INCENTIVE COMPENSATION IN LLCS AND PARTNERSHIPS

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1 INCENTIVE COMPENSATION IN LLCS AND PARTNERSHIPS First Run Broadcast: December 20, :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) The flexibility of LLCs and partnerships allows for a wide range of incentive compensation structures. The choice is not merely between equity and straight cash payments. Rather, the entity can offer a blend of equity, profit participation interests and appreciation rights. Within each structure, there are variations, including timing, vesting and taxability. A new consideration is the application of the new 3.8% Medicare tax. This program will provide you with a practical guide to forms of incentive compensation for LLCs and partnerships, the tax and non-tax consequences and tradeoffs of each, application of the new 3.8% Medicare tax and common traps. Incentive compensation in LLCs/partnerships ownership stakes v. profit participation interests v. appreciation rights Compensation plans for LLC members/partners v. employees Restricted interests and types of vesting schedules Employment tax considerations, including the new 3.8% Medicare Tax Traps of exchanging ownership interests for services Speaker: 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 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.

2 VT Bar Association Continuing Legal Education Registration Form Please complete all of the requested information and fax or with credit card 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 Incentive Compensation in LLCs and Partnerships Teleseminar December 20, :00PM 2:00PM 1.0 GENERAL MCLE CREDIT VBA Members $75 Non-VBA Members $115 NO REFUNDS AFTER December 13, 2013 PAYMENT METHOD: Check enclosed (made payable to Vermont Bar Association) Amount: Credit Card (American Express, Discover, Visa or Mastercard) Credit Card # Exp. Date Cardholder:

3 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: December 20, 2013 Seminar Title: Location: Credits: Incentive Compensation in LLCs and Partnerships Teleseminar 1.0 General MCLE Credit 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.

4 Incentive Compensation in LLCs and Partnerships L. Andrew Immerman Alston & Bird LLP Atlanta (o)

5 LLC = Partnership In this outline: Any LLC (other than a single-member LLC) is assumed to be classified as a partnership for income tax purposes. So in most of this outline, partnership and LLC are interchangeable. A single-member LLC is assumed to be disregarded as an entity separate from its owner for income tax purposes (but not, as explained below, for employment tax purposes). Classifying LLC members as limited partners for compensation purposes is discussed below. 2 2

6 Typical LLC Compensation General Partner/ Managing Member (Provides services, gets a profits interest) LLC/ LP Limited Partner/ Non-Managing Member Assets (Real Estate, Securities, or anything else) 3 3

7 Equity for Services: Corp vs. LLC An employee or other service provider is taxable on the receipt of C Corp or S Corp stock as compensation for services, although the tax can be deferred until the stock is vested. Code 83. As explained below, a service provider is generally not taxable on receipt of a vested or unvested "profits interest" in an LLC as compensation for services to or for the LLC. 4 4

8 Example: Equity for Services A and B form X. Each has an equal interest. A contributes property with a fair market value of $1,000 and a basis of zero. B contributes future services that he will perform for X, and receives an unrestricted interest in X. FMV = $1,000 Basis = 0 A X Services B 5 5

9 Equity for Services: X is a Corp If X is a corporation: A and B both have taxable gain. A has gain, equal to $1,000, because he is not in control of X immediately after the exchange (and is not part of a control group) B has taxable ordinary income equal to $500 (assumed to be the value of his interest in X). However, X may have a $500 deduction for the compensation to B. 6 6

10 Equity for Services: X is an LLC If X is an LLC: A has no taxable gain. 721 (no requirement of 80% control). As explained below, in general B also will have no taxable gain if he receives only a profits interest in X. However, if B receives a capital interest B will be taxable. 7 7

11 Property Transfers A challenge in determining the tax consequences of compensatory LLC interests is coordinating and reconciling two perhaps irreconcilable sets of rules: 83 (transfer of property in connection with the performance of services), based on fair market value concepts. Subchapter K (partnership tax), based on capital account concepts. 8 8

