COMPENSATION ISSUES FOR THE

STARTUP VENTURE

Structuring Partnership/LLC Non-Qualified Deferred Compensation

Before and after Enactment of Section 409A

Equity Incentive Compensation Considerations for Both Corporations and Partnerships/LLC’s

White Paper: Year–End Tax Planning Considerations for Flow‐

Through Investment Fund Management Companies, Their Principals and Executives

PPT Reasonable Compensation

by

THOMAS J. RIGGS JD, CPA, MAS

O’Connor Davies, LLP New York, NY

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Structuring Partnership/LLC Non-Qualified Deferred Compensation Before and after Enactment of Section 409A

Thomas J. Riggs JD, CPA, MAS

O’Connor Davies, LLP

Overview of the Taxation of Deferred Compensation Arrangements Before the Enactment of Section 409A:

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

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shares awarded. At the time the Employee is required to recognize compensation income upon exercise, the employer is entitled to a corresponding payroll expense deduction, subject to the full withholding requirements as specified elsewhere in applicable Code provisions. In the context of a partnership or LLC, no express statutory roadmap yet exists for structuring grants of the future right to purchase partnership or LLC interests. However, IRC Notice 2005-43 provides useful guidance in this area through a fairly extensive set of proposed Regulations. These proposed regulations act to apply the overall tax framework which currently exists in the area of the grant of future rights of corporate stock, to partnerships and LLC’s, and although these proposed regulations have yet to be finalized, it is reasonable to assume that they represent the current thinking of the IRS in this area, and can therefore be relied upon for structuring purposes.

V Overview of the Taxation of

Deferred Compensation Arrangements Before the Enactment of Section 409A:

Non-Property Based Plans The second common format for deferred compensation arrangements which allow key employees to participate in growth in the underlying enterprise value of the firm are referred to as Stock Appreciation Rights (SAR) plans, or in the context of a partnership or LLC, Unit Appreciation Rights (UAR) or Partnership Percentage Rights (PPR) plans. These types of plans differ from ‘property’ based plans as discussed above, in that instead of allowing for the actual purchase of shares or partnership interests during future intervals, SAR and UAR plans provide for key employees to share in equity appreciation through the grant of a ‘phantom’ stock or partnership interests. These plans, at inception, grant key employees a hypothetical share of equity, expressed either as a hypothetical number of shares or a percentage of the fair market value of the enterprise determined at the inception of the plan. Then at future intervals, as the overall fair market value of the firm presumably grows, the employee is entitled to receive a cash payment equal to the difference between his hypothetical share of the fair market value that existed at the date of the initial grant, and his hypothetical share as determined at the future date of exercise. In other words the key employee never actually owns an equity interest in his company, but is compensated as if he had. One of the primary advantages of an SAR plan over plans which actually grant future ownership interests is that key employees can be compensated on an incentive basis without diluting the equity interest of existing owners. Another advantage is that the compensated employees do not have to come up with funds to purchase the equity interest at the time of exercise.

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With regard to the tax framework applicable to SAR and UAR plans, they fall under the general category of ‘non-qualified’ deferred compensation, and since they do not grant actual ownership interests or ‘property’ in exchange for services, the express provisions of Section 83 do not apply. Instead, the traditional doctrines of ‘constructive receipt’ and ‘economic benefit’ are controlling. The result is generally that there are no tax consequences, to either the granting entity or to the employee, upon either the initial grant or the vesting of the interest, as long as the amount of the employees’ entitlement remains subject to a ‘substantial risk of forfeiture’. Only after vesting and ultimate exercise occur, and the employee thereby has access to the remuneration, does the amount of the award generally become taxable as compensation. It should again be noted that as in the case of property based plans, at the time the employee is required to recognize compensation income upon exercise the employer is entitled to a corresponding payroll expense deduction, subject to the full withholding requirements as specified elsewhere in the Code.

VI The Enactment of Code Section 409A in 2004

Code Section 409A was enacted in 2004, and applicable Regulations which were proposed in 2005 became final in 2007. Section 409A overlays the existing body of law governing the taxation of nonqualified deferred compensation in general; it does not specifically replace that body of law. The basic thrust of Section 409A is to place additional restrictions on non-qualified deferred compensation plans placed into effect after January 1st, 2009. Where a non-qualified deferred compensation plan is subject to 409A but is not in compliance, the result is the immediate recognition of otherwise deferred income, as well potentially triggering certain 20% penalty and related interest provisions.

VII The Applicability of Code Section 409A

to Partnerships and LLC’s:

The issuance of options or UARs on partnership or LLC interests is not addressed in Section 409A or in the subsequent proposed and adopted regulations. The Internal Revenue service has stated its intent to issue regulations specific to the issuance of such interests in pass-through entities, pursuant to rules comparable to those set forth with respect to options and SARs in the corporate context, but to date such regulations have not been issued. We must conclude therefore that for purposes of structuring deferred compensation plans for partnerships and/or LLC’s, one must apply not only the Code and related case law regarding such non-qualified deferred compensation plans, but the principles of the Section 409A overlay as well.

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Section 409A states that a number of non-qualified deferred compensation arrangements shall be exempt from its provisions. With regard to SAR plans in the corporate context, the regulations specifically exempt such plans as long as three conditions are met by the plan as originally drafted and implemented:

- Deferred compensation payable pursuant to the plan cannot be greater than the difference between the fair market value of the ‘phantom’ interest at inception over the amount of the interest at the date of exercise.

