Leveraging LLCs in Structuring M&A Transactionsmedia.straffordpub.com/products/leveraging-llcs-in...2016/05/12 · Presenting a live 90-minute webinar with interactive Q&A Leveraging

Presenting a live 90-minute webinar with interactive Q&A

Leveraging LLCs in StructuringM&A TransactionsAssessing Deal Structures; Navigating Complex Capital Account and Tax Allocation Principles

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THURSDAY, MAY 12, 2016

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Today’s faculty features:

1pm Eastern | 12pm Central | 11am Mountain | 10am Pacific

Tarik J. Haskins, Partner, Morris Nichols Arsht & Tunnell, Wilmington, Del.

Joseph C. Mandarino, Partner, Smith Gambrell & Russell, Atlanta

David K. Staub, Member, Staub Anderson, Chicago

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M&A: LEVERAGING LLCsIN STRUCTURING TRANSACTIONS

MAY 12, 2016

TARIK J. HASKINSPARTNER

COMMERCIAL LAW COUNSELING GROUP

MORRIS, NICHOLS ARSHT & TUNNELL LLP(302) [email protected]

Limited Liability Companies Generally

The limited liability company is anunincorporated entity structure that has becomeincreasingly popular in the business communityand has arguably become the preferred form ofbusiness entity.

The limited liability company is anunincorporated entity structure that has becomeincreasingly popular in the business communityand has arguably become the preferred form ofbusiness entity.

6

Limited Liability Companies Generally (cont’d)

The popularity of the limited liability company formarises primarily because it combines the limitedliability protection of a corporation together with thepass-through taxation of a partnership and providesthe investors with a vast amount of flexibility.

The popularity of the limited liability company formarises primarily because it combines the limitedliability protection of a corporation together with thepass-through taxation of a partnership and providesthe investors with a vast amount of flexibility.

7

Limited Liability Companies Generally (cont’d)

For LLCs that choose to be taxed as a partnership, it willbe critical for the investors and the drafters of the limitedliability company agreement to understand how theallocation, distribution and capital account provisionswork.

A “capital account” is used to keep track of what eachmember is entitled to receive from the entity if itliquidates. A “capital account” shows how much eachmember put into the LLC and how much each member isentitled to receive.

The allocation provisions are NOT merely boilerplate,and failure to properly draft the allocation anddistribution provisions may affect the actual dollaramounts that the members are entitled to receive.

For LLCs that choose to be taxed as a partnership, it willbe critical for the investors and the drafters of the limitedliability company agreement to understand how theallocation, distribution and capital account provisionswork.

A “capital account” is used to keep track of what eachmember is entitled to receive from the entity if itliquidates. A “capital account” shows how much eachmember put into the LLC and how much each member isentitled to receive.

The allocation provisions are NOT merely boilerplate,and failure to properly draft the allocation anddistribution provisions may affect the actual dollaramounts that the members are entitled to receive.

8

Limited Liability Companies in Transactions

Limited liability companies are being used inmany different ways in M&A Transactions: Acquisition Vehicle Investing Joint Ventures Series LLC Asset Sale Mergers LLC Interest Sale

Limited liability companies are being used inmany different ways in M&A Transactions: Acquisition Vehicle Investing Joint Ventures Series LLC Asset Sale Mergers LLC Interest Sale

9

Limited Liability Companies in Transactions (cont’d)

The Limited Liability Company Agreement isimportant. In comparing the corporate form to the limited

liability company form, the first thing to realize ishow incredibly important the limited liabilitycompany agreement is with respect to limited liabilitycompanies.

Most Limited Liability Company Acts are enabling innature and set forth default rules that can be adjustedpursuant to the LLC Agreement.

The Limited Liability Company Agreement isimportant. In comparing the corporate form to the limited

liability company form, the first thing to realize ishow incredibly important the limited liabilitycompany agreement is with respect to limited liabilitycompanies.

Most Limited Liability Company Acts are enabling innature and set forth default rules that can be adjustedpursuant to the LLC Agreement.

10

Limited Liability Companies in Mergers

Most limited liability company acts permit alimited liability company to merge with one ormore limited liability companies or otherbusiness entities.

The default consent requirement for approval of amerger varies by jurisdiction, but moreimportantly, the default merger consent can bemodified by contract.

Most limited liability company acts permit alimited liability company to merge with one ormore limited liability companies or otherbusiness entities.

The default consent requirement for approval of amerger varies by jurisdiction, but moreimportantly, the default merger consent can bemodified by contract.

11

Limited Liability Companies in Mergers (cont’d)

Under Delaware law, for example, Section 18-209 ofthe Delaware LLC Act provides for the approval of amerger by a majority in interest. Delaware’s default LLC merger provision can, in some

instances, provide those in control of the LLC with theability to avoid super-majority votes, by amending theLLC Agreement in connection with the merger. This opportunity exists if the merger consent requirement is

different than the amendment provision.

Under Delaware law, for example, Section 18-209 ofthe Delaware LLC Act provides for the approval of amerger by a majority in interest. Delaware’s default LLC merger provision can, in some

instances, provide those in control of the LLC with theability to avoid super-majority votes, by amending theLLC Agreement in connection with the merger. This opportunity exists if the merger consent requirement is

different than the amendment provision.

12

Limited Liability Companies in Mergers (cont’d)

Section 18-209 of the Delaware LLC Act providesthat the equity interests in the merging entity may beexchanged for or converted into cash, property,rights or securities in the surviving or resultingentity.

Section 18-209 of the Delaware LLC Act providesthat the equity interests in the merging entity may beexchanged for or converted into cash, property,rights or securities in the surviving or resultingentity.

13

Sale of Limited Liability Company Interests

Nature of Limited Liability Company Interests Limited Liability Company Interests are personal property. A limited liability company interest, disaggregates the

economic rights from the management rights. Definition – The buyer must be careful to accurately define

what is being transferred and ensure that the description isbroad enough to include both economic interests andgovernance rights associated with the LLC interests.

Admission – In addition to transferring the limited liabilitycompany interest, it is also important to actually admit thetransferee to the LLC, otherwise the transferee will merely bea holder of the economic interest therein.

Nature of Limited Liability Company Interests Limited Liability Company Interests are personal property. A limited liability company interest, disaggregates the

economic rights from the management rights. Definition – The buyer must be careful to accurately define

what is being transferred and ensure that the description isbroad enough to include both economic interests andgovernance rights associated with the LLC interests.

Admission – In addition to transferring the limited liabilitycompany interest, it is also important to actually admit thetransferee to the LLC, otherwise the transferee will merely bea holder of the economic interest therein.

14

Sale of Limited Liability Company Interests (cont’d)

The specific rights and remedies of the limited liabilitycompany interests are established pursuant to the LLCAgreement.

The Delaware LLC Act’s default allocation anddistribution provisions provides that allocations anddistributions shall be based upon the agreed value of thecontributions that have been made to the LLC.

In connection with the sale of interests in the LLC, thetransferee will succeed to Seller’s interest in allocations.

The specific rights and remedies of the limited liabilitycompany interests are established pursuant to the LLCAgreement.

The Delaware LLC Act’s default allocation anddistribution provisions provides that allocations anddistributions shall be based upon the agreed value of thecontributions that have been made to the LLC.

In connection with the sale of interests in the LLC, thetransferee will succeed to Seller’s interest in allocations.

15


Transfer Restrictions – Many limited liabilitycompany agreements contain restrictions ontransfer of interests. Restrictions on transfers may be specifically

enforced.

Transfer Restrictions – Many limited liabilitycompany agreements contain restrictions ontransfer of interests. Restrictions on transfers may be specifically

enforced.

16


“Pick your partner doctrine.” Unless modified by contract, the admission of a

transferee would require the consent of the othermembers.

“Pick your partner doctrine.” Unless modified by contract, the admission of a

transferee would require the consent of the othermembers.

17

Investments in Limited Liability Companies

Investments Under the Delaware LLC Act, in contrast to corporations, a

limited liability company is not required to authorize and issue aset limited number of interests.

This flexibility provides an opportunity to issue limitedliability company interests in connection with transactions.

Under the Delaware LLC Act, Section 18-302(c) provides in part,that the relative rights, powers and duties of a member of a limitedliability company shall be as set forth in the LLC Agreement.Coupled with the ability to modify fiduciary duties to an LLC andits members, an LLC can structure truly preferred equity interests.

Investments Under the Delaware LLC Act, in contrast to corporations, a

limited liability company is not required to authorize and issue aset limited number of interests.

This flexibility provides an opportunity to issue limitedliability company interests in connection with transactions.