12 Property Transfers General rules of 83 (not specific to partnerships): Taxable event occurs at grant, or when property is transferable or no longer subject to substantial risk of forfeiture (i.e., substantially vested). Amount included in income of service provider is fair market value of property over amount paid (if any). Deduction allowed to business for amount included in income by service provider. 9 9

13 Property Transfers 83(b) election: Service provider may elect to include value of unvested property in compensation income at time of transfer. Subsequent appreciation in value is generally capital gain. Election must be made within 30 days of transfer no exceptions

14 Receipt of Profits Interest Rev Proc 93-27, CB 343, defines two types of partnership interests, as determined at time of issuance: Capital Interest: partnership interest that would entitle the holder to a share of liquidation proceeds if partnership assets were sold at FMV. Profits Interest: partnership interest that is not a capital interest; generally entitles holder only to a share of post-issuance partnership income and gain

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

16 Unvested Profits Interest Rev Proc , CB 191, says that Rev Proc applies to a profits interest that is subject to a substantial risk of forfeiture if partnership and recipient treat the recipient as the owner of the partnership interest from the date of grant. 83(b) election is not required, although is often recommended by advisors as a protective measure. In effect, the two Rev Procs give precedence to Subchapter K principles over

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

18 Safe Harbor vs. Substantive Law Rev Proc and Rev Proc are safe harbors; follow them and the IRS won t challenge you. They are not substantive rules of law, but depart from them and you are thrown back to a confusing mass of authorities. For example, 83 seems irrelevant under the two Rev Procs, but how does 83 apply outside of them? 15 15

19 2005 Proposals Proposed regulations under several Code sections, and accompanying proposed revenue procedure, Notice , issued in May REG In the unlikely event they ever become effective, they would obsolete current guidance, including Rev Proc and Rev Proc However, the proposals would generally allow partnerships to achieve the same favorable results as under current guidance, if the right elections are made: Safe harbor liquidation value election. 83(b) election for unvested interests

20 FMV or Liquidation Value Default rule (no election): Service partner taxable on fair market value of partnership interest. Value of partnership interest is the amount a willing buyer would pay a willing seller. Even a pure profits interest has some fair market value, and is taxable at grant. Thus the default rule follows 83 rather than the two Rev Procs

21 FMV or Liquidation Value Safe Harbor election: Value of partnership interest equals liquidation value. Thus the election more or less permits the parties to follow the Rev Procs, and to sidestep 83. However, there are many obstacles to making an election: Partnership agreement must contain provisions, legally binding on all of the partners, that all partners agree to comply with the safe harbor. Alternative: Each partner in the partnership must execute a legally binding document agreeing to the safe harbor. Effective date of election cannot be prior to execution date. IRS has informally acknowledged that the proposed requirements for the election were overly strict. Proposed legislation may make liquidation value the default rule, so no election would be necessary

22 2005 Proposals: Unvested Interests Under the proposals, an unvested compensatory partnership interest in itself does not make the holder a partner for tax purposes. Vesting of the interest makes the holder a partner. The holder has compensation income. Other partners have compensation deduction (subject to possible capitalization). 83(b) election is treated like vesting; it makes the holder a partner for tax purposes

23 2005 Proposals: Capital Shift On issuance of a capital interest, some of the capital of the existing partners shifts, in effect, to the new partner. Similarly, on vesting of an unvested profits interest, capital often shifts from the existing partners to the new one. If a service provider gets a capital interest without putting in capital, then the only place that the service provider s capital can be coming from is the other partners. Generally if property is transferred as compensation for services, the transferor recognized gain as if it sold the property to the service provider? Issue: Do the existing partners recognize gain on a capital shift, as if they had sold an interest in the assets of the LLC to the new partner? 20 20

24 2005 Proposals: Capital Shift The 2005 proposals take the pro-taxpayer (but somewhat controversial ) position that the existing partners do not recognize gain. Prop Reg (b)(2)(i) and -1(b)(3). Trap: Gain would be recognized by the LLC member on the issuance or vesting to a new member of an interest in a disregarded LLC that becomes a partnership for tax purposes as a result of the issuance or vesting

