusal Triggered by third party offer Right to purchase Price usually set by third party Right of First Offer Triggered by Member s intent to sell Right to make a first offer Price determined by Member or valuation formula 99

106 BUY-SELL Most useful for breaking deadlocks Can only be used with two or three members An offer to sell, or purchase, for the same price Offeree, not offeror, controls the direction of sale Rarely consummated 100

107 TAG ALONGS & DRAG ALONGS; CO-SALE RIGHTS Tag Along Benefits Minority Owners Allows Minority Owners to opt to participate in transaction on a pro rata basis Both Minority and Majority Owners generally participate on the same terms Drag Along Benefits Majority Owners Requires Minority Owners to participate in a change of control transaction Both Minority and Majority Owners generally participate on the same terms Puts, Calls and other forms of Take Outs 101

108 OTHER PURCHASE RIGHTS AND Triggering Events: Death of a Member Disability of a Member OBLIGATIONS Departure of Employee-Member Non-permitted transfer Right or Obligation of Company or other Members to purchase interest Price may vary depending on reason for repurchase 102

109 VALUATION Book value Original Cost Formula based on EBIDTA Agreed Value Appraised Value "Appraised Value" means the value determined by a majority of a board of three appraisers, where the Personal Representative of a deceased Member or Member disputing the Fair Market Value appoints one appraiser and the other Members appoint one appraiser and the two appointed appraisers appoint the third appraiser. 103

110 FUNDING In the event of the death of a Member, the purchase price for the deceased Member's Membership Interest will be paid in one lump sum from the Company upon (a) the tenth (10th) day after the proceeds of the insurance policy insuring the life of the deceased Member have been received by the Company if the Company purchased a life insurance policy for such Member, or (b) within ninety (90) days after the date of the Member's death if the Company did not purchase a life insurance policy for the Member. In the event of a nonpermitted Transfer or attempted Transfer, the purchase price will be paid in equal quarterly installments (including principal and interest) over a five (5) year period (unless a shorter period is agreed to by all All Cash Promissory Note Installment Payments the Managers). 104

111 FUNDING Cash Flow Limitations Insurance In no event, however, will the sum of the quarterly payments be in excess of percent ( %) of the Company's Net Income for such quarter after considering mandatory distributions and any other redemption payments the Company is obligated to make, or any Reserve created therefore (the " % Limitation"). In the event the % Limitation is triggered, the applicable payment period shall be extended by the shortest period possible without violating the % Limitation. Notwithstanding any other provision to the contrary in this Agreement, no portion of the premiums paid or proceeds received with respect to any life and/or disability insurance maintained by the Company in the case of a Member s death or disability shall be allocated to such Member. 105

112 SALES OF LLC INTERESTS The sale of an LLC (or partnership) interest creates an assignee not a Member What does it take to become a member: Consent of other Members (or Managers) Joinder to the Operating Agreement A Permitted Transfer Payment of expenses Compliance with securities laws, if applicable Optional closing of the books 106

113 ALLOCATIONS WHEN MEMBERSHIP INTERESTS CHANGE This Agreement has provisions explaining how to make allocations in case interests change. The tax rules permit two general methods: Close the Company's books when interests change. Allocate pro rata (e.g., a 50% interest held 30 days is allocated 30/365 of 50% of the year's Profits and Losses). 107

114 ALLOCATIONS WHEN MEMBERSHIP INTERESTS CHANGE This Agreement lets the transferee and transferor choose the allocation method they want. (e) Transfer of Percentage Interests. If one or more Percentage Interests are transferred during any fiscal year of the Company, the Company income or loss attributable to such Percentage Interests for such fiscal year shall be allocated between the transferor and the transferee in any manner permitted by law as they shall agree

115 ALLOCATIONS WHEN MEMBERSHIP INTERESTS CHANGE If the Company issues interests to a new Member, the Managers under this Agreement choose the allocation method (but in practice the method is often negotiated). The Managers may, at their option, at the time a Member is admitted, close the Company books (as though the Company's tax year had ended) or make pro rata allocations of loss, income and expense deductions to a new Member for that portion of the Company's tax year in which a Member was admitted in accordance with the provisions of Section 706(d) of the Code. 109