- The exercise price of the SAR interest can never be less than the fair market

value of the interest at inception. - The SAR plan does not include any feature for the deferral of compensation

other than the deferral provided up to and until the date of exercise.

By meeting the above requirements, a corporate SAR plan should expressly avoid the strictures imposed by 409A, and thus be subject only to the traditional tax framework in place for such deferred compensation plans in general. Further, even though Section 409A does not specifically address its application in the context of a partnership or LLC, the final regulations specify that the exemption requirements for corporate appreciation rights plans would be consistent with those for partnership or LLC based plans. As such it is reasonable to conclude that compliance with the three conditions stated above would exempt a partnership or LLC plan from the strictures of the 409A overlay as well. Thomas J. Riggs JD CPA MST

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Equity Incentive Compensation Considerations for Both Corporations and Partnerships/LLC’s

Thomas Riggs JD, CPA, MST

Bruce Blasnik CPA O’Connor Davies, LLP

212-286-2600

Plans for Corporations

Employee Stock Option Plans

Employee stock option plans (SOPs) are a popular form of equity incentive within the corporate

setting. With the typical SOP, employees are granted options to purchase a stated number of

shares of the company's common stock at a predetermined exercise price, generally equal to the

fair value of a share of the issuing company’s stock on the date of grant. The options will vest

based on time, performance parameters or some combination of the two. The employee will

generally have up to ten years from the date of grant to exercise the options as long as the

employee remains employed by the Company. If employment is terminated, the terminated

employee will generally have up to 90 days after the termination date to exercise the options that

have vested.

Under the tax code, employee stock options may be designated as either qualified incentive stock

options (ISO’s) or non-qualified stock options (NQSO’s). ISO’s provide a potential benefit to

the employees, as the difference between the exercise price and fair value of the stock on the date

of exercise will not be subject to ordinary income tax as long as the stock is held by the

employee for at least one year after exercise1 ( otherwise there would be a disqualifying

disposition). With an ISO, however, the issuing company does not get a tax deduction at the time

of issuance or at the time of exercise, but may get a deduction if there is a disqualifying

disposition. With NQSO’s, the difference between the exercise price of the option and the fair

value of the stock on the date of exercise is treated as ordinary income to the employee, subject

to income tax withholding and employment taxes. The Company, however, receives a full

deduction for the amount includable in the employee’s wages. With both ISO’s and NSQO’s,

1 However, the difference between the fair value of the stock on the exercise date and the exercise price is subject to the alternative minimum tax (AMT). Employees with high earnings or those that exercise a large number of shares within a calendar year may have to pay the AMT.

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the employee’s holding period for capital gain treatment begins on the exercise date (unless there

is a disqualifying disposition of the ISO shares, in which case there is no capital gain treatment

available). For ISO’s, the employee’s basis is the exercise price, whereas with NSQO’s the

employee’s basis is the fair value at the time of exercise.

While still quite popular, SOPs are not nearly as valuable a benefit to employees of private

companies as they once were. Prior to 2005, the regulatory and accounting environment for

private company SOPs was much different than it is today. Private companies were able to issue

NQSOs to employees with a very low exercise price, often $.01, generally without negative tax

consequences.2 This all ended in 2005 when Internal Revenue Code section (IRC) 409A took

effect. With the advent of IRC 409A, SOPs became subjected to the relatively harsh rules

thereunder governing deferred compensation unless the exercise price on the date of grant is at

least equal to the fair value of the underlying stock on the date of grant. As a result, substantially

all options issued by private companies since IRC 409A became effective have an exercise price

equal to the fair value of the stock on the date of grant.

Just one year after IRC 409A became effective, Financial Accounting Standard No. (FAS) 123R,

Accounting for Stock-Based Compensation, became effective for private companies, further

clouding the landscape for private company stock option plans. As a result of FAS 123R, private

companies were no longer allowed to use the intrinsic value method3 to determine stock-based

compensation expense and the disclosure requirements became much more complex.

Despite the lingering popularity of private company SOPs, the now decade old changes in the

regulatory and financial reporting landscape create several issues that should be considered:

In order to comply with both IRC 409A and FAS 123R (now ASC 718) private

companies are required to periodically value their stock. Given the complexity of capital

structures and option valuation models, it is advisable for those valuations to be

performed by a qualified independent valuation professional. Depending on how quickly

2 The Internal Revenue Code provided at the time that as long as the underlying stock did not have “a readily determinable fair market value, the granting of a stock option was not a taxable event.

3 Under the intrinsic value method, the expense to be recognized for accounting purposes was equal to the difference between the exercise price of the option and the fair value of the stock on the option grant date.

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a company is growing, such a valuation might have to be performed each time stock

options are issued to employees; although most companies can get away with performing

these valuations annually, or in some cases every other year. In addition to being

expensive, having a valuation performed takes time away from other tasks.

The accounting and disclosure requirements for employee stock option plans under

generally accepted accounting principles in the United States of America (USGAAP) are

quite complex. Under USGAAP, the issuing company must recognize an expense on

their books equal to the fair value of the options on the date of grant. The Black-Scholes

pricing model4 is the most common model used to value the options on the grant date, but

other, more complex models, might be more appropriate in certain circumstances. This

expense is recognized over the vesting period, which can be particularly challenging to

determine when vesting is wholly or partially based on performance parameters. Beyond

computing the expense associated with the issuance of employee stock options and

determining the period over which to recognize the expense, there are a number of

detailed disclosures including weighted average exercise price, weighted average vesting

periods and expiration dates which are tedious and time consuming to compute each

reporting period.

