INCENTIVE COMPENSATION IN BUSINESS ENTITIES, PART 1 & PART

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1 INCENTIVE COMPENSATION IN BUSINESS ENTITIES, PART 1 & PART 2 First Run Broadcast: February 16 & 17, 2016 Live Replay: December 27 & 28, :00 p.m. E.T./12:00 p.m. C.T./11:00 a.m. M.T./10:00a.m. P.T. (60 minutes each day) Companies of every type, whether operated as C or S Corporations, LLCs or partnerships, often prefer to offer their managers and other employees incentive compensation as part of their overall compensation packages to provide real and tangible incentives to help grow the company. The range of incentive compensation tools and techniques available to these companies depend on the type of entity involved but are generally extensive. Corporate entities have stock options, restricted stock and other forms of profit or capital appreciation rights. LLCs are even more flexible and can award a variety of forms of profit or capital rights. These alternatives, together with voting and vesting restrictions, provide companies alternatives for virtually every circumstance. But each alternative comes with tradeoffs practical, tax and financial. This program will provide you with a real world guide to the incentive compensation alternatives to C and S corporations, LLCs and partnerships. Day 1 December 27, 2016: Incentive compensation in C and S corporations, LLCs and partnerships How incentive compensation differences between corporate and pass-through entities Framework of incentive compensation alternatives in each type of entity Advantages and drawbacks of stock options, restricted stock, and profit participation rights How IRC Section 83 impacts corporate stock options, the award of restricted stock and other rights Use of vesting to impact the tax consequences of incentive compensation Special incentive compensation issues in S Corps Day 2 December 28, 2016: Use of profit interests and capital interest in LLCs, partnerships Exchanging incentive compensation for services Incentive compensation in single member LLCs Impact of IRC Section 409A and deferred compensation Employment tax considerations Role of the 3.8% tax on net investment income Understanding how carried interests in incentive compensation Speakers: Norman Lencz is a partner in the Baltimore, Maryland office of Venable, LLP, where his practice focuses on a broad range of federal, state, local and international tax matters. He advises clients on tax issues relating to corporations, partnerships, LLCs, joint ventures and real estate transactions. He also has extensive experience with compensation planning in closely held

2 businesses. Mr. Lencz earned his B.S. from the University of Maryland and his J.D. from Columbia University School of Law. 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.

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 Incentive Compensation in Business Entities, Part 1 Teleseminar December 27, :00PM 2:00PM 1.0 MCLE GENERAL CREDITS VBA Members $75 Non-VBA Members $115 NO REFUNDS AFTER December 20, 2016 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 Incentive Compensation in Business Entities, Part 2 Teleseminar December 28, :00PM 2:00PM 1.0 MCLE GENERAL CREDITS VBA Members $75 Non-VBA Members $115 NO REFUNDS AFTER December 21, 2016 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: December 27, 2016 Seminar Title: Incentive Compensation in Business Entities, 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: December 28, 2016 Seminar Title: Incentive Compensation in Business Entities, 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 SUMMARY OF TYPES OF EQUITY AWARDS IN A CORPORATE EMPLOYER Norman Lencz Venable LLP Baltimore, Maryland (o) (410) nlencz@venable.com Description Federal Income Taxation STOCK OPTIONS RESTRICTED STOCK STOCK APPRECIATION RIGHTS ( SAR ) A right (but not an obligation) A grant of company A right to receive the excess to purchase a certain number stock, generally without of the value of a certain of shares of company stock at payment by the employee, number of shares of company a specified price for a certain subject to forfeiture if stock over a specified base period of time. The right is vesting conditions are not value (generally the value of generally exercisable after the met. The stock is issued company stock on the grant option vests. However, some in the employee's name at date) at a certain time in the options allow exercise before the grant date, but future after the SAR vests. vesting, with the shares generally held by the The payout may be in cash or purchased subject to forfeiture company with a stock in an equivalent number of until the option would have power in blank until the shares. vested. shares vest. 1. Regular Federal Income Tax Treatment Nonqualified Option Employee is taxed at exercise of the option on the excess of the then value of the stock over the amount paid. In the case of an employee, the income is subject to tax withholding and reported on Form W-2. The company gets a corresponding deduction. 1. Regular Federal Income Tax Treatment Employee is taxed on the excess of the then value of the stock over the amount paid (if any) at one of the following times. The taxation occurs at receipt of the stock if an "83(b)" election is filed within 30 days of receipt. 1. Regular Federal Income Tax Treatment Employee is generally taxed on the appreciation in the shares covered by the SAR when payment is received. In the case of an employee, the income is subject to tax withholding and reported on Form W-2. The company is entitled to a corresponding deduction. PHANTOM STOCK A right to receive the full value of a certain number of shares of company stock at a certain time in the future after the grant vests. The payout may be in cash or in an equivalent number of shares. (If the payout is made in shares, this is tantamount to what is known as a "Restricted Stock Unit"). 1. Regular Federal Income Tax Treatment Employee is generally subject to income tax on the value of the number of shares covered by the Phantom Stock award when payment is received. However, FICA taxes apply when the phantom shares are vested. In the case of an employee, the income is subject to tax withholding and reported on Form W-2. The company is