Under the Delaware LLC Act, Section 18-302(c) provides in part,that the relative rights, powers and duties of a member of a limitedliability company shall be as set forth in the LLC Agreement.Coupled with the ability to modify fiduciary duties to an LLC andits members, an LLC can structure truly preferred equity interests.

18

Investments in Limited Liability Companies (cont’d)

The flexibility inherent in the Delaware LLC Act enablesinvestors to structure their investment in an LLC in a waythat provides preferential allocations, distributions andrights to interim and liquidating distributions and providecontrol rights to such holders. Further, many of the protections sought in a preferred stock

investment are easily incorporated into the subject limited liabilitycompany agreement, without the risk that such protections will befound unenforceable.

The flexibility inherent in the Delaware LLC Act enablesinvestors to structure their investment in an LLC in a waythat provides preferential allocations, distributions andrights to interim and liquidating distributions and providecontrol rights to such holders. Further, many of the protections sought in a preferred stock

investment are easily incorporated into the subject limited liabilitycompany agreement, without the risk that such protections will befound unenforceable.

19


Typically, the structuring of an investment in alimited liability company will require an amendmentto the limited liability company agreement.

20


Under the Delaware LLC Act, if the applicableLLC Agreement does not provide otherwise, anamendment will require approval of all members. An LLC Agreement that permits amendments with

less than unanimous consent will permit anamendment to the LLC Agreement that could havethe effect of imposing restrictions on non-consentingmembers and/or diluting their interests.

Under the Delaware LLC Act, if the applicableLLC Agreement does not provide otherwise, anamendment will require approval of all members. An LLC Agreement that permits amendments with

less than unanimous consent will permit anamendment to the LLC Agreement that could havethe effect of imposing restrictions on non-consentingmembers and/or diluting their interests.

21

Sale of Substantially All of the Assets of an LLC

Sale of substantially all of the assets.

Very similar to a sale of assets by a corporation.

DGCL Section 271 provides for specific authorizationprocedures in order to authorize a sale of substantiallyall of the assets. Unless the limited liability company agreement provides

otherwise, the Delaware LLC Act does not provide for aspecific statutory authorization to sell assets.

Authorization of the sale will be governed by the LLCAgreement, as will the related decision to cause a dissolutionand liquidation of assets.

Sale of substantially all of the assets.

Very similar to a sale of assets by a corporation.

DGCL Section 271 provides for specific authorizationprocedures in order to authorize a sale of substantiallyall of the assets. Unless the limited liability company agreement provides

otherwise, the Delaware LLC Act does not provide for aspecific statutory authorization to sell assets.

Authorization of the sale will be governed by the LLCAgreement, as will the related decision to cause a dissolutionand liquidation of assets.

22

“Appraisal Rights”

Unlike many corporate statutes that provideequityholders with appraisal rights with respectto a merger or other transactions, most LLC Actsdo not provide appraisal rights. A limited liability company agreement can provide

for appraisal rights.

Unlike many corporate statutes that provideequityholders with appraisal rights with respectto a merger or other transactions, most LLC Actsdo not provide appraisal rights. A limited liability company agreement can provide

for appraisal rights.

23

Fiduciary Duties

Under Delaware law Unless otherwise provided in the limited liability

company agreement, the traditional fiduciary dutiesapplicable to a Delaware corporation apply to themanaging and controlling persons of an LLC: The duty of care

Equates to a gross negligence standard of care.

The duty of loyalty Act in the best interest of the LLC and its investors.

Under Delaware law Unless otherwise provided in the limited liability

company agreement, the traditional fiduciary dutiesapplicable to a Delaware corporation apply to themanaging and controlling persons of an LLC: The duty of care

Equates to a gross negligence standard of care.

The duty of loyalty Act in the best interest of the LLC and its investors.

24

Fiduciary Duties (cont’d)

Most Limited Liability Company Acts permit themodification of fiduciary duties and the DelawareLLC Act in fact permits the elimination offiduciary duties, provided that the impliedcovenant of good faith and fair dealing cannot beeliminated.

Most Limited Liability Company Acts permit themodification of fiduciary duties and the DelawareLLC Act in fact permits the elimination offiduciary duties, provided that the impliedcovenant of good faith and fair dealing cannot beeliminated.

25


A complete elimination of fiduciary duties willseverely limit the ability of a minority investor tochallenge conduct by the controlling persons. “When parties exercise authority provided by the LP

Act to eliminate fiduciary duties, they take away themost powerful of a court’s remedial gap-fillingpowers.”

Lonegran v. EPE Holdings LLC, 5 A. 3d 1008 (Del. Ch. 2010).

A complete elimination of fiduciary duties willseverely limit the ability of a minority investor tochallenge conduct by the controlling persons. “When parties exercise authority provided by the LP

Act to eliminate fiduciary duties, they take away themost powerful of a court’s remedial gap-fillingpowers.”

Lonegran v. EPE Holdings LLC, 5 A. 3d 1008 (Del. Ch. 2010).

26


In the event that fiduciary duties are eliminated, aparty is left solely with an implied covenant of goodfaith and fair dealing claim. In general, the implied covenant of good faith and fair

dealing: Protects a party from being deprived of the fruits of the

bargain;

Is based on reasonable expectations at the time contract wasentered into;

Applies to the exercise of discretionary authority.

In the event that fiduciary duties are eliminated, aparty is left solely with an implied covenant of goodfaith and fair dealing claim. In general, the implied covenant of good faith and fair

dealing: Protects a party from being deprived of the fruits of the

bargain;

Is based on reasonable expectations at the time contract wasentered into;

Applies to the exercise of discretionary authority.27

Indemnification and Exculpation

Closely related to the consideration of fiduciaryduties are the appropriate levels forindemnification and exculpation. Subject to public policy limitations, Delaware law

allows parties to include indemnification provisionsthat will permit a person to be indemnified by theLLC for his or her own acts.

Subject to public policy limitations, Delaware lawallows parties to include exculpation provisions in anLLC Agreement that will protect a person frompersonal liability.

Closely related to the consideration of fiduciaryduties are the appropriate levels forindemnification and exculpation. Subject to public policy limitations, Delaware law

allows parties to include indemnification provisionsthat will permit a person to be indemnified by theLLC for his or her own acts.

Subject to public policy limitations, Delaware lawallows parties to include exculpation provisions in anLLC Agreement that will protect a person frompersonal liability.

28

M&A: Leveraging LLCs inStructuring Transactions

───────────────────────Capital Accounts and Tax Issues

May 12, 2016

Joseph C. Mandarino

Smith, Gambrell & Russell, LLPPromenade, Suite 3100

1230 Peachtree Street N.E.Atlanta, GA 30309www.sgrlaw.com

A. Understanding Capital Accounts

B. Basics of LLC Taxation

C. Preferred Interests

D. Liquidating Distributions

E. Incentive Compensation

F. Techniques Involving Disregarded LLCs

A. Understanding Capital Accounts

B. Basics of LLC Taxation

C. Preferred Interests

D. Liquidating Distributions

E. Incentive Compensation

F. Techniques Involving Disregarded LLCs

30

Capital Account Rules

31

Capital Account RulesAssets versus Liabilities

property $1,000 mortgage $500cash $200 other $50misc $100 sub-total $550sub-total $1,300

total $1,300 total $550

Balance sheet does not "balance"!

Assets Liabilities

Assets versus Liabilities

property $1,000 mortgage $500cash $200 other $50misc $100 sub-total $550sub-total $1,300



Assets Liabilities

32

Capital Account RulesDifference Plugged to Equity

property $1,000 mortgage $500cash $200 other $50misc $100 sub-total $550



Assets Liabilities

Difference Plugged to Equity




Assets Liabilities

33

Capital Account RulesDifference Plugged to Equity


member A $250member B $250member C $250sub-total $750

total $1,300 total $1,300

Balance sheet balances!

Difference between assets and liabilities almost always "plugged" in equity.

For an LLC, the equity amounts are called "capital accounts"

Assets Liabilities

Capital

capitalaccounts

Difference Plugged to Equity




Balance sheet balances!

Difference between assets and liabilities almost always "plugged" in equity.

For an LLC, the equity amounts are called "capital accounts"

Assets Liabilities

Capital

34

Capital Account Rules• profits – increase capital accounts

• losses – decrease capital accounts

• contributions – increase capital accounts

• distributions – decrease capital accounts

• profits – increase capital accounts

• losses – decrease capital accounts

• contributions – increase capital accounts

• distributions – decrease capital accounts

35

Capital Account RulesCapital Accounts Are Increased by Profits


member A $350member B $350member C $350sub-total $1,050


Assets (cash) increase by $300 total.