And perhaps most significant, within the private company setting, there is often little, if

any advantage to either the issuing company or the employees of a SOP over much

simpler forms of incentive compensation. This has primarily to do with the fact that there

is no market for the private company stock held by employees once an option grant is

exercised. The employee has to pay the cash purchase price to exercise the options and

perhaps additional cash to pay the taxes where there is a difference between the exercise

price and the stock’s fair value upon exercise. Yet, unless or until the issuing company is

sold, there is generally no way to benefit from the increase in the stock’s value over time.

For this reason, most options are not exercised until a company is sold. At that point, the

stock received is immediately sold for cash, making the entire difference between the

exercise price and the cash received by the employee taxable as ordinary income subject

to withholding and employment taxes.

4 Under the Black-Scholes pricing model, options are priced using a formula that takes into account a number of factors, the most complex of which is the stock’s volatility or a surrogate based on the volatility of a relevant stock index or basket of public company stocks.

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Stock Appreciation Rights

Although not as common, stock appreciation rights (SARs) are another equity-based incentive

plan alternative for private company’s to consider. SARs can provide for the payment of cash or,

in the alternative, the issuance of stock upon exercise by the employee.

Where the SAR plan provides for the payment of cash, it essentially acts as a deferred bonus

arrangement. Cash payout SARs may present an attractive alternative to the founders where they

wish to attract and retain key employees but would prefer not to disperse their voting rights or

increase the number of actual shares outstanding. However, cash payment SARs may not be

appropriate for many private-equity portfolio companies where cash is needed to repay debt and

fuel growth. SARs that payout in stock may be better suited for these companies.

SARs that provide for the issuance of stock are similar to NSQO’s except that, rather than paying

an exercise price to receive the shares of stock, the employee receives shares equal in value to

the increase in the value of the stock between the grant date and the exercise date. It is the

equivalent of a cashless exercise of stock options. The advantage to the employee is that they do

not have to pay cash to exercise their options; however, they will end up owning fewer shares.

The advantage to the company is that there is less dilution to existing shareholders because they

are issuing fewer shares.

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Table 1 – NSQO vs SAR

Value of stock on grant date (exercise price) 2.00$             

Value of stock on exercise date 4.00$             

No. of shares subject to grant 1,000             

NSQO SAR

Value of shares on exercise date 4,000$           

Less exercise price (2,000)           

Appreciation in value 2,000$            2,000$         

No. of shares of stock issued 1,000              500               

Taxable compensation 2,000$            2,000$         

Just as with NSQO’s, employees who exercise SARs will be taxed at ordinary rates on the

difference between the value of the stock on the date of grant and the date of exercise, and the

company will receive an ordinary tax deduction for the same amount. The employee may still

have to contribute cash to pay the withholding taxes. Any gain from the exercise date forward

will be treated as capital gain to the employee (short-term or long-term, depending on how the

long the stock is held before it is sold).

As with stock options, there is little incentive for an employee of a private company to exercise a

SAR unless the company is being sold because the employee may need to come up with cash to

pay taxes on ‘phantom income’ at the time of exercise, while no market exists to provide

liquidity for the stock. However, since the cash required to exercise a SAR can be significantly

less than the cash required to exercise a stock option (because with an option the employee will

need to come up with cash for both the exercise price and the taxes) some employees might be

motivated to exercise a SAR in order to lock in long-term capital gains treatment or to avoid

having the SAR expire upon termination.

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Restricted Stock Grants

Restricted stock grants (RSG’s)5 are generally not suitable for widespread use, but may be

appropriate to reward a small number of relatively senior employees. With an RSG, an

employee is given shares of stock in a company. This stock generally vests over time; although

this is not a requirement. For tax purposes, as long as an employee makes a valid election under

IRC 83(b), the fair value of the stock, both vested and unvested, on the date of grant is taxable to

the employee as ordinary income subject to withholding and employment taxes. Assuming a

valid election under IRC 83(b)6 is made, the RSG grant date is also the start date for the capital

gains holding period. The company receives a current tax deduction equal to the amount taxed

to the employee. For financial reporting purposes, the company recognizes the expense over the

vesting period, which may result in a deferred tax liability due to the timing difference between

when the expense is recognized for tax purposes and when it’s recognized for financial reporting

purposes.

RSG’s are particularly useful to help compensate the first few employees of a start-up company.

At that time, as long as a valid 83(b) election is made, the tax consequences to the employee are

minimal since the stock has little or no value. All future appreciation benefits the employees

who also receive favorable capital gain treatment for tax purposes. RSG’s are less beneficial to

employees of more mature companies (where the stock may have significant value) because of

the tax due upon grant. Say, for example, Mary earns $125,000 a year and she receives a RSG

worth $75,000 from her employer. Mary will have to come up with about $25,000 to pay the

withholding taxes on the grant date and will have to hold the stock until a liquidity event, if and

when that occurs, to realize any benefits. In many ways, this has economics similar to exercising

a nonqualified stock option.