8 Incentive Stock Option Employee is not taxed at exercise of the option, but the "spread" is a tax preference for the alternative minimum tax. The employee is taxed on the gain upon disposition of the stock. The income on sale is capital gain if the stock has been held for 2 years from the option grant date and 1 year from option exercise. Otherwise a portion of the gain up to the "spread" at exercise is ordinary income. The company gets a corresponding deduction only as to the portion of the gain taxed as ordinary income to the employee. Otherwise taxation occurs upon vesting In the case of an employee, the income is subject to tax withholding and reported on a W-2. The company gets a corresponding deduction at the same time as the employee recognizes income. entitled to a corresponding deduction. 2. Section 409A Implications Stock options for "service recipient" stock are exempt from Code Section 409A if the option is an incentive stock option or, if a nonqualified option: (i) the exercise price may never be less than the fair market value at the grant date, (ii) the stock transferred upon exercise is subject to taxation, and (iii) there are no deferral features under the option other than deferral until exercise. (If Section 409A applies to a stock option, the option would 2. Section 409A Implications Generally restricted stock of the service recipient is not subject to Section 409A if it is taxable immediately upon vesting. 2. Section 409A Implications SARs in service recipient stock are exempt from Code Section 409A if: (i) Compensation under the SAR cannot be greater than the difference between the fair market value of the stock on the exercise date over the fair market value on the grant date of a fixed number of shares, (ii) The exercise price can never be less than the fair market value of the underlying stock on the grant date, and (iii) The SAR does not include any feature for the 2. Section 409A Implications Phantom shares are generally subject to Code Section 409A and thus must comply with the rules as to elections regarding deferral and payment. (An exception would be if payout is set to occur within 2½ months of the end of the employee s or service recipient s tax year in which the phantom shares vest.) Failure to comply with the rules of Section 409A results in income taxation at vesting, potential interest payments and a 20% penalty tax.

9 have to meet the requirements of Section 409A. Otherwise, the option would be taxable at vesting, with a 20 percent penalty tax.) deferral of income other than deferral until the SAR s exercise.

10 Pros STOCK OPTIONS RESTRICTED STOCK SAR PHANTOM STOCK No shareholder rights until Greater value to employee No shareholder rights until No shareholder rights until exercise per share awarded exercise payment Cons Taxation delayed until exercise Conveys only appreciation in shares No immediate accounting expense Possibility that option will be exercised before company sale Typically used for only a core founder group Provides for more "skin in the game" to align top level executives with shareholders Immediate shareholder rights Taxation immediate or upon vesting Dilutes existing shareholder value No shareholder rights after exercise if payable in cash Conveys only appreciation in shares If paid in cash, entails cash outlay at payout If payable in cash results in mark-to-market compensation expense on financials. (Need to check with accountant). No shareholder rights after payment if paid in cash Greater value to employee per phantom share awarded If paid in cash, entails cash outlay at payout If payable in cash, results in mark-to-market compensation expense on financials. (Need to check with accountant). Dilute existing shareholder value FICA taxation at vesting Strict rules as to payout dates under Section 409A. The above is merely a brief overview of certain types of equity compensation. The tax and legal consequences of equity compensation are complex and may vary based on individual circumstances. Therefore, companies and executives must consult their own legal and tax advisors regarding these matters.

11 LLC Incentive Compensation L. Andrew Immerman Alston & Bird LLP (o) (404)

12 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

13 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. 3 3

14 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 4 4

15 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 an 80% control group) This problem for A can often be avoided with proper planning 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. 5 5

16 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. 6 6

17 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. 7 7

18 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., when it is 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. 8 8

19 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. 9 9

20 Profits Interest Defined 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

21 Receipt of Profits Interest If an individual provides services to or for the benefit of the partnership in a partner capacity or in anticipation of being a partner, the IRS will accept that the receipt of a profits interest 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 apparently is taking the position that the safe harbor is inapplicable if one party performs the services and another party receives an associated allocation and distribution. IRS treats 83 as irrelevant for this purpose