25 Final Regulations? Treasury reportedly is not working on finalizing the 2005 proposals. Treasury, very sensibly, is waiting to see what Congress comes up with. Proposed legislation is discussed below

26 Fee vs. LLC Equity For one illustration of the stakes in characterizing amounts as fees rather than as the return on an LLC equity interest, see Rigas v. United States, S.D. Tex. (May 2, 2011). Even in what appears to be a simple contract for services, tax advice on deal structure can make a big difference

27 Example: Fee for Services B manages $1,000 of investments for A. B is entitled to 20% of future profits. A $400 A earns $2,000 capital gain. A pays $400 to B. Services B A has $2,000 capital gain less $400 expense = $1,600 taxable income. A (a corporation) pays 35% of $1,600 = $560. B (an individual) pays 39.6% of $400 = $ B also pays self-employment tax

28 Example: Equity for Services A and B form X LLC. A contributes $1,000 for 80% of future profits. B contributes services for 20% of future profits. X earns $2,000 capital gain. A pays 39.6% of $1,600 = $ B pays 20% of $400 = $80. No self-employment tax. However, net investment income tax likely applies. $1,000 Services A B X 25 25

29 Fee vs. LLC Equity As discussed above, neither A nor B is taxed on receiving the LLC interest. If the tax treatment of LLC compensation were comparable to the tax treatment of corporate compensation, B would pay tax on receipt. However, Congress has not shown much inclination to change that result. Because A is a corporation, A pays the same amount of tax whether B gets a fee or LLC equity. However, B pays about half as much tax on his share of the LLC income than on the service fee. Arguably, B s capital gain on future appreciation is no different than the corporate employee s capital gain on future appreciation in stock received as compensation. However, there has been a serious push in Congress to tax B at ordinary rates (plus self-employment tax)

30 Basic Private Equity Fund Individual Managers Manager, LLC 20% Carried Interest 1% Capital Investors 99% Capital 2% Service Fee Fund, LLC Affiliate, LLC Investments 27 27

31 Carried Interests Carried interest = carry or promote. Often used interchangeably with profits interest. It is a profits interest issued for services; the holder has a greater interest in profits than in capital. The holder of a carried interest ( Manager ) often participates in a straight percentage of the LLC s future profits (for example, 20%), after some return to the cash investor. Manager may put in cash (perhaps 1% - 10% of the total equity), but the carried interest is not granted for the cash

32 Carried Interests Manager reports its distributive share of income, gain, loss, deduction and credit. No one deducts any amount as wages, compensation or otherwise with respect to Manager s share of income. If the LLC recognizes long-term capital gain, Manager (or individual owners of the Manager entity) is taxed on its share of the gain at capital gain rates. Maximum long-term capital gain rate for individuals is generally 20%, rather than 39.6% (rates beginning in 2013)

33 Carried Interests Carried interests have been around forever. They suddenly spawned controversy in 2007, largely because of publicity surrounding private equity managers huge capital gains and lavish spending. If the LLC has ordinary income, Manager s share is ordinary as well. Hedge funds make extensive use of carried interests but may generate little long-term capital gain

34 Management Fee Manager or an affiliate of Manager may also have a service contract providing for a management fee (for example, 2% of assets). Management fee is not a carried interest. Management fee is ordinary income. However, sometimes the management fee is converted into a profits interest, which arguably can convert the ordinary income into capital gain

35 Management Fee A management fee to a partner is generally a guaranteed payment as defined under Code 707(c), which does not mean it is truly guaranteed. It is determined without regard to the partnership s income. It is made to the partner in its capacity as a partner It is ordinary income to the partner and generally deductible by the partnership. If the management fee is paid to an affiliate of the partner (rather than to the partner) it is generally just a business expense of the partnership

36 Non-Partner Capacity Payments Payments made to a partner who is not acting in his capacity as a partner are generally treated as if made between the partnership and a non-partner. Code 707(a). In many contexts, the difference between a 707(a) payment and guaranteed payment is not of great importance. But if allocations under a profits interest could be recharacterized as 707(a) payments, the tax consequences would be enormous. Such recharacterization is theoretically possible, especially if the recipient of the profits interest does not bear entrepreneurial risk. However, it generally would be hard position for the IRS to sustain. The IRS has never issued regulations on point and does not appear to be pursuing that line of attack