Plans for Partnerships/Limited Liability Companies

5 The term restricted stock grant carries over from the public company setting. In the private company setting all stock is restricted, so these are really just stock grants. 6 Under IRC 83(b) an employee can elect to include the fair value of property received in income on the date of grant even if that property is not yet vested. Without such an election, the value of the property received is included in income when it vests, at which point the value may be significantly higher than it was at the grant date.

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Profits Interests

For partnerships or limited liability companies which are treated as partnerships for tax purposes,

the ‘profits interest’ is by far the most common type of equity-based compensation plan in use

today7. A profits interest is very similar to a SAR in that it allows an employee to participate in

the future income and growth in value of the awarded interest (often in the form of units). Like

SAR plans, profits interests can provide for vesting and for forfeiture upon termination; although

neither of these features is required.

The tax aspects of profits interests are somewhat complex and more ambiguous than those in the

area of stock options, SARs or RSGs. Also, differentiating a ‘profits interest’ from a ‘capital

interest’ is critical. The distinction is important because a capital interest is generally taxable at

the date of grant, whereas a profits interest is not. The proper classification under any particular

set of facts may be difficult. Since the wording of the plan itself and/or the underlying operating

agreement will be determinative, proper drafting of both is essential. More specifically, a

‘capital interest’ is defined in the subject Regulations as one in which the recipient or holder

would be entitled to a distribution of net cash and/or assets if the company were liquidated on a

hypothetical basis, and the above referenced distributions proceeded in accordance with the plan

and the underlying operating agreement. The Regulations go on to define a ‘profits interest’ as

any interest which does not constitute a capital interest.

Once the threshold issue of ‘profits interest’ versus ‘capital interest’ has when dealt with, the

issue of vested versus nonvested/contingent interests must be addressed.

With respect to a fully vested and noncontingent profits interest ( generally any interest which is

not subject to a ‘substantial risk of forfeiture’), Revenue Procedure (Rev. Proc.) 93-27 provides

a safe harbor which renders the grant nontaxable as long as three requirements are met:

The grant is made to an individual in his or her capacity of a member of the LLC, or in

anticipation of becoming a member of the LLC, in exchange for past or future services.

7 In addition to being used as a type of equity-based incentive for operating partnerships and LLC’s, profits interests are typically used by PE and VC funds to incentivize the fund managers. In PE/VC setting the profits interests are generally referred to as ‘carried interests’.

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The interest cannot relate to a substantially certain and predictable stream of income such

as income from high quality debt securities or a high quality net lease.

The recipient must not dispose of the profits interest within two years of receipt.

Rev. Proc. 93-27 left a certain amount of ambiguity with respect to nonvested and/or contingent

interests, and as such the IRS subsequently followed up with Rev. Proc. 2001-43. This later

Rev. Proc., which essentially contained a separate safe harbor for nonvested and/or contingent

interests, provided that neither the granting nor vesting of such interests will be taxable to the

recipient as long as the following requirements are met:

The recipient of the profits interest is treated as a member of the LLC for tax purposes

with respect to the entire interest (both vested and unvested portions) being granted.

The LLC does not take a compensation deduction in connection with the granting or

vesting of the profits interest.

All the other requirements of Rev. Proc. 93-27 have been met.

While the tax treatment of profits interests that meet the requirements of either Rev. Proc. 93-27

or 2001-43 may seem clear, in practice many grants of nonvested and/or contingent interests do

not fall squarely within the scope of the fact patterns envisioned by the two Rev. Procs. cited

above. For example:

Individuals receiving profits interests are sometimes treated as W-2 employees for

compensation purpose subsequent to receipt of the grant. This can jeopardize the safe

harbor requirement that the recipients be treated as partners.

Even if the individual is treated as a member for tax reporting purposes, other limitations

on the rights and obligations of the individual receiving the profits interest may preclude

him or her from being considered a member by the IRS8.

The profits interest may be granted in an entity other than the entity to which the

employee/member provided services to (as would be the case in tiered ownership

structures).

8 Under Private Letter Ruling 9533008 it was concluded, among other things, that a mere right to a percentage of a partnership’s income does not make someone a partner absent other rights and obligations of a partner such as the ability to exercise control or the obligation to share in losses.

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A note on Section 83(b)

Section 83(b provides, among other things, for a taxpayer to elect to treat the receipt of a future

or contingent interest in property in exchange for services (where the interest is subject to a

‘substantial risk of forfeiture’ and therefore not currently taxable) as the grant of a present and

currently taxable interest in the property. Although at first blush this might appear to accelerate

the recognition of taxable income, as a practical matter the present valuation of such interests is

typically zero (for income tax purposes). In such cases the election has the effect of treating

future accretion in value as investment return and hence capital gain, at no current tax cost to the

recipient.

Although the existence of the Rev. Procs. cited above would appear to obviate the specific need

for a Section 83(b) election in the context of a profits interest, many practitioners still

recommend making the election as a ‘belt and suspenders’ approach. Presumably in that case,

the election could act to preserve the tax benefits afforded by Rev. Procs. 93-27 and/or 2001-43

even if one of the safe harbor requirements therein were not met.