22 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

23 Unvested Profits Interest If the partnership grants an unvested profits interest, the 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

24 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 jumble of authorities. For example, 83 seems irrelevant under the two Rev Procs, but how does 83 apply outside of them? 14 14

25 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

26 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

27 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

28 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

29 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 recognizes 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? 19 19

30 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

31 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

32 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, USTC 50,372 (S.D. Tex. 2011), aff d per curiam, USTC 50,530 (5 th Cir. 2012) Even in what appears to be a simple contract for services, tax advice on deal structure can sometimes make a big difference

33 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

34 Example: Equity for Services Suppose instead 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 35% of $1,600 = $560. B pays 20% of $400 = $80. No self-employment tax on capital gains. However, 3.8% net investment income tax may apply. $1,000 Services A B X 24 24

35 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 ($80 vs. $158.40). 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, for many years now there has been a push in Congress to tax B at ordinary rates (plus self-employment tax), at least if B is an investment manager of some kind

36 Taxation of Manager: Profits Interest The manager, as the holder of a profits interest, reports his or her distributive share of income, gain, loss, deduction and credit. No one deducts any amount as wages, compensation or otherwise with respect to the manager s share of income. If the partnership recognizes long-term capital gain, the 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% (not counting net investment tax)

37 Taxation of Manager: Fee for Services If a payment for services is determined without regard to the net income of the LLC, it is a guaranteed payment as defined under Code 707(c), which does not mean it is guaranteed in any normal sense of the word. 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. Salary to service providers of an operating business are generally guaranteed payments if made to a partner. If the management fee is paid to an affiliate of the partner (rather than to the member) it is generally just a business expense of the partnership

38 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 some contexts, the difference between a 707(a) payment and guaranteed payment is not of great importance. But if allocations of capital gain under a profits interest could be recharacterized as 707(a) payments, the tax consequences would be enormous

39 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 certain carried interests as ordinary income, subject to: Ordinary income tax rates plus, Self-employment tax. Tend to apply to many entities besides private equity funds, although private equity funds are the main target. 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

40 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 is likely to be drafted narrowly. Versions have been passed several times by the House but not enacted. The idea has been showing up every year recently in the President s budget proposals, including the proposals for fiscal year

41 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 perhaps less likely to be affected. However, no one really knows what future legislation will say

42 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

43 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 primarily because of this familiarity. LLC clients who want to issue options sometimes will prefer profits interests once they understand how profits interests work. One difference between profits interests and options is that the holder of a profits interest is considered a partner but the holder of only an option is not. 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. Final regulations on noncompensatory options were issued a few years ago (T.D. 9612, Feb. 5, 2013) but final regulations on compensatory options are still not in sight

44 LLC Options If the LLC does grant options, then the following treatment seems reasonable (assuming that the optionholder is treated only as an optionholder and not as a partner): 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)

45 Fee Waivers (Conversions) If the management fee is a source of income for the manager, and not just a mechanism for covering the LLC s expenses, it is tempting to convert management fees (always ordinary income) into carried interests (often capital gain). These transactions are called waivers or conversions. Another advantage of the waiver or conversion is deferral because the income from the carried interest generally will be recognized later than the fee would have been However, the management fee is a fixed amount, and therefore is more certain to be realized than an interest in profits. There is a tension between the manager s desire to be assured of receiving the amount and the manager s desire for capital gains

46 Fee Waivers Structures Depending on the particular arrangement, there may be more or less risk that the fee the manager attempted to convert will still be treated as a management fee, rather than as a carried interest. Many advisors believe a waived management fee may be exchanged for a profits interest if: The conversion is done before the right to the payment of the management fee accrues. The right the manager receives in exchange for the waived management fee is the right to future profits, if any. There is a realistic risk that the future profits will not materialize, although commonly the manager does have a priority claim with respect to the amount of the waived fee

47 Fee Waivers - Issues If the manager has already earned the fee before making the waiver, the manager may already be in constructive receipt of the fee and it may too late to avoid tax on ordinary fee income. Even if the waiver is effective, there may be a question whether the profits interest qualifies under Rev. Proc For example, if the profits interest gives the manager a share of future gross income, is the interest a guaranteed payment? If not a guaranteed payment does it still fall outside the safe harbor of Rev. Proc by virtue of being related to a substantially certain and predictable stream of income from partnership assets? 37 37

48 Proposed Fee Waiver Regulations Regulations proposed in July 2015 would generally treat a fee waiver in exchange for an income allocation as ordinary compensation income, unless the manager is subject to significant entrepreneurial risk with respect to the income allocation. Entrepreneurial risk is measured relative to the overall risk of the partnership. If the partnership as a whole is low-risk, then the fact that the partner s risk is equally low will not be fatal. Even if there is significant entrepreneurial risk the arrangement will be characterized as a disguised fee based on other factors, including (but not limited to) factors listed in the proposed regulations