37 Carried Interests: Proposed Legislation Several bills have been introduced in Congress to add new Section 710 to the Code. There are differences among the bills but all would: Characterize allocations attributable to many carried interests as ordinary income, subject to: Ordinary income tax rates plus, Self-employment tax. Apply to many entities besides private equity funds. Deny any compensation deduction to the other LLC members. Continue to permit carried interests to be received free of initial tax, unlike compensatory corporate stock

38 Carried Interests: Proposed Legislation All versions have some exception for invested capital. To the extent managers receive a return on their own invested capital, 710 does not apply. However, the exception has been drafted narrowly. Versions have been passed several times by the House but not enacted

39 What Can Managers Do? Techniques that might work under some versions of 710 are prohibited under others. Be skeptical of reports suggesting that managers are rushing en masse to restructure their carried interests. For example, under the more recent proposals, it won t help for the managers to: Borrow from the cash investors to make a bigger capital investment in the LLC. Take convertible or contingent debt, options, or derivatives, with respect to the LLC

40 What Won t Section 710 Affect? The scope of 710 if enacted -- is impossible to predict. However, although the versions that have passed the House are overbroad, Congress target has been investment managers. LLC members active in operating businesses are the least likely to be affected, even though they (like recipients of corporate stock) often earn capital gain by performing services

41 Profits Interests vs. Options Corporate options and carried interests both enable workers to participate in future growth. The strike price of the corporate option usually must be at least the fair market value of the stock on the date of grant. Thus the option holder does not have a share of the existing fair market value, value, but can profit from future increases in value. The profits interest by definition does not entitle the member to share in any of the liquidation value that the LLC has on the date of grant. Thus the option holder does not have a share of the existing liquidation value, but can profit from future increases in value. Compensatory options in corporations or LLCs do not result in capital gains for the holders when exercised. Profits interests often generate capital gains for the holders

42 Profits Interests vs. Options For partnerships, carried interests traditionally (and deservedly) have been more popular than options. Options are familiar in the corporate world, and are sometimes used by LLCs only because of this familiarity. LLC clients who want to issue options sometimes will prefer profits interests once they understand how profits interests work. The 2005 proposals have little detail on compensatory options, but do take the position that the existing partners recognize no gain on issuing a partnership interest on the exercise of a compensatory option

43 LLC Options If the LLC does grant options, then the following treatment seems reasonable (assuming that the optionholder is treated only as an optionholder) : The optionholder continues to be treated as an employee. The employee should not have any income on receipt of the option. The employee has ordinary compensation income (presumably based on fair market value ) on exercising the option. The partnership should have a deduction (or in some cases a capitalized cost) when the employee exercises the option. The partnership should not recognize income on the granting or exercise of the option (but gain is likely recognized on the exercise of a an option on an interest in a single-member LLC)

44 Code 409A 409A (enacted 2004) caused an upheaval in the treatment of corporate executive compensation. Under 409A, amounts deferred under a nonqualified deferred compensation plan are currently includible in gross income to the extent not subject to a substantial risk of forfeiture, unless strict requirements are met. Failure to meet the requirements subjects the service provider to interest plus a 20% penalty. 409A is not intended to apply to transfers of property that are subject to Code

45 Code 409A Partnerships are not exempt from 409A. Preamble to the final 409A regulations: taxpayers may apply the principles applicable to stock options or stock appreciation rights under these final regulations, as effective and applicable, to equivalent rights with respect to partnership interests. T.D. 9321, 72 Fed Reg (April 11, 2007). There is not much authority on applying 409A to LLC compensation, but in general the impact of 409A on equity-based LLC compensation has been very muted compared to its pervasive influence on corporations