One final point with respect to the Section 83(b) election bears mention here. Some practitioners

believe that a profits interest, being a mere promise to receive something in the future, does not

meet the statutory definition of property as defined within Section 83. In fact, Regulation

Section 1.83-3(e) specifically states that property does not include “either money or an unfunded

and unsecured promise to pay money or property in the future”. The IRS attempted to address

this issue in 2005 by issuing proposed regulations that make it clear that partnership interests

(both capital interests and profits interests) qualify as property for purposes of section 83(b).

Although those proposed regulations, which contain a host of other requirements, have not yet

been finalized, most practitioners remain comfortable that the proposed regulations provide the

requisite insight into the thinking of the IRS on the topic.

A Note on Section 409A

This comprehensive statute was enacted in 2004 as part of the American Jobs Creation Act, and

it generally provides that any amount of compensation deferred under nonqualified deferred

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compensation plans is currently includible in gross income to the extent that the deferred

compensation is not subject to a ‘substantial risk of forfeiture’ and was not previously included

in income. However the statute specifically reserved guidance with respect to transactions

between partnerships and partners providing services.

IRS Notice 2005-1 provided a degree of interim guidance regarding the application of Section

409A to arrangements between partnerships and partners, providing that taxpayers may treat an

issuance of a profits interest in connection with the performance of services that is properly

treated under ‘other applicable provisions’ as not resulting in inclusion of income by the service

provider at the time of issuance, and thus does not result in ‘deferred compensation’ as defined in

Section 409A. However, the deferral of guaranteed payment compensation owed to partners, as

opposed to future returns as contemplated by a profits interest, is still widely believed to come

under the strictures of Section 490A.

Accounting Requirements

Under US GAAP, the accounting for profits interests is similar to the accounting for NSQOs and

SARs. The fair value of the profits interest is recognized as an expense over the vesting period

(requisite service period). Some have argued that because a profits interest has no current

(intrinsic) value at the time of grant there should not be any expense. But using that argument,

the same would be true for NSQOs and SARs, which is not the case under USGAAP. And,

clearly, there is some value in issuing a profits interest or companies would not bother.

Options Granted on Partnership and/or LLC interests

Partnerships, or LLCs treated as partnerships, can issue options to purchase units, similar to

corporation option plans. The general view is that a Section 83(b) election is not be available to

the recipient of an option on a partnership or LLC interest, since the regulations treat the granting

of an option for property as a non-event for tax purposes. More specifically, and in the case of

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the grant of an option on a capital interest in exchange for an exercise price, the treatment should

be similar to a NSQO, may subject to the strictures of Section 409A and would generate

ordinary income to the holder upon exercise equal to the difference between the fair value of the

interest on the date of exercise and the exercise price.

Keeping It Simple Can Avoid Problems

ISOs, NSQOs, RSGs and profit interests are valuable incentives that allow employees to share in

the growth and success of a company. However, the tax and accounting rules affecting the most

commonly designed plans are complex, and complying with those rules can be costly. By taking

away one feature from these typical plans, many of the headaches and costs can be avoided.

That one feature is vesting.

As discussed above, owning equity or the right to purchase equity in a private company generally

has little value until the company is actually sold or liquidated (unless an individual owns a

significant interest, there are annual dividends or distributions or the company has an equity buy-

back plan). And most employees don’t exercise their rights to receive equity until an exit

occurs. A right to equity that vests only upon the occurrence of an event not certain to occur

(contingent vesting) is not taxable until the contingency is removed, nor is the expense

associated with that right recognizable under USGAAP, until and unless the contingent event

becomes probable of occurrence. IRC 409A is not applicable, annual external valuations of the

Company are not required, and many of the complex accounting disclosures are not relevant. At

the time the Company is sold, the employees’ right to a portion of the proceeds vests. Those

proceeds are taxable as ordinary income, subject to employment taxes and withholding, just as it

would be with a NSQO or a disqualifying disposition of an ISO. While a non-vesting or

contingently vesting equity incentive plan may not be appropriate for the most senior people in a

company, it would likely work for everyone else.

Conclusion

The tax and financial reporting rules covering equity incentive plans for both corporations and

LLCs are quite complex. Additionally, other rules relating to the issuance of equity securities

not discussed above, such as Regulation D and state securities laws, also need to be considered

and appropriately dealt with. Before establishing an equity incentive plan, owners and

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management should give careful consideration to the benefits and costs of such a plan and what

they are hoping to achieve by instituting it. Often, the most popular answer is not the best

answer.

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White Paper: 

Year–End Tax Planning Considerations for Flow‐Through Investment Fund  

Management Companies, Their Principals and Executives. 

 

I. The Interrelationship Between Entity and Owner: 

With  the ever  increasing demands placed on hedge  fund and private equity principals and executives 

(which include raising capital, managing portfolio(s), dealing with regulators, etc.) it is not uncommon for 

personal income and estate planning opportunities to be overlooked. These lost opportunities can occur 

throughout the life cycle of the entity, but at inception or launch the problem is particularly acute. The 

unique  interplay  between management  companies  and  their  principles  and  executives  gives  rise  to 

significant year‐end income and estate tax planning opportunities.   In this article we will explore several 

of those opportunities; some of which may be familiar to you, and some which may not.  