No change in liabilities so capital accounts must increase by $300 total or will not balance.

Assumed that A, B and C share equally.

Assets Liabilities

Capital

Capital Accounts Are Increased by Profits




Assets (cash) increase by $300 total.

No change in liabilities so capital accounts must increase by $300 total or will not balance.

Assumed that A, B and C share equally.

Assets Liabilities

Capital

36

Capital Account RulesCapital Accounts Are Decreased by Distributions




Assume $150 distribution, so cash decreased by $150 total.

No change in liabilities so capital accounts must decrease by $150 total or will not balance.

Assumed that A, B and C share in distributions equally.

Assets Liabilities

Capital

Capital Accounts Are Decreased by Distributions




Assume $150 distribution, so cash decreased by $150 total.

No change in liabilities so capital accounts must decrease by $150 total or will not balance.

Assumed that A, B and C share in distributions equally.

Assets Liabilities

Capital

37

Capital Account RulesCompany is Liquidated Flat




Assets sold for face value, or $1,450 in cash..

Cash applied first to liabilities (i.e., $550).

After paying off liabilities, Company has $900 left over.

Balance is distributed to A, B and C in satisfaction of their interests.

Assets Liabilities

Capital

Company is Liquidated Flat




Assets sold for face value, or $1,450 in cash..


After paying off liabilities, Company has $900 left over.

Balance is distributed to A, B and C in satisfaction of their interests.

Assets Liabilities

Capital

38

Capital Account RulesCompany is Liquidated at Profit




Property worth $1,600, so total FMV of assets = $2,050 in cash.


After paying off liabilities, Company has $1,500 left over.

Balance is distributed to A, B and C in satisfaction of their interests

Assumed that A, B and C share profit equally.

Assets Liabilities

Capital

Company is Liquidated at Profit




Property worth $1,600, so total FMV of assets = $2,050 in cash.


After paying off liabilities, Company has $1,500 left over.

Balance is distributed to A, B and C in satisfaction of their interests

Assumed that A, B and C share profit equally.

Assets Liabilities

Capital

39

Capital Accounts -- Life Cycle of BusinessExample -- Year 1

member A member B member C total40% 40% 20%

Year 1 start up initial contribution $1,000 $1,000 $500 $2,500start up losses profit (loss) -$600 -$600 -$300 -$1,500

closing balance $400 $400 $200 $1,000



closing balance $400 $400 $200 $1,000

40




closing balance $400 $400 $200 $1,000

Year 2 continued losses opening balance $400 $400 $200 $1,000profit (loss) -$200 -$200 -$100 -$500closing balance $200 $200 $100 $500



closing balance $400 $400 $200 $1,000


41




closing balance $400 $400 $200 $1,000


Year 3 slight profit opening balance $200 $200 $100 $500profit (loss) $200 $200 $100 $500closing balance $400 $400 $200 $1,000



closing balance $400 $400 $200 $1,000



42




closing balance $400 $400 $200 $1,000



Year 4 growing profit opening balance $400 $400 $200 $1,000profit (loss) $500 $500 $250 $1,250distributions -$300 -$300 -$150 -$750closing balance $600 $600 $300 $1,500



closing balance $400 $400 $200 $1,000




43




closing balance $400 $400 $200 $1,000




Year 5 sell assets and opening balance $600 $600 $300 $1,500liquidate profit (loss) $2,400 $2,400 $1,200 $6,000

distributions -$3,000 -$3,000 -$1,500 -$7,500closing balance $0 $0 $0 $0



closing balance $400 $400 $200 $1,000




Year 5 sell assets and opening balance $600 $600 $300 $1,500liquidate profit (loss) $2,400 $2,400 $1,200 $6,000

distributions -$3,000 -$3,000 -$1,500 -$7,500closing balance $0 $0 $0 $0

44

More Complex Allocations – Year 1

member A member B member C total

Year 1 start up initial contribution $2,000 $500 $0 $2,500preferred return (10%) $200 $0 $0 $200

start up losses operating profit (loss) -$850 -$850 $0 -$1,700closing balance $1,350 -$350 $0 $1,000

member A 10% preferred return; 50% of operating profits; 40% of capital profitsmember B 50% of operating profits; 40% of capital profitsmember C 20% of capital profits





45





Year 2 continued losses opening balance $1,350 -$350 $0 $1,000preferred return (10%) $200 $0 $0 $200operating profit (loss) -$350 -$350 $0 -$700closing balance $1,200 -$700 $0 $500







46




Year 3 slight profit opening balance $1,200 -$700 $0 $500preferred return (10%) $200 $0 $0 $200operating profit (loss) $150 $150 $0 $300closing balance $1,550 -$550 $0 $1,000






47




Year 4 growing profit opening balance $1,550 -$550 $0 $1,000preferred return (10%) $200 $0 $0 $200operating profit (loss) $525 $525 $0 $1,050distributions -$300 -$300 -$150 -$750closing balance $1,975 -$325 -$150 $1,500






48




Year 5 sell assets and opening balance $1,975 -$325 -$150 $1,500liquidate preferred return (10%) $200 $0 $0 $200

operating profit (loss) $525 $525 $0 $1,050capital profit (loss) $1,900 $1,900 $950 $4,750distributions -$4,600 -$2,100 -$800 -$7,500closing balance $0 $0 $0 $0




Year 5 sell assets and opening balance $1,975 -$325 -$150 $1,500liquidate preferred return (10%) $200 $0 $0 $200

operating profit (loss) $525 $525 $0 $1,050capital profit (loss) $1,900 $1,900 $950 $4,750distributions -$4,600 -$2,100 -$800 -$7,500closing balance $0 $0 $0 $0


49

Basic Taxation

• “double taxation” v. “pass-through”• check-the-box rules

50

Double Taxation

taxable income of Newco $100

corporate taxes (40%) -$40

cash flow available for dividend $60

dividend to Sam $60dividend to Sam $60

tax to Sam on dividend income (25%) -$15

net after-tax cash flow $45

all taxes $55

effective tax rate 55%

51

Single Taxation

taxable income of Newco $100

taxes on Newco (0%) -$0

cash flow available for distribution $100

tax to Sam on her allocable share of Newco’s income (40%) -$40

distribution to Sam $100distribution to Sam $100

tax to Sam on distribution (0%) -$0

net after-tax cash flow $60

all taxes ($40) $40

effective tax rate 40%

52

Check-the-Box Rules• The check-the-box rules provide for default classification for certain entities.

• In the case of a partnership or LLC, the default classification is a partnership (ifthere are two or more owners) or a disregarded entity (“DRE”) if there is onlyone owner.

• A partnership or LLC can also elect to be taxed as a corporation.

• A partnership or LLC that wants to elect to be taxed as a corporation, or wishesto make a safe-harbor election as to its default classification makes the electionon IRS Form 8832.

• Generally, the effective date of the election is the date the form is filed.However, the entity can select and effective date as much as 75 days prior tothe filing date or as much as 12 months after the filing date. In addition, theIRS will sometimes grant an extension of time to make an election.

• Generally, an entity cannot change its election for 60 months, but there areexceptions.

• The check-the-box rules provide for default classification for certain entities.

• In the case of a partnership or LLC, the default classification is a partnership (ifthere are two or more owners) or a disregarded entity (“DRE”) if there is onlyone owner.

• A partnership or LLC can also elect to be taxed as a corporation.

• A partnership or LLC that wants to elect to be taxed as a corporation, or wishesto make a safe-harbor election as to its default classification makes the electionon IRS Form 8832.

• Generally, the effective date of the election is the date the form is filed.However, the entity can select and effective date as much as 75 days prior tothe filing date or as much as 12 months after the filing date. In addition, theIRS will sometimes grant an extension of time to make an election.

• Generally, an entity cannot change its election for 60 months, but there areexceptions.

53

Preferred or Senior Interests

54

• As noted, partnership and LLC interests can be designedin an almost unlimited fashion.

• In general, a preferred or senior interest will entitle theholder to distributions and profits earlier than otherholders.

• In some cases, senior investors may prefer to structuretheir investment as debt and require a special allocationof interest.

Preferred or Senior Interests

• As noted, partnership and LLC interests can be designedin an almost unlimited fashion.

• In general, a preferred or senior interest will entitle theholder to distributions and profits earlier than otherholders.

• In some cases, senior investors may prefer to structuretheir investment as debt and require a special allocationof interest.

