Structuring Equity Compensation for Partnerships and LLCs Navigating Capital and Profits Interests Plus Section 409A and Tax Consequences

Transcription

1 Presenting a live 90-minute webinar with interactive Q&A Structuring Equity Compensation for Partnerships and LLCs Navigating Capital and Profits Interests Plus Section 409A and Tax Consequences TUESDAY, FEBRUARY 14, pm Eastern 12pm Central 11am Mountain 10am Pacific Today s faculty features: Edward E. Bintz, Partner, Arnold & Porter, Washington, D.C. Brian J. O'Connor, Partner, Venable, Baltimore The audio portion of the conference may be accessed via the telephone or by using your computer's speakers. Please refer to the instructions ed to registrants for additional information. If you have any questions, please contact Customer Service at ext. 10. NOTE: If you are seeking CPE credit, you must listen via your computer phone listening is no longer permitted.

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5 Structuring Equity Compensation for Partnerships and LLCs February 14, 2017 Edward E. Bintz (202) Brian O Connor (410) bjoconnor@venable.com

6 Overview Discussion Topics Partnerships and LLCs Core Principles Profits interests Capital interests Options Phantom arrangements Partner/employee status Section 409A considerations Corporate conversions 6

7 Partnerships and LLCs Core Principles Classification Issues LLCs generally taxed as partnerships unless elections are made to treat them as corporations Consequences of Pass-through Tax Treatment No entity level tax and income, gain, loss and deduction flow-through to entity owners regardless of distributions by the entity 7

8 Partnerships and LLCs Core Principles (cont.) Allocation and Distribution Provisions Section 704(b) safe harbor Capital account maintenance Book-ups Liquidating or not liquidating with capital accounts Treatment of partnership distributions Differences between distributions made with regard to income and distributions made without regard to income 8

9 Equity Compensation Alternatives Profits Interests What is a profits interest? Case law Diamond v. Com r, 56 T.C. 530 (1971), aff d, 492 F.2d 286 (7 th Cir. 1974). GCM (July 25, 1977) St. John v. U.S., 84-1, USTC 9158 (C.D. Ill 1983). Kenroy Inc. v. Com r, 47 T.C.M (1984). Campbell v. Com r, 59 T.C.M. 236 (1990), aff d in part and rev d in part, 943 F.2d 815 (8 th Cir. 1991). 9

10 Equity Compensation Alternatives Profits Interests (cont.) Rev. Proc Provides guidance on what constitutes a profits interest and tax consequences associated with profits interests Profits interest defined as an interest other than a capital interest. A capital interest is an interest that gives holder a share of proceeds if partnership s assets sold at FMV and proceeds distributed in liquidation If Rev. Proc applies, grant of profits interest not a taxable event for service provider or partnership Applies if profits interest is granted to person for provision of services to (or for the benefit) of a partnership in partner capacity or in anticipation of being a partner 10

11 Equity Compensation Alternatives Profits Interests (cont.) Does not apply if: Profits interest relates to substantially certain stream of income from partnership assets (such as high grade debt security or net lease) Profits interest is disposed of within two years Profits interest is an LP interest in a publicly traded partnership Modifications under proposed regulations addressing management fee waivers (80 Fed. Reg. No. 141 (July 23, 2015)) 11

12 Equity Compensation Alternatives Profits Interests (cont.) Rev. Proc Provides guidance on treatment on profits interests subject to vesting requirements Provides that Rev. Proc applies at the time of grant of a profits interest even if not vested if: Service provider treated as owner of the partnership interest from the date of grant and takes into account allocations of income, loss, etc. in determining tax liability Neither partnership nor partners claim a deduction upon grant or vesting of the profits interests Distributions and Allocations prior to vesting. Alternatives include: Participate on same basis as if vested Participate in distributions but retained in separate account maintained by partnership until vested (at which point actually distributed). Tax distributions paid currently No participation 12

13 Equity Compensation Alternatives Profits Interests (cont.) 83(b) elections Importance of book-ups; valuations Effect of forfeiture Is it a profits interest or a bonus arrangement? Current proposed regulations and other proposed guidance Common structural approaches for profits interests Carried interest legislation and the President s budget 13

14 Equity Compensation Alternatives Capital Interests What is a capital interest? As of date of grant entitles holder to share of liquidation proceeds if partnership liquidated Also entitles holder to share of future profits Tax treatment of capital interests Similar to tax consequences associated with compensatory transfers of stock Service provider recognizes income equal to FMV value of interest at time vested (less any amount paid). Basis equal to income recognized 83(b) elections Partnership (and therefore partners) get compensation deduction equal to FMV included in service provider s income (subject to Sections 162 and 212) 14

15 Equity Compensation Alternatives Capital Interests (cont.) Capital shift issues Valuation of capital interest liquidation value or arm s length sale price for capital interest Effect of forfeiture Is a fill-up a profits interest or a capital interest? 15