 

Tax Impact of Your Current Fund Structure 

Prior to year‐end is always a good time to reconsider your overall fund structure. Is it the most tax efficient 

structure for you and your investors? One potential savings opportunity arises by virtue of the interplay 

between the 3.8% Medicare surtax (i.e., Net Investment Income Tax), the self‐employment (SE) tax.  The 

legal/tax structure of your fund will typically dictate which, if either of these taxes will apply.  Tax savings 

can sometimes be achieved by converting an existing  incentive allocation  into an  incentive fee.   This  is 

particularly true where a fund’s trading strategy generates mostly short‐term capital gains and where an 

IRC Sec. 475 election is in place.   

 

Tax Impact of Your Current Management Company Structure. 

In a typical fund structure, the management company is set up as a “flow through” entity; i.e. a limited 

liability company (LLC), limited partnership (LP), or a Subchapter S Corporation (“Sub S Corp”). These are 

not tax paying entities at the Federal level in and of themselves, but are instead conduits, meaning that 

all  items of  income, expense, gain or  loss, along with tax classifications and/or attributes at the entity 

level, pass through directly to their owners, who ultimately pay the tax on their allocable share(s). 

It becomes readily apparent, therefore, that  tax efficiency  in a “flow through” environment should be 

analyzed holistically, viewing the entity and its owners essentially as one.  

For example, anticipated results at the management company level can and should be considered when 

making tax based decisions at the owner(s) personal level. In a year where a management company’s net 

income is anticipated to be low, certain owners may wish to accelerate personable taxable income from 

other sources, for example  through implementation of a Roth IRA Conversion. In years where net income 

at the entity level is expected to be high, deferral of income or creating deductions at the personal level 

is typically paramount.  In this latter situation, particular owners may want to consider strategies such as 

creation of a charitable lead trust or contributions to a personal foundation. 

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Conversely, the owners’ personal tax situation (s) can be the driver for tax based decisions at the entity 

level.  If an owner(s)’ projected taxable income for a subject year is anticipated to be high, consideration 

should be given accelerating expenses or deferring income recognition at the entity level. This approach 

can take various forms, such as by accelerating executive bonuses or reducing current management fee 

income through transition to a greater carried interest participation.  

  

II. Other Topics: 

The Carried Interest; What’s next? 

Deferred compensation can be a very powerful tool in attracting, retaining, and incentivizing talent, and 

in this regard there is no more powerful tool than the carried Interest. If structured properly, a carried 

interest allows an entity to award equity ownership to employees and/or owners, without requiring a 

cash  investment  and without  triggering  income  recognition  on  the  part  of  the  recipient.  In  certain 

circumstances, such as where an investment fund generates tax advantaged income in the form of long 

term capital gains and/or qualified dividend  income,  it can also act  to convert ordinary compensation 

income into long term capital gain. 

It has recently become fashionable for politicians on both sides of the aisle to attack the carried interest 

as ‘give away to rich hedge fund managers”, when in reality nothing could be further from the truth. The 

carried interest remains the primary means by which an entrepreneur with an idea but no capital can start 

and participate in and grow his business as an owner. Nevertheless, both the Republican and Democratic 

platforms now specifically call for elimination or at least substantial curtailment of the carried interest.  

Legislation  to  repeal  the  carried  interest has  languished  in Congress  for  several  years. However,  the 

writers anticipate that regardless of which political party captures the White House this November, the 

effort to repeal the carried interest will gain traction.  It is therefore incumbent upon fund managers to 

implement and grant their carried interest awards as soon as possible.  

 

Section 457A:  Income Recognition of Manager’s Deferred Compensation 

2008  Legislation  required  current  income  inclusion  upon  vesting  of  certain  nonqualified  deferred 

compensation  paid  by  "tax  indifferent"  entities.   The  legislation  effectively  capped  at  10  years,  the 

maximum deferral of such compensation earned prior to January 1, 2009, meaning that such deferred 

compensation would be taxable no later than the 2017 tax year.  Many fund managers managing offshore 

funds were caught up in this legislation and may therefore have a significant tax liability accruing in 2017. 

Managers affected by this legislation should be planning now for this looming 2017 income recognition 

event. Private foundation contributions, charitable lead trusts, and certain life insurance approaches are 

some  of  the  strategies  that  can  be  utilized  to mitigate  the  potential  tax  consequences  to  affected 

managers, but from both an income as well as estate planning perspective the planning can be complex 

and must be done correctly. Affected managers are therefore urged to address the issue early on so as 

not to be caught up with time constraints later next year. 

 

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Consider a Tandem Subchapter S/ESOP liquidity Solution 

At  some point  in  the  life  cycle of most management  companies  the principles’  thoughts  turn  to exit 

strategies,  succession,  and  or monetization  of  their  equity.  In  this  context  a  tandem  Subchapter  S/ 

Employee Stock Ownership Plan (ESOP) structure can afford significant wealth creation and tax planning 

opportunities for both the principals and employees of an existing entity. These benefits can be achieved 

without the loss of control, and can provide a tax optimized source of funds outside of more traditional 

approaches such as a complete or partial sale  to private equity. The  framework can be put  into place 

relatively quickly, with a few months lead time prior to a year end.  It is worth noting if the management 

company is an LLC or an LP, additional structuring may be required. 

 

Section 179/Bonus Depreciation 

As  part  of  the  Protecting  Americans  from  Tax  Hikes  (PATH)  Act  of  2015,  Congress  extended  bonus 

depreciation through 2019.   Within certain criteria,  limitations and phase‐outs which apply, electing or 

choosing to forego the bonus depreciation election can be a useful tool  in maximizing tax efficiencies. 