55

Senior Interests -- Examplesenior owners other owners total owner/lenders other owners total

preferred payment 750$ -$ 750$ -$ -$ -$common payment 125$ 125$ 250$ 125$ 125$ 250$

preferred allocation 750$ -$ 750$common allocation 125$ 125$ 250$ 500$ 500$ 1,000$interest expense (750)$ -$ (750)$taxable income 875$ 125$ 1,000$ (250)$ 500$ 250$

tentative income 875$ 125$ 1,000$ 500$ 500$ 1,000$less interest expense -$ (750)$ -$ (750)$taxable income 875$ 125$ 1,000$ (250)$ 500$ 250$

partnership income 875$ (250)$interest income -$ 750$net income to senior owners 875$ 500$

preferred payment 750$ -$common payment 125$ 125$interest payment -$ 750$total cash to senior owners 875$ 875$

preferred units treated as equity preferred units treated as debt

56

senior owners other owners total owner/lenders other owners total

preferred payment 750$ -$ 750$ -$ -$ -$common payment 125$ 125$ 250$ 125$ 125$ 250$

preferred allocation 750$ -$ 750$common allocation 125$ 125$ 250$ 500$ 500$ 1,000$interest expense (750)$ -$ (750)$taxable income 875$ 125$ 1,000$ (250)$ 500$ 250$

tentative income 875$ 125$ 1,000$ 500$ 500$ 1,000$less interest expense -$ (750)$ -$ (750)$taxable income 875$ 125$ 1,000$ (250)$ 500$ 250$

partnership income 875$ (250)$interest income -$ 750$net income to senior owners 875$ 500$

preferred payment 750$ -$common payment 125$ 125$interest payment -$ 750$total cash to senior owners 875$ 875$

preferred units treated as equity preferred units treated as debt

Liquidating Distributions

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• In general, a liquidating distribution can be analogized toa stock redemption.

• The partner receives a distribution from the partnershipin exchange for or liquidation of his or her interest in thepartnership.

• Can be a single or series of distributions.

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• In general, a liquidating distribution can be analogized toa stock redemption.

• The partner receives a distribution from the partnershipin exchange for or liquidation of his or her interest in thepartnership.

• Can be a single or series of distributions.


• The tax treatment of a liquidating distribution variesdepending on what type of property is distributed.

• cash – gain/loss recognized

• “marketable securities” – treated same as cash

• all other property – generally no gain/loss – insteadtake the property with a carryover basis.

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• The tax treatment of a liquidating distribution variesdepending on what type of property is distributed.

• cash – gain/loss recognized

• “marketable securities” – treated same as cash

• all other property – generally no gain/loss – insteadtake the property with a carryover basis.


• Cash includes “deemed” cash distributions from relief ofliabilities.

• “Marketable securities” are financial instruments andforeign currencies that are actively traded – these aretreated as cash substitutes and the same taxconsequences attend them.

• “financial instruments” defined as stocks and otherequity interests, debt, options, forward or futurescontracts, notional principal contracts, and derivatives

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• Cash includes “deemed” cash distributions from relief ofliabilities.

• “Marketable securities” are financial instruments andforeign currencies that are actively traded – these aretreated as cash substitutes and the same taxconsequences attend them.

• “financial instruments” defined as stocks and otherequity interests, debt, options, forward or futurescontracts, notional principal contracts, and derivatives


• If cash or marketable securities are received, and the totalexceeds the partner’s outside tax basis, then thedifference is recognized as gain.

• Loss can be recognized but only if the to the extent thedistribution consists solely of cash or §751 assets.

• Receipt of other property generally will not result in gainor loss. Instead, the partner’s outside tax basis will bespread over the received property.

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• If cash or marketable securities are received, and the totalexceeds the partner’s outside tax basis, then thedifference is recognized as gain.

• Loss can be recognized but only if the to the extent thedistribution consists solely of cash or §751 assets.

• Receipt of other property generally will not result in gainor loss. Instead, the partner’s outside tax basis will bespread over the received property.

Liquidating Distributions -- Example

• A and B are unrelated corporations. They decide form ABCo. to manufacture and exploit a new product.

• A contributes technology and other intangible propertyvalued by A and B at $1 million.

• B contributes a factory and equipment which A and Bvalue at $1 million.

• A and B agree to share all items 50/50.

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• A and B are unrelated corporations. They decide form ABCo. to manufacture and exploit a new product.

• A contributes technology and other intangible propertyvalued by A and B at $1 million.

• B contributes a factory and equipment which A and Bvalue at $1 million.

• A and B agree to share all items 50/50.

Liquidating Distributions -- Example

• At the end of year 3, it is clear that the new product is notselling well and A and B agree to end the relationship.

• AB Co. distributes (i) the technology and other intangibleproperty back to A, and (ii) the factory and equipmentback to B.

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Liquidating Distributions -- ExampleFirst Observation:

• In general, this will not be a taxable transaction.

• Note, in contrast, that the break up of a similar jointventure housed in a corporation could be taxabledepending on the facts; even if it qualified as a tax–freesplit up, the transaction would likely trigger significant taxcompliance costs and delays.

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First Observation:

• In general, this will not be a taxable transaction.

• Note, in contrast, that the break up of a similar jointventure housed in a corporation could be taxabledepending on the facts; even if it qualified as a tax–freesplit up, the transaction would likely trigger significant taxcompliance costs and delays.

Liquidating Distributions -- ExampleSecond Observation:

• Assume that there is a pool of receivables and cash, inaddition to the property originally contributed by A and B.

• The cash likely can be received tax-free, but will reducethe basis of A and B in the property they receive.

• The A/R probably can be received tax-free.

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Second Observation:

• Assume that there is a pool of receivables and cash, inaddition to the property originally contributed by A and B.

• The cash likely can be received tax-free, but will reducethe basis of A and B in the property they receive.

• The A/R probably can be received tax-free.

Liquidating Distributions -- ExampleThird Observation:

• Assume that there are also some payables and otherliabilities.

• Depending how these are allocated between A and B, oneor the other partner could be treated as being relieved ofa liability that was previously included in basis. This istreated as a deemed cash distribution.

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Third Observation:

• Assume that there are also some payables and otherliabilities.

• Depending how these are allocated between A and B, oneor the other partner could be treated as being relieved ofa liability that was previously included in basis. This istreated as a deemed cash distribution.

Compensation Planning, Optionsand Incentive Arrangements

A.OverviewB.Capital vs. Profits InterestsC. Section 83 and VestingD. Options to Acquire LLC InterestsE. Consequences to the LLCF. Proposed IRS Regulations

A.OverviewB.Capital vs. Profits InterestsC. Section 83 and VestingD. Options to Acquire LLC InterestsE. Consequences to the LLCF. Proposed IRS Regulations

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Compensation Planning, Optionsand Incentive Arrangements

• In general, the receipt of an LLC interest inexchange for services performed (or to beperformed) for the LLC is taxable to the recipient.The amount of income is equal to the fair marketvalue (“FMV”) of the LLC interest, and is taxed ascompensation income.

• However, this general rule is subject to numerousexceptions.

• In general, the receipt of an LLC interest inexchange for services performed (or to beperformed) for the LLC is taxable to the recipient.The amount of income is equal to the fair marketvalue (“FMV”) of the LLC interest, and is taxed ascompensation income.

• However, this general rule is subject to numerousexceptions.

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Capital vs. Profits Interests

• The first exception to the general rule is that the receipt of aprofits-only interest is usually not taxable to the recipient.In order to understand the operation of this exception, it isimportant to distinguish between profits and capitalinterests.

• An equity interest in an LLC can give the holder an interestin the LLC’s capital, its profits, or both.

• The first exception to the general rule is that the receipt of aprofits-only interest is usually not taxable to the recipient.In order to understand the operation of this exception, it isimportant to distinguish between profits and capitalinterests.

• An equity interest in an LLC can give the holder an interestin the LLC’s capital, its profits, or both.

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Capital Interest

• A capital interest is an interest in the LLC’s capital.

• Example 1: Smith and Jones form Newco, LLC, by investing$500 each. Newco has a total capital balance of $1,000. Aday later, Newco issues a 20% capital interest to Dewey, inexchange for Dewey’s promise to perform services forNewco.

• A 20% capital interest should entitle the recipient to 20% ofthe capital of the LLC. Here, the LLC has a capital balance of$1,000, so the FMV of the interest is $200. Absent anyother facts, Dewey will be treated as receiving $200 incompensation income as a result of this award.

• A capital interest is an interest in the LLC’s capital.