46 LLC Compensation Exempt from 409A Profits interests that qualify under Rev. Proc are exempt from 409A. Notice , CB 274, 279 (Q&A 7) Yet another reason to prefer profits interests over other forms of LLC compensation! Since capital interests seem to clearly be property subject to Code 83, they are probably not subject to 409A. Guaranteed payments (Code 707(c)) are generally not subject to 409A, unless payment by a cash-basis LLC is delayed more than 2 ½ months after the end of the year

47 LLC Compensation Exempt from 409A Retirement payments (described in Code 736) are generally not subject to 409A. Exception: 409A does apply to retirement payments under Code 1402(a)(10). Payments to an individual that continue at least until death. Made after all capital has been returned. Individual provides no services to the LLC. The other partners have no obligations to the individual except for these payments. The advantage of 1402(a)(10) payments is exemption from self-employment tax

48 LLC Compensation Subject to 409A Code 707(a) payments are subject to 409A. As noted above, these are payments made to a partner, other than in his capacity as a member of the partnership. They are generally treated as occurring between the partnership and a non-partner. Options are subject to 409A. LLC options seem to treated under 409A much like corporate options. Most importantly, the option exercise price must not be less than the fair market value of the employer stock (or LLC interest) on the date of grant

49 LLC Compensation and 457A Code 457A (enacted 2008) is in some ways an expansion of 409A. It accelerates tax on deferred compensation paid by "nonqualified entities, even if the deferred compensation complies with 409A. The provision was directed at hedge fund managers who were deferring compensation through foreign corporations; however, the provision applies much more broadly. Nonqualified entities include: A foreign corporation (unless substantially all of its income is effectively connected with the conduct of a U.S. trade or business or subject to a "comprehensive foreign income tax ). A partnership (unless at least 80% of its income is allocated to persons other than foreign persons not subject to a comprehensive foreign income tax, and organizations that are exempt from U.S. federal income tax). Partnerships that have substantial foreign or tax-exempt ownership should consider 457A carefully. See Notice , I.R.B

50 Allocations and Distributions An LLC distribution is an amount that the LLC member receives. An LLC allocation is an amount of profits, losses, or other items that are attributed to the member on the LLC's books. Typically -- although there are many exceptions -- the distribution is tax-free and the allocation is taxable. The allocation is taxable whether or not there is a corresponding distribution. It may seem exactly backwards that you can receive distributions taxfree but must pay tax on accounting entries. However, for holders of LLC equity interests, that is the normal pattern. Contributions, distributions, and allocations are interrelated concepts. Over the life of the LLC, contributions plus or minus allocations equal distributions. Any time you change one of these items contributions, distributions, and allocations you must consider how the others may be affected

51 Two LLC Drafting Approaches Traditional (layer-cake) allocation. Specifies the allocation of income and loss. Liquidating distributions are made so as to match allocations. More precisely, the distributions are made in accordance with the capital accounts, which in turn reflect the allocations that have been made. Considered the safer approach under the tax regulations. However, may give the members less certainty about the way liquidating distributions will be made

52 Two LLC Drafting Approaches Targeted (forced) allocation. Specifies the distribution of proceeds on liquidation of the LLC. Allocations are made so as to match liquidating distributions. More precisely, allocations are made so that capital accounts (subject to some adjustment) equal the amounts that would be distributed on a liquidation of the LLC at book value. Validity of approach under tax regulations is less clear. However, it is now widely used, and may give the members more certainty about the way liquidating distributions will be made. This approach requires special care when dealing with profits interests

53 Example: Traditional Allocations Investors put in $1,000 and get 50 Class A Units. Workers put in services and get 100 Class B Units. 50 Class B Units are issued on the first day of Year One, when the net value of all the LLC's assets is $1, Class B Units are issued on the first day of Year Two, when the net value of all the LLC's assets has increased to $3,000. Nothing else of relevance occurs during the year (i.e., no capital contributions, distributions, profits, or losses)

54 Example: Traditional Allocations Allocation of Profit and Loss: Allocate profits to offset prior losses. Allocate all remaining profits pro rata by unit. Allocate losses in accordance with capital accounts. Before the Year Two Class B Units are issued, the $2,000 of increased value is treated as profit for purposes of booking up (restating) capital accounts of all unit holders. Capital accounts for Class A Units and Year One Class B Units are increased by $2,000/100 = $20 per unit