Entities often  incorrectly assume  that electing bonus depreciation  is beneficial, however  this may not 

always be the case.  Considerations such as rising future income tax rates and current taxable losses at 

the entity level can dictate foregoing the election entirely. 

 

Retirement Plans 

Another tax efficient way to reduce one’s current  income tax obligation can be to fund a tax‐deferred 

retirement account. Not only do the funds in a retirement account grow tax‐deferred, or in some cases 

tax‐free (in a Roth account), but the growth is not subject to the 3.8% tax on net investment income (IRC 

Section 1411). In addition, a robust retirement plan can be a way to attract and retain top talent.  There 

are many retirement plan and deferred compensation options available to help fund partners’ optimize 

their income taxes. Viable options such as a 401(k), SEP IRA, cash balance and defined benefit plans, each 

have different requirements and many of them require formation prior to year‐end, so advance planning 

is critical.  If structured properly, it may be possible for the retirement plan to include an owner’s managed 

fund as an investment option for the retirement plan portfolio. 

 

 

Charitable Contributions and NYC UBT Tax 

Management companies which are partnerships, conduct their trade or business within New York City, 

and have  total  gross  income of more  than $95,000  are  subject  to NYC Unincorporated Business  Tax 

(“UBT”) at a rate of 4%. NYC allows a tax deduction for charitable contributions made by the partnership, 

to  the  extent  contributions would  be  deductible  for  Federal  income  tax  purposes.  There  are  certain 

requirements and limitations, but this is an often overlooked NYC UBT tax deduction at the entity level.  

 

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State Income Tax Planning and the AMT 

Much is written about the Alternative Minimum Tax (AMT), and it frightens many taxpayers. Those living 

in states with relatively high state and city income and real estate taxes are often subject to this tax. The 

top AMT rate is 28% versus the current top income tax rate of 39.6%. The interplay between the AMT rate 

and the ordinary  income rate can give rise to planning opportunities, particularly with respect to state 

income  taxes.   While a  full discussion of the AMT  is beyond the scope of  this article, AMT planning  is 

relatively complex and warrants careful consideration. .  

 

 

Gifting — Start Early 

The 2016 annual exclusion from transfer tax is currently $14,000 ($28,000 for married couples) per year, 

per donee.  For example, a married couple with 3 children can currently “shift” $84,000 ($28,000 x 3) out 

of their estate annually, free of transfer taxes. Appreciation on the assets transferred accrues outside of 

the  donor’s  estate.  In  our  experience,  management  company  principals  overlook  this  planning 

opportunity at every phase of the fund lifecycle, from start‐up to liquidation.   

   

 

III. Conclusion: 

The  cornerstone  of  sound  tax  planning  for  fund managers  is  an  in  depth  understanding  of  the  tax 

environment that a management company and its owners face in tandem. After the end of a subject tax 

year it is often too late to implement strategies or approaches which could have minimized the overall tax 

burden. We strongly recommend that principals and executives in the investment fund space consult their 

tax advisors well in advance of the end of the year in order to fully utilize planning opportunities.  

For more information on our investment fund and management company tax, accounting and advisory 

services, please contact: 

 

 

Thomas J. Riggs, JD, CPA, MST 

212‐286‐2600 

. 

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Reasonable Compensation

November 18, 2016

Leo ParmegianiTax Partner, PKF O’Connor Davieslparmegiani@odpkf.com

Unreasonable Compensation→ Usual context is compensation that is too high and reclassified as a 

dividend

→ Typical issue if operating through a closely held C Corporation

→ IRS closely scrutinizes owner compensation for reasonableness

→ In S Corp context, IRS argument is turned upside‐down

→ IRS scrutinizes compensation for being too low since owners would 

prefer to avoid social security taxes

→ For LLC’s, not much of an issue for owners.  Social security taxes are 

due for partnership profits allocation and guaranteed payments alike.  

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Statutory Context

• IRC Section 162 and Regulations thereunder provide the test of deductibility

• Two Prong Test

1. Payment is reasonable in relation to services performed 

and

2. Whether payment was intended to be compensation

3

Paula Construction Case

• S Corp whose election was retroactively terminated.• No salary declared to shareholders because it was believed 

not necessary.• Tax Court acknowledged valuable services were provided.• However, Tax Court held “Nothing in the records indicate 

that compensation was paid or intended to be paid.” • Compensation deduction was disallowed.  • Tax Court stated “It is now settled law that only if payment 

is made with the intent to compensate is it deductible as compensation.  Whether such intent has been demonstrated is a factual question to be decided on the basis of the particular facts and circumstances of the case.”

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Closely Held Corporation Setting

Even if intent exists, payment will not be deductible if substance of payment does not comport with taxpayer’s characterization.  

An ostensible salary will likely be re‐characterized as a dividend distribution if:• The taxpayer‐corporation is closely held and all the 

shareholders receive salaries;

• The salaries are more than what customarily is paid for similar services; and

• The excessive salaries “correspond or bear relationship” to the employees’ stockholdings.  

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Compensatory Intent

• Heavy judicial reliance on initial characterization

– Objective criteria such as BOD approval

– Payroll tax treatment

– Deducted as salary in books and records

• Leading case is Paula Construction Co. [58 TC 1055 (1972)] – Initial Multi‐Factor Test

• Tax Court stated that it is “settled law”?