• Example 1: Smith and Jones form Newco, LLC, by investing$500 each. Newco has a total capital balance of $1,000. Aday later, Newco issues a 20% capital interest to Dewey, inexchange for Dewey’s promise to perform services forNewco.

• A 20% capital interest should entitle the recipient to 20% ofthe capital of the LLC. Here, the LLC has a capital balance of$1,000, so the FMV of the interest is $200. Absent anyother facts, Dewey will be treated as receiving $200 incompensation income as a result of this award.

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Profits Interest

• A profits interest is an interest solely in the profits of the LLC.

• Example 2: Smith and Jones form Newco, LLC, by investing $500 each.A day later, Newco issues a 20% profits interest to Dewey, in exchangefor Dewey’s promise to perform services for Newco.

• A 20% profits interest should entitle the recipient to 20% of the profitsof the LLC. However, unless the LLC actually earns profits, the holder isnot entitled to anything.

• As discussed below, the IRS has taken the position that in general thegrant of a profits interest in exchange for services is not a taxableevent. (The recipient will, of course, be taxable on his or her share ofany income earned by the LLC.)

• A profits interest is an interest solely in the profits of the LLC.

• Example 2: Smith and Jones form Newco, LLC, by investing $500 each.A day later, Newco issues a 20% profits interest to Dewey, in exchangefor Dewey’s promise to perform services for Newco.

• A 20% profits interest should entitle the recipient to 20% of the profitsof the LLC. However, unless the LLC actually earns profits, the holder isnot entitled to anything.

• As discussed below, the IRS has taken the position that in general thegrant of a profits interest in exchange for services is not a taxableevent. (The recipient will, of course, be taxable on his or her share ofany income earned by the LLC.)

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Distinction

• A good test to determine whether an LLC interest is taxable is todetermine what would happen if the LLC immediately vested.

• In general, the holder of a capital interest would be entitled to his orher share of LLC capital, while a profits interest generally only entitlesa recipient to profits going forward.

• In the absence of unusual facts (i.e., an LLC which holds governmentbonds), the IRS has taken the position that future profits are toospeculative to warrant taxing a profits interest on the front end.

• In analyzing a grant of an LLC interest it is very important to focus onthe specific terms of the grant. For example, a back-dated grant of aprofits interest could be a capital interest.

• A good test to determine whether an LLC interest is taxable is todetermine what would happen if the LLC immediately vested.

• In general, the holder of a capital interest would be entitled to his orher share of LLC capital, while a profits interest generally only entitlesa recipient to profits going forward.

• In the absence of unusual facts (i.e., an LLC which holds governmentbonds), the IRS has taken the position that future profits are toospeculative to warrant taxing a profits interest on the front end.

• In analyzing a grant of an LLC interest it is very important to focus onthe specific terms of the grant. For example, a back-dated grant of aprofits interest could be a capital interest.

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Distinction

• Example 3: The facts are the same as Example 2, but theprofits interest is drafted so that it entitles Dewey to a 20%interest in the profits of the LLC for the entire year. As afactual matter, the interest was actually granted on July 1,not January 1.

• In this case, the back dating of the grant has converted anon-taxable profits interest into a taxable capital interest.This is because Dewey receives a right to already-earnedincome, even though the interest purports to be a profitsinterest. The interest would be taxable to Dewey at leastto the extent of the already earned income.

• Example 3: The facts are the same as Example 2, but theprofits interest is drafted so that it entitles Dewey to a 20%interest in the profits of the LLC for the entire year. As afactual matter, the interest was actually granted on July 1,not January 1.

• In this case, the back dating of the grant has converted anon-taxable profits interest into a taxable capital interest.This is because Dewey receives a right to already-earnedincome, even though the interest purports to be a profitsinterest. The interest would be taxable to Dewey at leastto the extent of the already earned income.

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Section 83 and Vesting

• A capital interest that is granted subject to certain conditions can bereceived tax free.

• The IRS takes the position that section 83 applies to LLC interests.Accordingly, if property is transferred to a taxpayer in exchange forservices, the taxpayer must include the FMV of the property inincome. However, if the property is subject to a substantial risk offorfeiture, the income event does not occur until the risk lapses. TheFMV of the property at that time (the vesting date) is the amountincluded in income.

• Thus, if an otherwise taxable capital interest is granted to a taxpayer,but the grant is subject to certain types of restrictions, then the FMVof the interest is not included in income until the restrictions lapse.

• A capital interest that is granted subject to certain conditions can bereceived tax free.

• The IRS takes the position that section 83 applies to LLC interests.Accordingly, if property is transferred to a taxpayer in exchange forservices, the taxpayer must include the FMV of the property inincome. However, if the property is subject to a substantial risk offorfeiture, the income event does not occur until the risk lapses. TheFMV of the property at that time (the vesting date) is the amountincluded in income.

• Thus, if an otherwise taxable capital interest is granted to a taxpayer,but the grant is subject to certain types of restrictions, then the FMVof the interest is not included in income until the restrictions lapse.

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Section 83 and Vesting

• The most common type of restriction that qualifies for this treatmentis a requirement that the recipient continue to perform services.Thus, if a grant of a capital interest is conditioned on the recipientworking for the LLC for four years, and if the interest would beforfeited because of a violation of this condition, then the receipt ofthe interest will not be taxable. When the interest vests in four years,the recipient will have to include the then-FMV into income.

• Another common restriction is a requirement that the LLC’s earningsincrease by a stated percentage or dollar amount.

• Although the matter is not clear, it appears that until a recipient’s LLCinterest vests, he or she is not treated as a member of the LLC for taxpurposes. Any distributions to the recipient by virtue of his or herrights in the LLC under state law are treated as compensation incometo the recipient.

• The most common type of restriction that qualifies for this treatmentis a requirement that the recipient continue to perform services.Thus, if a grant of a capital interest is conditioned on the recipientworking for the LLC for four years, and if the interest would beforfeited because of a violation of this condition, then the receipt ofthe interest will not be taxable. When the interest vests in four years,the recipient will have to include the then-FMV into income.

• Another common restriction is a requirement that the LLC’s earningsincrease by a stated percentage or dollar amount.

• Although the matter is not clear, it appears that until a recipient’s LLCinterest vests, he or she is not treated as a member of the LLC for taxpurposes. Any distributions to the recipient by virtue of his or herrights in the LLC under state law are treated as compensation incometo the recipient.

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Section 83(b) Election

• The Code provides a significant tax election that permits the recipientof property subject to a substantial risk of forfeiture to ignore thatrestriction for tax purposes.

• In effect, this allows a recipient to override the regular rules of section83 and take property into income as of the date of grant (rather thanthe date it vests).

• Thus, if the grant is likely to be much more valuable by the time itvests, it may make sense to treat the grant as a taxable event today,and thereby avoid having to treat the increase in value at the time ofvesting as income.

• The Code provides a significant tax election that permits the recipientof property subject to a substantial risk of forfeiture to ignore thatrestriction for tax purposes.

• In effect, this allows a recipient to override the regular rules of section83 and take property into income as of the date of grant (rather thanthe date it vests).

• Thus, if the grant is likely to be much more valuable by the time itvests, it may make sense to treat the grant as a taxable event today,and thereby avoid having to treat the increase in value at the time ofvesting as income.

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Section 83(b) ElectionExample:

• Smith and Jones form Newco, LLC, by investing $500 each. A day later, Newcoissues a 20% capital interest to Dewey, in exchange for Dewey’s promise toperform services for Newco. The terms of the grant require Dewey to forfeithis interest if he does not provide certain stated services to Newco for the nextfour years. As of the date of the grant, Dewey’s capital interest is worth $200.Assume that four years after grant, Dewey’s capital interest is now worth$2,000.

• Absent a §83(b) election, Dewey is taxed at the time of vesting oncompensation income of $2,000.

• HOWEVER -- if Dewey makes a §83(b) election, he is taxed at the time of granton compensation income of only $200.

• Note that this tax election has a very short fuse and must be filed within 30days of the date of grant.

Example:

• Smith and Jones form Newco, LLC, by investing $500 each. A day later, Newcoissues a 20% capital interest to Dewey, in exchange for Dewey’s promise toperform services for Newco. The terms of the grant require Dewey to forfeithis interest if he does not provide certain stated services to Newco for the nextfour years. As of the date of the grant, Dewey’s capital interest is worth $200.Assume that four years after grant, Dewey’s capital interest is now worth$2,000.

• Absent a §83(b) election, Dewey is taxed at the time of vesting oncompensation income of $2,000.

• HOWEVER -- if Dewey makes a §83(b) election, he is taxed at the time of granton compensation income of only $200.