16 Equity Compensation Alternatives Options on Partnership and LLC Interests Options to acquire capital interests Similar to stock options Upon exercise service provider and partnership have same tax treatment as grant of capital interest (taking into account payment of exercise price) Options to acquire profits interests No income to service provider at time of exercise and no deduction for partnership Generally not attractive to service providers from economic perspective 16

17 Equity Compensation Alternatives Phantom Interests Similar to phantom stock Service provider recognizes ordinary income at time of payment Partnership gets deduction equal to amount paid Can be subject to Section 409A if not eligible for short-term deferral exception or other exceptions 17

18 Equity Compensation Alternatives Phantom Interests (cont.) Section 409A structuring challenges if phantom interest holders are intended to share in event-based partnership distributions Example: Real estate partnership ABC holds multiple parcels of real estate. The partnership agreement provides for the distribution of profits upon the sale of a parcel. ABC would like to grant fully vested phantom interests to employees that provide for distributions to be made to phantom holders upon the sale of a parcel. Doing so would, however, present Section 409A compliance issues because the sale of a parcel of real estate is not a Section 409A-permitted payment event. Possible design solutions include requiring the holder to be providing services at the time of distribution, imposing performance goal conditions on the right to payment, and providing for fixed payment date(s) on which payment is made in respect of all prior sales. Each can have significant drawbacks. 18

19 Partner/Employee Status Can a partner be an employee? Case law Armstrong v. Phinney, 394 F.2d 661 (5 th Cir. 1968) IRS pronouncements Rev. Rul ; GCM (Dec. 23, 1969); GCM (July 25, 1969) Practical considerations Income tax consequences of non-employee treatment Withholding issues Employment taxes Employee deductions State tax considerations Compliance burdens 19

20 Partner/Employee Status (cont.) Employee benefit consequences of Non-employee status Not eligible to participate in cafeteria plans Health benefits not excluded from income, but deduction for premiums paid by self-employed No group term life insurance exclusion Qualified transportation and qualified moving expense reimbursement exclusions not available Can still participate in qualified retirement plans 20

21 Applicability of Section 409A To Grants of Partnership Equity Interests Final regulations do not address partnership equity compensation Preamble says that until guidance issued can rely on Notice Under Notice : May treat issuance of a partnership interest or an option to acquire a partnership interest in connection with performance of services under same principles as govern issuance of stock Service recipient stock requirement for options Option modification/extension rules If profits interest is treated under applicable guidance as not resulting in inclusion of income by service provider, then not Section 409A deferred compensation May treat issuance of capital interest in same manner as issuance of stock 21

22 Applicability of Section 409A to Partnership Allocations and Partner Service Provider Payments Guaranteed Payments Under Section 707(c) In general, guaranteed payments are payments made to a partner (in his capacity as a partner) without regard to the partnership s income for services or the use of capital The preambles to the proposed and final regulations provide that Section 409A applies to guaranteed payments described in Section 707(c) (and the rights to receive such payments in the future), only in cases where the guaranteed payment is for services and the partner providing the services does not include the payment in income [within the applicable short-term deferral period] 22

23 Applicability of Section 409A to Partnership Allocations and Partner Service Provider Payments (cont.) Example: A joins an accounting firm as a partner on January 1, As a part of terms of his joining the firm, he is entitled to a $50,000 bonus payment regardless of partnership profits, on April 15, 2016, provided that he remains as a partner through the end of The $50,000 payment would be a guaranteed payment that constitutes deferred compensation subject to Section 409A. 23

24 Applicability of Section 409A to Partnership Allocations and Partner Service Provider Payments (cont.) Payments Made to a Partner for Services Rendered Other Than in His Capacity as a Partner Under Section 707(a) Subject to Section 409A as if no partnership involved. Example: A is a one-third partner in a partnership ABC that operates a multiple printing shops. A is also a professional architect and pursuant to a contract with the partnership provides architectural services to ABC during 2014 in connection with the opening a new print shop. Under the terms of the contract, A is entitled to a payment of $15,000 on December 15, 2015 and a payment of $15,000 on April 15, The payments are Section 707(a) payments, and the $15,000 payment on April 15, 2016 would be deferred compensation subject to Section 409A. 24

25 Applicability of Section 409A to Partnership Allocations and Partner Service Provider Payments (cont.) Partner s Distributive Share of Partnership Income Under Sections 702 and 704 Not addressed by Section 409A regulations or other Section 409A guidance Although not addressed by the IRS, a partner s distributive share of income under Sections 702 and 704 from a partnership for which the partner provides services should not be treated as compensation for the partner s services to the partnership for purposes of applying Section 409A Note that the character of some or all of the income that flows through the partnership to the partner could be compensation income subject to Section 409A to the extent that the partnership has compensation income for services performed by the partnership 25