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Compensatory Intent (con’t)

• Courts more commonly determine reasonable compensation cases under the amount test because it requires a more objective analysis.  Regs. § 1.162‐7 (b)(3) provides:

It is, in general, just to assume that reasonable 

and true compensation is only such amount as would ordinarily be paid for like services by like enterprise under the circumstances.  

7

Reasonableness of Compensation

Subjective Criteria & Factors to Consider1. The employee’s qualifications.

2. The nature, extent, and scope of the employee’s work.  

3. The size and complexities of the business. 

4. A comparison of the salaries paid with the gross income and the net income of the business.

5. The prevailing general economic conditions.

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Reasonableness of Compensation Cont.

6. A comparison of salaries with distributions to stockholders.

7. The prevailing rates of compensation for comparable positions and comparable businesses.

8. The salary policy of the taxpayer for all employees.

9. The compensation paid to the particular. 

Courts have rejected argument that profitable corporations must use their earnings to pay dividends.  

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Contingent Compensation Arrangements• Invite scrutiny because such arrangements normally depend on profitability.

• However, method of fixing compensation not decisive as to deductibility. 

• If pay is paid pursuant to a free bargain, agreed upon in advance of service and not influenced by other circumstances should be allowed.  

• Not normally possible in closely held setting if single owner but if shareholders bargain among themselves, could be respected.  

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Independent Investors TestElliots – Five factors used by court

1. Employee’s role in the company, his or her importance to the success

2. External comparison of salaries for like positions in similar companies

3. Character and condition of company4. Whether related parties or conflicts of interest exists5. A reasonable long‐standing consistently applied 

compensation plan for executives is helpful

• Focus on Return on Equity and whether an independent investor would be satisfied with return after paying compensation

• If answer is positive, strong indication that compensation is reasonable

• Strong basis for assessing reasonableness 

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Recent Cases Addressing Reasonable Compensation Menard, Inc.  (560 F3d 620)CEO’s pay was reasonable.Factors considered

• Long work days• Increased corporate profits and ROI• Incentive compensation plan established, adopted by BOD

• Independent Investors would have been satisfied with 18.8% rate of return

• Corporations are not required to pay dividends

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Recent Cases Addressing Reasonable Compensation 

Multi‐Pak Corp. (T. C. Memo 2010‐39)

• Looked at managerial duties

• Business expansion

• External Comparables

• Character and condition of the company test

• Hypothetical Investor

Mulcahy

• Independent investor test applied to a professional service corporation

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Recent Cases Addressing Reasonable Compensation Thousand Oaks Residential Care Home Inc. (T.C. Memo 2013‐10)• Applied Five Factor Test and Independent Investor Tests

• Reasonable compensation included “catch up” payments for years of underpayment

K&K Veterinary Supplies Supply Inc. (T.C. Memo 2013‐84)• Nine factors applied

• Expert witnesses were key to government’s report

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Independent Investor Standard (IIT)

• Some courts have simplified the analysis to what a hypothetical independent investor would accept as a ROI after the salary– Abandoned multifactor test

• Believed multi‐factor analysis does not give guidance on weighing factors

• Strays away from the primary reason for disallowance, prevent dividends from being paid as deductible salary” 

• Invites TC to become a super‐personnel department.  • Second circuit – IIT is the lens through which the entire analysis should be viewed.  

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Statutory Limits under IRC§162(m)For publicly traded corporation, there is a statutory limit of $1 million paid to “covered” employees. 

Covered employee is CEO or four highest compensation officers required to be reported under Securities and Exchange Act of 1934.

Exception for remuneration payable on a commission basis or other performance based criteria as established by board of directors, agreed upon in advance.  

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Unreasonably Low Compensation S Corporation Context

• S Corporation distributive share earnings are not subject to social security taxes nor 3.8% tax on net investment income

• Incentive not to pay salaries since SST tax and additional Medicare tax is imposed on salary

17

6.2%  OASDI (up to $118,500)1.45% Medicare.9% Additional Medicare 

3 Taxes

S Corporations and Social Security TaxSocial Security Tax and Tax on NII

• S Corp income does not constitute Net Earnings from Self Employment (NESE) Revenue Ruling 59‐221

• Since not NESE, No SE tax imposed• Wages paid to S Corp shareholders are subject to SST• Significant incentive to be fully compensated by S Corp earnings to avoid SST.  

• S Corp earnings are subject to neither .9% nor 3.8% Medicare taxes

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Reclassification RisksRevenue Ruling 74‐44- Express purpose for avoiding SST- Payment of no compensation does not work

Joseph Radtke, S.C. 65 AFTR (1990) 

- Services provider requires payment of some salaryDavid E. Watson P.C. (109 AFTR 2d 2012‐1059) ₋ Intent is one factor but not controlling.  Look to whether remuneration is 

for services. ₋ Look to qualifications, efforts and success of business₋ Comparable positions

Sean McAlary Ltd. Inc. (TC Summary 2013‐32)

₋ Multifactor test employed

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Non‐Abusive SituationIRS may have difficulty in re‐characterizing distribution as salary in non‐abusive situations

IRS Fact Sheet 2008‐25  (August 2012)

- No bright line test for determining reasonableness

- Multi‐Factor test employed

- Conclusion → Non‐abusive situations are effective tax planning

- Recent attempts by Congress to Subject S Corps to SE Tax 

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