49 Proposed Fee Waiver Regulations Listed factors besides entrepreneurial risk are: A cap on allocations of income, which is reasonably expected to apply in most years. The allocations are for a fixed number of years in which the partner s distributive share of income is reasonably certain. Allocations of gross income. Allocations that are predominantly fixed in amount, reasonably determinable, or designed to ensure that sufficient net profits are highly likely to be available to make the allocation (e.g., allocations from specific transactions or specific accounting periods without regard to the overall performance of the partnership. Waiver is non-binding or the partner fails to timely and adequately notify the partnership and the partners of.the terms of the waiver

50 Proposed Fee Waiver Regulations Some additional factors of secondary importance are also specified: Partnership interest is transitory or of short duration. The time frame of the allocation and distribution is comparable to the time frame in which a non-partner service provider would be paid. Service provider was made a partner primarily for tax benefits. Value of the service provider s interest is general and continuing profits is small relative to the allocation and distribution. Terms of the allocations or distributions to a partner or related partners are subject to significantly different levels of entrepreneurial risk that vary significantly (e.g., some are subject to a clawback and some are not). The proposed regulations are not in force but the IRS thinks that they generally reflect current law

51 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

52 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. TD 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

53 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

54 LLC Compensation Exempt from 409A Partnership 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

55 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

56 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 entity includes: 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 , IRB 347, amplified, Rev Rul , IRB

57 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. Under state law nowadays, it is often possible for a partner or LLC member to be considered an employee, depending on the facts and the applicable law. However, tax law has not kept up, and technically the IRS considers it impossible for a partner to be an employee of his or her own partnership. The same rules apply to LLC members who are taxed as partners

58 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. It is unclear how actively the IRS is enforcing this rule; some practitioners are under the impression that the IRS is not. IRS officials have informally expressed some interest in reconsidering this rule, but a change is unlikely in the near future. Partners receive a Schedule K-1 each year and not a Form W

59 Guaranteed Payments Fixed salary of partners is normally 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. It is not really guaranteed. For key purposes, a guaranteed payment is not treated as a distribution or allocation; it does not directly affect the recipient s capital account

60 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

61 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

62 SECA Compared to FICA SECA and FICA are intended to be equal: Both comprise: Old-age, survivor and disability insurance ( OASDI ), known as the social security component, plus Hospital insurance ( HI ) or Medicare component. SECA rates: OASDI rate of 12.4%, on the first $118,500 (in 2016), 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)

63 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

64 SECA and Profits 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

65 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? 55 55

66 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

67 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

68 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

69 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

70 LLCs vs. S Corps From time to time 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 (or a C 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

71 Tax on Net Investment Income A special Medicare tax on net investment income of higher-income individuals went into effect in Code 1411; see TD 9644 (Dec. 2, 2013) (adopting final regulations) The tax is 3.8% of modified adjusted gross income above a threshold ($250,000 for joint returns). 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. Benefit of actively participating would be lost under some legislative proposals. A partner is not subject to both self-employment tax and net investment income tax on the same income. However, a higher-income partner most likely will have to pay one or the other on income passed through from the partnership

72 Increased Medicare Tax Effective in 2013, 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

73 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)

74 Deduction of Business Expenses One benefit of partner status 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)

75 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 holding profits interests 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

76 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

77 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. Sometimes there are more substantive disadvantages of partner status, such as the state tax cost for individuals who live in low-tax states but are members of partnerships doing business in lowtax states

78 Converting Partners to Employees At the same time, it is often important for those individuals to have an equity stake in the business. As the partnership and LLC form of doing business keeps expanding, this dilemma becomes more acute Every proposed solution has a down side, but there are some alternatives worth considering. One popular structure is the tiered partnership diagrammed on the next slide. If you have a profits interest in the upper-tier partnership but are employed by the lower-tier partnership, did you receive the profits interest for service to or for the benefit of the lower tier? 68 68

79 Converting Partners to Employees A and B are partners in LLC Holdco. A B LLC Holdco Other Owners LLC Since A and B are no longer partners in LLC, they likely can be employees of LLC

80 Phantom Equity LLCs sometimes try to avoid reclassifying employees as partners by giving them only some type of contractual right that is based in some way on equity (which might be called phantom equity). Designed to replicate or resemble the economic benefits of a partner s equity interest, but without the tax consequences of partner status. 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

81 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, LLCs generally take the position that the corporate precedents apply