• Note that this tax election has a very short fuse and must be filed within 30days of the date of grant.

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Option to Acquire LLC Interest

• A compensatory option to acquire an interest in an LLC is generally nottreated as a property interest which is taxable under section 83. As aresult, until the option is exercised there is no taxable event. If theinterest received as a result of the grant is a profits interest, thetransaction will usually not result in any taxable income.

• If the interest received is a capital interest, the recipient will have toinclude the value of the interest in income. However, if the interest issubject to a substantial risk of forfeiture, then the income event will bedeferred until the risk lapses.

• A compensatory option to acquire an interest in an LLC is generally nottreated as a property interest which is taxable under section 83. As aresult, until the option is exercised there is no taxable event. If theinterest received as a result of the grant is a profits interest, thetransaction will usually not result in any taxable income.

• If the interest received is a capital interest, the recipient will have toinclude the value of the interest in income. However, if the interest issubject to a substantial risk of forfeiture, then the income event will bedeferred until the risk lapses.

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Effects on LLC• The grant of an LLC interest in exchange for services may give rise to two LLC-level

tax consequences.

• First, the value of the grant will be a compensation expense for the LLC.

– If the timing of the income is deferred by section 83, the timing of thecompensation expense will also be deferred. Generally, the amount and timingof the income included by the recipient should match the amount and timing ofthe deduction for the LLC.

– Note that in many cases compensation expense is an ordinary and necessarybusiness expense and can be deducted in full under section 162. However, ifthe capitalization rules apply, the expense will have to be capitalized into basisand recovered (possibly) through depreciation and amortization deductionsover time.

• Second, if the grant is a capital interest there is an argument that the resultingcapital shift may trigger LLC-level gain. This would only be the case if some or all ofthe LLC’s assets are appreciated. There is no guidance on the matter andreasonable arguments can be made for and against.

• The grant of an LLC interest in exchange for services may give rise to two LLC-leveltax consequences.

• First, the value of the grant will be a compensation expense for the LLC.

– If the timing of the income is deferred by section 83, the timing of thecompensation expense will also be deferred. Generally, the amount and timingof the income included by the recipient should match the amount and timing ofthe deduction for the LLC.

– Note that in many cases compensation expense is an ordinary and necessarybusiness expense and can be deducted in full under section 162. However, ifthe capitalization rules apply, the expense will have to be capitalized into basisand recovered (possibly) through depreciation and amortization deductionsover time.

• Second, if the grant is a capital interest there is an argument that the resultingcapital shift may trigger LLC-level gain. This would only be the case if some or all ofthe LLC’s assets are appreciated. There is no guidance on the matter andreasonable arguments can be made for and against.

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Proposed IRS Regulations

• In 2005, the IRS proposed extensive rules to govern the granting ofpartnership and LLC interests in exchange for services.

• They substantially conform to current IRS practice.

• Thus, a vested capital interest is taxable to the recipient.

• A vested profits interest is also taxable, but the IRS would establish a specialvaluation safe harbor that would treat such an interest as having zero value.If the safe harbor is not used, a grant of a profits interest could be taxable tothe recipient, but it would depend on the value of the interest.

• In the case of unvested interests, the section 83 regime would apply, with theeffects described above.

• The proposed regulations also appear to state that the issuance of a capitalinterest would not trigger taxable gain to the LLC.

• In 2005, the IRS proposed extensive rules to govern the granting ofpartnership and LLC interests in exchange for services.

• They substantially conform to current IRS practice.

• Thus, a vested capital interest is taxable to the recipient.

• A vested profits interest is also taxable, but the IRS would establish a specialvaluation safe harbor that would treat such an interest as having zero value.If the safe harbor is not used, a grant of a profits interest could be taxable tothe recipient, but it would depend on the value of the interest.

• In the case of unvested interests, the section 83 regime would apply, with theeffects described above.

• The proposed regulations also appear to state that the issuance of a capitalinterest would not trigger taxable gain to the LLC.

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Techniques InvolvingDisregarded Entities

A. Treatment of LLC as Disregarded Entity

B. Simple Example – Transfer of Real Estate

C. Transfer of Risky Assets

D. Corporate Reorganizations

E. Regulatory Issues

F. Like-Kind Exchanges

G. Alternative to Series LLC

A. Treatment of LLC as Disregarded Entity

B. Simple Example – Transfer of Real Estate

C. Transfer of Risky Assets

D. Corporate Reorganizations

E. Regulatory Issues

F. Like-Kind Exchanges

G. Alternative to Series LLC

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Treatment of LLC as Disregarded Entity

• If an LLC has only a single owner, by default the LLC will be treated asa “disregarded entity” or “DRE”. Alternatively, the owner can elect totreat the LLC as a corporation.

• An LLC treated as a DRE is, as the term implies, ignored for taxpurposes.

• Thus, the assets and liabilities of the DRE are treated, for taxpurposes, as the assets and liabilities of the sole owner of the DRE.

• In addition, in many cases the actions of the DRE are treated as theactions of the sole owner.

• This can provide significant planning opportunities.

• If an LLC has only a single owner, by default the LLC will be treated asa “disregarded entity” or “DRE”. Alternatively, the owner can elect totreat the LLC as a corporation.

• An LLC treated as a DRE is, as the term implies, ignored for taxpurposes.

• Thus, the assets and liabilities of the DRE are treated, for taxpurposes, as the assets and liabilities of the sole owner of the DRE.

• In addition, in many cases the actions of the DRE are treated as theactions of the sole owner.

• This can provide significant planning opportunities.

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Simple Example – Transfer of Real Estate

• One of the simplest uses of DREs is to hold real estate.

• Example 1: Smith and Jones form Newco, LLC with $1million each. Newco desires to purchases fourseparate apartment buildings, each costing $2 million.Newco goes to a bank and arranges for a $1.75 millionloan on each building (it uses the contributed cash tofund the balance of each purchase price).

• In the absence of any additional structuring, thisarrangement poses the following potential problems:

• One of the simplest uses of DREs is to hold real estate.

• Example 1: Smith and Jones form Newco, LLC with $1million each. Newco desires to purchases fourseparate apartment buildings, each costing $2 million.Newco goes to a bank and arranges for a $1.75 millionloan on each building (it uses the contributed cash tofund the balance of each purchase price).

• In the absence of any additional structuring, thisarrangement poses the following potential problems:

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• Liability Protection – Because each building is held in a separateentity, the assets of one DRE are walled off against the liabilitiesof the other DREs.

• Transfer Taxes – If Newco desired to sell one of the buildings, itsimply transfers its membership interest in the DRE that ownsthat building. This (under current law) should not trigger realestate transfer taxes. In addition, if the assets consisted oftangible personal property, a transfer of a DRE that owned theassets should also avoid sales tax.

• Recordation/Delays – Because Newco need only transfer itsmembership interest in one of the DREs to effectuate a transfer,there is no need to record the change and no fees associatedwith that. Furthermore, such a transfer can generally beaccomplished faster and cheaper than a transfer of real property.

• Liability Protection – Because each building is held in a separateentity, the assets of one DRE are walled off against the liabilitiesof the other DREs.

• Transfer Taxes – If Newco desired to sell one of the buildings, itsimply transfers its membership interest in the DRE that ownsthat building. This (under current law) should not trigger realestate transfer taxes. In addition, if the assets consisted oftangible personal property, a transfer of a DRE that owned theassets should also avoid sales tax.

• Recordation/Delays – Because Newco need only transfer itsmembership interest in one of the DREs to effectuate a transfer,there is no need to record the change and no fees associatedwith that. Furthermore, such a transfer can generally beaccomplished faster and cheaper than a transfer of real property.

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• Example 2: Same facts as Example 1, except thatNewco forms four DREs below it, each of which holds adifferent apartment building. Each DRE separatelyborrows $1.75 million and Newco contributes$250,000 to each, so that each DRE can purchase oneof the building buildings.

• This arrangement resolves the potential problemslisted above:

• Example 2: Same facts as Example 1, except thatNewco forms four DREs below it, each of which holds adifferent apartment building. Each DRE separatelyborrows $1.75 million and Newco contributes$250,000 to each, so that each DRE can purchase oneof the building buildings.

• This arrangement resolves the potential problemslisted above:

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Transfer of Risky Assets

• As noted above, assets that may have liabilitiesassociated with them can benefit from being held inan LLC.

• Risky assets can include assets with potential liabilityfrom past actions (i.e., real estate which may haveenvironmental complications) or assets that may incurliability in the future (i.e., a business that is nowsubject to potentially damaging liability – i.e., fast foodfranchises, database companies, etc., that could besued as part of a class action).