55 Example: Traditional Allocations Liquidating Distributions: Distribute proceeds in accordance with capital accounts. Does this work? Greatly oversimplified, but generally yes. On immediate liquidation after the Year Two units are received: Class A Units first get back $1,000. $2,000 is distributed pro rata between Class A Units and Year One Class B Units ($20 per unit). Holders of Year Two Class B Units get nothing. Even if all Class B Units looked the same on the surface, they in fact carried different rights; they were associated with different capital accounts. All Class B Units are profits interests However, some Class B Units carry greater distribution rights than others

56 Example: Targeted Allocations Same basic facts. Investors put in $1,000 and get 50 Class A Units. Workers put in services and get 100 Class B Units. 50 Class B Units are issued on the first day of Year One, when the net value of all the LLC's assets is $1, Class B Units are issued on the first day of Year Two, when the net value of all the LLC's assets has increased to $3,000. Nothing else of relevance occurs during the year (i.e., no capital contributions, distributions, profits, or losses)

57 Example: Targeted Allocations Allocation of Profit and Loss: Allocate as needed so that capital accounts are equal to the required liquidating distributions. $2,000 of increased value is treated as Profit for purposes of booking up (restating) capital accounts of all unit holders, so that capital accounts equal amounts that would be distributed on liquidation. Capital accounts for Class A Units and Class B Units are increased by $2,000/150 = $13.33 per unit. On liquidation, Class A Units get back their capital, and then all distributions are pro rata by unit. Does this work? No

58 Example: Targeted Allocations On liquidation, Class A Units get back any unrecovered capital, and then all distributions are pro rata by unit. Class A Units first get $1,000. Additional $2,000 is shared pro rata by all units ($13.33 per unit), including Class B Units issued in Year Two. Class B Units issued in Year One are profits interests, generally not taxable to the workers on receipt. On immediate liquidation after the units were received, Class B Units would get none of the $1,000. On liquidation after a year, Class B Units do get $13.33 per unit

59 Example: Targeted Allocations On these facts, Class B Units issued in Year Two are capital interests, generally taxable to the workers on receipt. On immediate liquidation after the units are received, these Class B Units get $13.33 per unit. The right to receive proceeds on a liquidation is the definition of a capital interest. Class B Units issued in Year Two are capital interests; they would share in a liquidating distribution even if there are no future profits or growth. All Class B Units had equal distribution rights, but the Year Two Class B Units were taxable capital interests

60 Example: Targeted Allocations Class B Units issued in Year Two should have had lower distribution rights than Class B Units issued in Year One, the same as in the traditional allocation example. It is possible to use targeted allocations even when workers receive profits interests at different times, but be careful. For example, LLC could have granted only Class C Units in Year Two, and provided that Class C Units only share in liquidating distributions over $3,000. Regardless of the allocation method, or the labels that are given to the units, profits interests granted at widely different times normally will not have the exact same rights to receive LLC distributions; and if they do have the exact same distribution rights they likely 57 are not strictly profits interests. 57

61 Partners Cannot be Employees Before the Internal Revenue Code of 1954, courts ruled that it was impossible for a person to serve the dual role of employer and employee in a single transaction. Each partner is in some sense the employer of the partnership s employees, so if a partner were an employee the partner would be both employer and employee which was (at least at that time) thought to be an absurd result

62 Partners Cannot be Employees The law seems reasonably well-settled that for tax purposes partners are not considered employees of their own partnership. Rev Rul , CB 256. Instead, partners who work for their partnerships are considered self-employed. IRS officials have informally expressed some interest in reconsidering this rule, but a change is very unlikely in the near future. The same rules apply to LLC members who are taxed as partners. Partners receive a Schedule K-1 each year and not a Form W

63 Guaranteed Payments Fixed salary of partners is characterized as a guaranteed payment for services under 707(c) rather than as wages. As noted above, a guaranteed payment is made to a partner in his capacity as a partner, but is determined without regard to the partnership s income. For key purposes, a guaranteed payment is not treated as a distribution or allocation; it does not directly affect the recipient s capital account