26 Applicability of Section 409A to Partnership Allocations and Partner Service Provider Payments (cont.) As result, Section 409A generally should not apply to the partner s distributive share of the partnerships income (except to the extent that Section 409A applies to income received by the partnership for services provided by the partnership). Example: A and B are partners in an auto parts business and share profits equally. A expects to have an increased need for cash during for a three year period. To accommodate A, A and B amend the partnership agreement so that profits will be shared 60%-40% for the three year period after the amendment, with the split flipping to 40%-60% for the next succeeding three year period, and then equally thereafter. B should not be treated as having any Section 409A deferred compensation. 26

27 Applicability of Section 409A to Partnership Allocations and Partner Service Provider Payments (cont.) Payments to Retiring Partners Under Section 736 The preamble to the final regulations provides that these payments may be treated as not subject to Section 409A, unless the payments meet the requirements for being exempt from SECA taxes under Section 1402(a)(10). Section 1402(a)(10) exempts payments to a retired partner if certain conditions are met, including that the payments be made on account of retirement and continue until the partner s death. 27

28 Equity Compensation Alternatives What is the Best Choice? Profits interests generally preferred Liquidity/exit considerations Partner/employee issues Complexity 28

29 Corporate Conversions General rules applicable when partnerships convert to corporations Treatment of corporate conversions to holders of profits interests Possibility of compensation treatment Valuation considerations Treatment of corporate conversions to holders of capital interests Treatment of corporate conversions to holders of compensatory options Treatment of corporate conversions to beneficiaries of phantom arrangements 29

30 Proposed Fee Waiver Regulations On July 22, 2015, the Treasury Department and the IRS released proposed regulations seeking to substantially curtail the use of management fee waivers. The proposed regulations address when profits interests will be treated as immediate disguised payments for services and, therefore, could impact the taxation of grants of profits interests well beyond management fee waiver situations. 30

31 Proposed Fee Waiver Regulations (cont d) Facts & Circumstances Test In determining when fee waivers will be treated as disguised payments for services, the proposed regulations adopt a facts and circumstances test. Under this test, if a fee waiver lacks significant entrepreneurial risk, the fee waiver would be taxed as ordinary income to the recipient. On the other hand, if there is real risk as to the amount of any future allocation, then the arrangement, as a general matter, may have significant entrepreneurial risk. 31

32 Proposed Fee Waiver Regulations (cont d) Positive Factors Factors suggesting significant entrepreneurial risk exists: Future allocation is based on net profits Future allocation is subject to a clawback obligation Recipient is reasonably likely to comply fully with any repayment responsibilities Future allocation is not certain to be available nor reasonably determinable at the time of the arrangement 32

33 Proposed Fee Waiver Regulations (cont d) Positive Factors Factors suggesting significant entrepreneurial risk exists: Future allocation is based on net profits Future allocation is subject to a clawback obligation Recipient is reasonably likely to comply fully with any repayment responsibilities Future allocation is not certain to be available nor reasonably determinable at the time of the arrangement 33

34 Proposed Fee Waiver Regulations (cont d) Negative Factors On the other hand, if there is a high likelihood that the recipient will receive an allocation regardless of the company s overall success, then the arrangement may not carry significant entrepreneurial risk. Factors suggesting there is not significant risk: Future allocation that is capped at the amount of the waived management fee and the cap is reasonably expected to apply in most years Future allocation is made out of the fund s gross income Future allocation of a share of income that is reasonably certain 34

35 Proposed Fee Waiver Regulations (cont d) Less Important Factors to Consider Service provider holds the LLC interest for a transitory period Service provider receives allocation/distribution in time frame comparable to that of non-partner service provider Service provider becomes partner primarily to obtain tax benefits which otherwise would not be available Value of service provider s interest is small in relation to allocation/distribution Arrangement provides for different allocations/distributions for different services received, and terms subject to differing levels of entrepreneurial risk 35

36 Proposed Fee Waiver Regulations (cont d) Proposed Regulations Preamble The preamble to the proposed regulations states that the IRS is likely to issue new guidance for applying Rev. Proc Specifically, the new guidance will add a fourth exception for profits interests issued in connection with a partner foregoing a payment. In addition, the new guidance is likely to remove from the safe harbor all profits interests where one party provides services and a related party receives the profits interests. 36

37 Contact Information Edward Bintz Brian O Connor Arnold & Porter Kaye Scholer Venable LLP 555 Twelfth Street 750 E. Pratt Street Washington, DC Baltimore, MD (202) (410) edward.bintz@apks.com bjoconnor@venable.com 37

38 Disclaimer Pursuant to IRS Circular 230, please be advised that, to the extent this communication contains any tax advice, it is not intended to be, was not written to be and cannot be, used by any taxpayer for the purpose of avoiding penalties under U.S. federal tax law. 38