• If a business is considering moving risky assets, a DREcan be used

• As noted above, assets that may have liabilitiesassociated with them can benefit from being held inan LLC.

• Risky assets can include assets with potential liabilityfrom past actions (i.e., real estate which may haveenvironmental complications) or assets that may incurliability in the future (i.e., a business that is nowsubject to potentially damaging liability – i.e., fast foodfranchises, database companies, etc., that could besued as part of a class action).

• If a business is considering moving risky assets, a DREcan be used

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Example• FoodCo is a limited partnership that owns 20 fast food

franchises throughout the southeast. Because ofconcern over potential class action lawsuits, FoodCowould like to restructure.

• One approach is for FoodCo to create a separate DREfor each franchise and hold it as a subsidiary. Thiswould be particularly helpful in connection with futurerisks. Because FoodCo historically operated thebusinesses that are being sued, this may not fullyprotect FoodCo if the basis for liability includes pastactions.

• FoodCo is a limited partnership that owns 20 fast foodfranchises throughout the southeast. Because ofconcern over potential class action lawsuits, FoodCowould like to restructure.

• One approach is for FoodCo to create a separate DREfor each franchise and hold it as a subsidiary. Thiswould be particularly helpful in connection with futurerisks. Because FoodCo historically operated thebusinesses that are being sued, this may not fullyprotect FoodCo if the basis for liability includes pastactions.

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Example• Another approach is for FoodCo to distribute out to its

owners any assets that are not at risk. For example,assume that FoodCo also operates several servicebusinesses that are not targets of class-action programs.

• In that case, it may be effective to distribute FoodCo’s“safe” assets out and operate them as separatebusinesses. FoodCo could form DREs to hold each safebusiness and distribute the DREs to its owners.

• In this way, the owners of FoodCo would receive acomplete business, would be shielded from anypotential liability associated with the business, and thebusiness could operate without interruption.

• Another approach is for FoodCo to distribute out to itsowners any assets that are not at risk. For example,assume that FoodCo also operates several servicebusinesses that are not targets of class-action programs.

• In that case, it may be effective to distribute FoodCo’s“safe” assets out and operate them as separatebusinesses. FoodCo could form DREs to hold each safebusiness and distribute the DREs to its owners.

• In this way, the owners of FoodCo would receive acomplete business, would be shielded from anypotential liability associated with the business, and thebusiness could operate without interruption.

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Corporate Reorganizations -- Simple Mergers

• Assume X Corp would like to acquire Y Corp. Theshareholders of Y Corp agree, but would like theacquisition to be non-taxable.

• One way to do this is for Y to merge into X, with Ygoing out of existence. The shares of Y are cancelledand convert into shares of X in an agreed upon ratio.

• Assume that Y is a consumer information databasecompany and X is concerned that any inappropriatesharing or leak of information could subject thebusiness to significant liability. If Y is merged into X,then any liability associated with the operations of Ycould threaten X’s other businesses.

• Assume X Corp would like to acquire Y Corp. Theshareholders of Y Corp agree, but would like theacquisition to be non-taxable.

• One way to do this is for Y to merge into X, with Ygoing out of existence. The shares of Y are cancelledand convert into shares of X in an agreed upon ratio.

• Assume that Y is a consumer information databasecompany and X is concerned that any inappropriatesharing or leak of information could subject thebusiness to significant liability. If Y is merged into X,then any liability associated with the operations of Ycould threaten X’s other businesses.

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Simple Mergers

• One solution is for X to form a DRE, Newco, LLC, andhave Y merge into Newco, with Newco surviving. Thiscan be accomplished on a tax-free basis with theshareholders of Y receiving X stock in exchange fortheir shares.

• Note that this could also be accomplished by using acorporate subsidiary of X. The benefit of using an LLCin this situation is primarily ease of use.

• However, if X owned a subsidiary, Z Corp, and wantedto acquire Y below Z, then it could not form a newcorporate subsidiary below Z to do this. Instead itwould have to use a DRE.

• One solution is for X to form a DRE, Newco, LLC, andhave Y merge into Newco, with Newco surviving. Thiscan be accomplished on a tax-free basis with theshareholders of Y receiving X stock in exchange fortheir shares.

• Note that this could also be accomplished by using acorporate subsidiary of X. The benefit of using an LLCin this situation is primarily ease of use.

• However, if X owned a subsidiary, Z Corp, and wantedto acquire Y below Z, then it could not form a newcorporate subsidiary below Z to do this. Instead itwould have to use a DRE.

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C Reorganizations

• Assume that X Corp wants to acquire Y Corp, but that Y owns a tract ofland that has significant potential environmental liability associated withit. If Y requires that the transaction be structured as a tax-freereorganization, the use of a merger may be resisted by X as that wouldput Y’s tract inside X (or a subsidiary). In this situation, X and Y canenter into what is called a “C” reorganization.

• Under a C reorganization, X (or a subsidiary of X) acquires substantiallyall the assets of Y and issues shares to Y in return. Y liquidates,distributing any remaining assets along with the X shares to itsshareholders.

• This generally is tax-free to Y’s shareholders, and means that X canacquire Y’s business assets without acquiring the risky tract of land.

• Assume that X Corp wants to acquire Y Corp, but that Y owns a tract ofland that has significant potential environmental liability associated withit. If Y requires that the transaction be structured as a tax-freereorganization, the use of a merger may be resisted by X as that wouldput Y’s tract inside X (or a subsidiary). In this situation, X and Y canenter into what is called a “C” reorganization.

• Under a C reorganization, X (or a subsidiary of X) acquires substantiallyall the assets of Y and issues shares to Y in return. Y liquidates,distributing any remaining assets along with the X shares to itsshareholders.

• This generally is tax-free to Y’s shareholders, and means that X canacquire Y’s business assets without acquiring the risky tract of land.

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C Reorganizations

• However, further protection can be added by the use ofDREs.

• Even though the transaction can be structured so that X (ora subsidiary) specifically does not acquire the tract of landthat has a significant liability associated with it, there maystill be a risk that X (and/or its subsidiary) will nonethelessshare some liability solely because of the acquisition of thebalance of Y’s assets.

• One approach to better protect against this is for X to forma subsidiary that in turn forms a DRE to receive the assets.

• This arguably will place two layers of protection betweenthe assets and X Corp.

• However, further protection can be added by the use ofDREs.

• Even though the transaction can be structured so that X (ora subsidiary) specifically does not acquire the tract of landthat has a significant liability associated with it, there maystill be a risk that X (and/or its subsidiary) will nonethelessshare some liability solely because of the acquisition of thebalance of Y’s assets.

• One approach to better protect against this is for X to forma subsidiary that in turn forms a DRE to receive the assets.

• This arguably will place two layers of protection betweenthe assets and X Corp.

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C Reorganizations

• In addition to the possible protection afforded to X Corp, aDRE can provide protection to Y’s shareholders.

• Recall that as a condition to the C reorganization, Y mustliquidate and distribute the X stock and its remaining assetsto Y’s shareholders.

• If the tract of land were received directly by theshareholders, there may be additional liability.

• One way to protect against this is to drop all or some of Y’sassets into a DRE and distribute out LLC interests in lieu ofdirect ownership.

• In addition to the possible protection afforded to X Corp, aDRE can provide protection to Y’s shareholders.

• Recall that as a condition to the C reorganization, Y mustliquidate and distribute the X stock and its remaining assetsto Y’s shareholders.

• If the tract of land were received directly by theshareholders, there may be additional liability.

• One way to protect against this is to drop all or some of Y’sassets into a DRE and distribute out LLC interests in lieu ofdirect ownership.

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Triangular Mergers

• As noted, if X Corp owns Z Corp, and Z would like toacquire Y Corp for stock of X Corp, but does not want YCorp to merge directly into Z Corp, it can accomplishthis by forming a DRE below Z and having Y mergerinto the DRE with the DRE surviving.

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Regulatory Issues

• Regulatory issues can also be resolved with the use of a DRE.

• For example, in some states, a bank and a bank holdingcompany cannot merge.

• However, a bank may be able to merge into a DRE owned bya bank holding company.

• Regulatory issues can also be resolved with the use of a DRE.

• For example, in some states, a bank and a bank holdingcompany cannot merge.

• However, a bank may be able to merge into a DRE owned bya bank holding company.

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Like-Kind Exchanges

• Under Code section 1031, a taxpayer can avoid gain onproperty by exchanging it for property of “like kind.”Particularly with respect to real estate, there is widelatitude as to what constitutes like kind property. As aresult, many owners of real estate frequently engage inlike kind exchanges rather than taxable sales.