64 Guaranteed Payments Includable in income of recipient partner ( 61(a)) and deductible ( 162(a)) by partnership unless required to be capitalized under 263. Inclusion occurs in partner s taxable year in which or with which the partnership s tax year ends. Deduction to partnership when paid or accrued

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

66 SECA Compared to FICA SECA and FICA are intended to be equal: Both comprise: Old-age, survivor and disability insurance ( OASDI ) or social security component, plus Hospital insurance ( HI ) or Medicare component. SECA rates: OASDI rate of 12.4%, on the first $113,700 (in 2013), plus HI rate of 2.9% on all amounts -- no ceiling. Partners are allowed a deduction for ½ of the self-employment tax paid. 164(f). SECA equals combined rate of employer's and employee's share of FICA. Beginning in 2013, additional 0.9% Medicare tax above a threshold ($250,000 for married taxpayers filing jointly)

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

68 SECA and Carried Interests Capital gain is not subject to SECA. However, if capital gain is recharacterized as ordinary income under 710 (the legislative proposal on carried interests discussed above) the recharacterized income would be subject to SECA

69 Comparing SECA and FICA Since partner pays 100% of SECA, but employee pays only part of FICA, a partner in a service partnership will pay more on a given amount of net earnings from self-employment than an employee will pay on the same amount of wages. Should a partner be paid more than a comparable employee, to take SECA into account? 66 66

70 SECA and Limited Partners Limited Partners are subject to SECA only on guaranteed payments for services. Code 1402(a)(13). Are LLC members general partners or limited partners? Proposed regulations from 1997 would have provided guidance on when LLC members (and also partners in partnerships) would be treated as limited partners for purposes of self-employment tax. Prop Reg (a)- 2. The proposed regulations became a political hot potato; they won t be finalized without direction from Congress. However, the IRS says it is planning to issue regulations on the treatment of LLC members as limited partners for purposes of the passive activity loss rules of Code

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

72 LLC Members as Limited Partners In the absence of final regulations, LLCs take different positions. The most conservative LLCs assume LLC members are never limited partners. Reasonably conservative LLCs follow the 1997 proposed regulations. More aggressive LLCs exclude amounts above reasonable compensation from selfemployment tax. The most aggressive LLCs assume all LLC members are limited partners

73 LLCs vs. S Corps S Corp shareholder/employees are subject to FICA and not SECA. A portion of earnings that would be subject to selfemployment taxes if earned by a sole proprietor or partner may in some cases escape employment tax if generated by an S Corp. Dividends from S Corps are not subject to employment tax, even if paid to a shareholder/employee. However, the IRS has been actively challenging closelyheld S Corps for failure to pay reasonable compensation

74 LLCs vs. S Corps Congress has considered proposals to subject many S Corp shareholders to the same treatment as general partners. If you are choosing an S Corp over an LLC taxed as a partnership in order to save employment taxes, consider that: Saving may be illusory even under current law. Congress may amend the rules to ensure that many S Corp shareholders/employees pay the same amounts as general partners. Unlike LLCs, S Corps generally cannot be liquidated tax-free (or converted into partnerships); you likely will be stuck as an S Corp indefinitely, even if Congress changes the rules. Many other disadvantages of S Corps over LLCs. Reduced compensation may limit the opportunity for qualified retirement plan contributions

75 Tax on Net Investment Income In 2013, for the first time, there is a special additional tax on net investment income (i.e., investment) income of individuals. Code 1411; see T.D (Dec. 2, 2013) (adopting final regulations) New tax is 3.8% of modified adjusted gross income above a threshold ($250,000 for joint returns). Although the 3.8% tax was enacted in 2010, the effective date was delayed until This net investment income tax is sometimes referred to as a Medicare tax

76 Tax on Net Investment Income Net investment income includes active business income of a partnership if the partner does not actively participate in the business. Incorporates concepts from passive activity loss rules. Same rule for S corporation shareholders. However, it has been argued that S corporation shareholders who actively participate in their businesses may have a greater opportunity than partners to avoid both FICA/SECA and the new tax on net investment income