• However, any direct interaction with real estate creates acertain amount of risk. One solution is to acquire the newproperty in a DRE. For tax purposes, the acquisition of aDRE that owns a piece of real estate will be treated thesame as the acquisition of a piece of real estate directly.

• Under Code section 1031, a taxpayer can avoid gain onproperty by exchanging it for property of “like kind.”Particularly with respect to real estate, there is widelatitude as to what constitutes like kind property. As aresult, many owners of real estate frequently engage inlike kind exchanges rather than taxable sales.

• However, any direct interaction with real estate creates acertain amount of risk. One solution is to acquire the newproperty in a DRE. For tax purposes, the acquisition of aDRE that owns a piece of real estate will be treated thesame as the acquisition of a piece of real estate directly.

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Alternatives to Series

• Series LLCs are not yet permitted in most states.

• It is unclear how a series LLC from, say Delaware, would betreated in a state that does not recognize such an entity,either as a matter of state tax law or state LLC law.

• Given the complexity associated with series LLCs and theuncertain state law and state tax treatment, are there viablealternatives?

• holding company LLC with LLC subsidiaries

• multiple separate LLCs

• single LLC with schedular allocations

• Series LLCs are not yet permitted in most states.

• It is unclear how a series LLC from, say Delaware, would betreated in a state that does not recognize such an entity,either as a matter of state tax law or state LLC law.

• Given the complexity associated with series LLCs and theuncertain state law and state tax treatment, are there viablealternatives?

• holding company LLC with LLC subsidiaries

• multiple separate LLCs

• single LLC with schedular allocations

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Holding LLC with SubsMember 1 Member 2 Member 3 Member 4

A = 25%B = 1%C = 90%D = 1%

A = 1%B = 1%C = 1%D = 59%

A = 73%B = 8%C = 8%D = 10%

A = 1%B = 90%C = 1%D = 30%

Holding LLC

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LLC A LLC B LLC DLLC C

Holding LLC with Subs

• Holding LLC owns 4 separate LLCs, each a “subsidiary” LLC.

• Note that by using separate LLCs, the assets of each LLCare walled off from the other LLCs.

• The Holding LLC also provides an additional layer ofprotection, and need not be an LLC that is formed underthe same jurisdiction as the subsidiary LLCs.

• Each subsidiary has only a single owner, so should betreated as “disregarded entities” for income tax purposes.

• Holding LLC owns 4 separate LLCs, each a “subsidiary” LLC.

• Note that by using separate LLCs, the assets of each LLCare walled off from the other LLCs.

• The Holding LLC also provides an additional layer ofprotection, and need not be an LLC that is formed underthe same jurisdiction as the subsidiary LLCs.

• Each subsidiary has only a single owner, so should betreated as “disregarded entities” for income tax purposes.

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Holding LLC with Subs

• Will Holding LLC be treated as a separate partnership forincome tax purposes?

• This an open question because of the schedularallocations. Under current law, Holding LLC may beignored and the four subsidiary LLCs may be treated asseparate entities.

• In fact, it may be preferable to ignore Holding LLC andtreat the subsidiary LLCs as separate entities.

• Will Holding LLC be treated as a separate partnership forincome tax purposes?

• This an open question because of the schedularallocations. Under current law, Holding LLC may beignored and the four subsidiary LLCs may be treated asseparate entities.

• In fact, it may be preferable to ignore Holding LLC andtreat the subsidiary LLCs as separate entities.

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Separate LLCsMember 1 Member 2 Member 3 Member 4

A = 25%B = 1%C = 90%D = 1%

A = 1%B = 1%C = 1%D = 59%

A = 73%B = 8%C = 8%D = 10%

A = 1%B = 90%C = 1%D = 30%

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LLC A LLC B LLC DLLC C

Separate LLCs

• The use of separate LLCs to hold, say, related real estateprojects, is a structure that is frequently used.

• The tax treatment should be identical between the separateLLCs and a series LLC with schedular allocations.

• Note that by using separate LLCs, the assets of each LLC arewalled off from the other LLCs.

• But, the use of separate LLCs can often be unwieldy. Forconvenience sake, it may be easier to form a single entrypoint and then as each investment opportunity comes up,provide for the specific economics of each investment.

• The use of separate LLCs to hold, say, related real estateprojects, is a structure that is frequently used.

• The tax treatment should be identical between the separateLLCs and a series LLC with schedular allocations.

• Note that by using separate LLCs, the assets of each LLC arewalled off from the other LLCs.

• But, the use of separate LLCs can often be unwieldy. Forconvenience sake, it may be easier to form a single entrypoint and then as each investment opportunity comes up,provide for the specific economics of each investment.

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Single LLCMember 1 Member 2 Member 3 Member 4

A = 25%B = 1%C = 90%D = 1%

A = 1%B = 1%C = 1%D = 59%

A = 73%B = 8%C = 8%D = 10%

A = 1%B = 90%C = 1%D = 30%

GiantCo LLC

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Asset/Line of Business AAsset/Line of Business BAsset/Line of Business CAsset/Line of Business D

Single LLC

• In this variation, we form a single LLC, put all the assets in it,and set out allocations based on specific assets or lines ofbusiness.

• Does not wall off one group of assets from another.

• Will this will be viewed as four separate LLCs for income taxpurposes because of the asset/business allocations?

• In this variation, we form a single LLC, put all the assets in it,and set out allocations based on specific assets or lines ofbusiness.

• Does not wall off one group of assets from another.

• Will this will be viewed as four separate LLCs for income taxpurposes because of the asset/business allocations?

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Thank You───────────────────────

Joseph C. Mandarino



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Joseph C. Mandarino



Important Issues to Consider

David K. StaubStaub Anderson LLC

Chicago, Illinois

Important Issues to Consider


Chicago, Illinois

Corporations raise capital by issuing shares LLC capital contributions governed by agreement Loans vs. additional capital contributions Capital calls Limitations on additional capital contributions Who decides on additional capital contributions Valuing non-cash capital contributions Tax consequences

Consequences of failure to meet capital call Protect against 3rd parties forcing a capital call

Corporations raise capital by issuing shares LLC capital contributions governed by agreement Loans vs. additional capital contributions Capital calls Limitations on additional capital contributions Who decides on additional capital contributions Valuing non-cash capital contributions Tax consequences

Consequences of failure to meet capital call Protect against 3rd parties forcing a capital call

107

General Rule: No gain or loss Exceptions Services Partnership investment company Disguised sale Assumption of indebtedness

General Rule: No gain or loss Exceptions Services Partnership investment company Disguised sale Assumption of indebtedness

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Loan from the other members Reduction in percentage interest Sale or redemption at appraised value Forfeiture Subordination Elimination of voting rights Elimination of all rights as a member Charging interest on the amount of the

defaulted capital call Foreclosure on the ownership interest

of the defaulting member

Loan from the other members Reduction in percentage interest Sale or redemption at appraised value Forfeiture Subordination Elimination of voting rights Elimination of all rights as a member Charging interest on the amount of the

defaulted capital call Foreclosure on the ownership interest

of the defaulting member

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Two types of anti-dilution provisions “Full ratchet” anti-dilution Weighted average anti-dilution

Anti-dilution carve outs Interests reserved for employees Interests issued pursuant to a merger,

acquisition, or similar business combination Interests issued pursuant to a financing Interests with respect to which the members

waive their anti-dilution rights

Two types of anti-dilution provisions “Full ratchet” anti-dilution Weighted average anti-dilution

Anti-dilution carve outs Interests reserved for employees Interests issued pursuant to a merger,

acquisition, or similar business combination Interests issued pursuant to a financing Interests with respect to which the members

waive their anti-dilution rights

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Notice of proposed sale Exercise of preemptive rights Transferability of preemptive

rights Limitation on ability to issue

interests and/or admit members

Notice of proposed sale Exercise of preemptive rights Transferability of preemptive

rights Limitation on ability to issue

interests and/or admit members

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Priorities of payments to LLC members Buyout transactions

Priority return of invested capital andpreferred return

Participating or nonparticipating Profits interests payments

o Percentage reserved for the managementprofits interest pool

o Vesting requirements Joint ventures

Priorities of payments to LLC members Buyout transactions

Priority return of invested capital andpreferred return

Participating or nonparticipating Profits interests payments

o Percentage reserved for the managementprofits interest pool

o Vesting requirements Joint ventures

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Chicago, [email protected]

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Chicago, [email protected]

Documents

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