77 Increased Medicare Tax on Earned Income Additional 0.9% Medicare (hospital insurance or HI) tax applies to wages in excess of: $250,000 (joint return or surviving spouse). $125,000 (married filing separate). $200,000 (other cases). Also applies to self-employment income in excess of these amounts. Previously, there had been no progressivity in the rates of employment and self-employment tax. Although the 0.9% increase was enacted in 2010, the effective date was delayed until

78 Employee Benefits Some favorable benefit rules do not cover partners. For example, a partner may not exclude from income: Premiums paid by the partnership for accident and health insurance However, a partner is entitled to deduct 100% of the premium the partner pays. 162(l). Group-term life insurance. 79; Reg (b)(2). Value of meals and lodging furnished for the convenience of the employer Qualified transportation fringes or qualified moving expense reimbursement. Reg (b)

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

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

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

82 Converting Partners to Employees Many individuals prefer the simplicity of wage withholding. This preference is especially pronounced outside professions -- like law and accounting -- that traditionally operated in partnership form. At the same time, it is often important for those individuals to have an equity stake in the business. Phantom equity plans may be an alternative that enable the individuals to retain employee status. Phantom equity will not generate capital gains for the individuals. Will it incentivize as well as true equity? As the partnership and LLC form of doing business keeps expanding, this dilemma becomes more acute Is there any solution? 79 79

83 Converting Partners to Employees Partners A and B contribute LLC interests to S Corp. A B S Corp Other Owners LLC Since A and B are no longer partners in LLC, can they be employees of LLC (or of S Corp)? 80 80

84 Converting Partners to Employees Partners A and B contribute LLC interests to LLC Holdco. A B LLC Holdco Other Owners LLC Since A and B are no longer partners in LLC, can they be employees of LLC? 81 81

85 Phantom Equity LLCs sometimes try to avoid reclassifying employees as partners by giving them only phantom equity. Designed to replicate or resemble the economic benefits of a partner s equity interest, but without partner status for tax purposes. Virtual options or equity appreciation rights are a kind of phantom equity, intended to give the employee a share of the LLC s appreciation in value, without turning the employee into a partner for tax purposes. Phantom equity likely needs to comply with the 409A rules applicable to corporations

86 Phantom Equity There is good authority that the holder of corporate stock appreciation rights ( SARs ) is not a stockholder for tax purposes. See, for example, Rev Rul , CB 165. There is no comparable express authority that the holder of LLC equity appreciation rights is not a partner for tax purposes. However, many LLCs take the position that the corporate precedents apply

87 Phantom Equity There are not even proposed regs on phantom interests in partnerships. However, the following treatment seems reasonable: Assuming the phantom interest is not treated as an actual interest for tax purposes, the employee is not be treated as a partner. The employee should not have any income on receipt of the interest. The employee has ordinary compensation income equal to the payments from the partnership. The partnership should have a deduction (or at worst a capitalized cost) when it pays the employee. The partnership should not recognize income on granting the interest

88 Single-Member LLCs In most cases a single-member LLC is classified as a disregarded entity (treated more or less like a branch or division of its owner) for federal income tax purposes. Effective January 1, 2009, disregarded LLCs are treated as corporations for federal employment tax purposes. Reg (c)(2)(iv), as amended by TD 9356, IRB

89 Single-Member LLCs If the single-member LLC has employees, it must report and pay federal employment taxes under its own name and have its own taxpayer identification number. This rule covers FICA, FUTA, and income tax withholding on wages. This rule does not cover self-employment tax when a single-member LLC is owned by an individual. An individual employed by his own single-member LLC must pay his own self-employment tax

90 Single-Member LLCs Previously, Notice 99-6, CB 321, gave taxpayers two reporting choices: Single-member LLC is employer, or Owner of single-member LLC is employer. Excise tax is also now reported separately by single-member LLC. Income tax treatment of single-member LLCs is not affected by employment tax and excise tax rules