LLCs: Latest Developments in Federal and State Tax Treatmentmedia.straffordpub.com/products/llcs-latest...Jan 09, 2013 · L. Andrew Immerman, Partner, Alston & Bird, Atlanta Saba

LLCs: Latest Developments in

Federal and State Tax Treatment Navigating the Opportunities and Pitfalls of Series LLCs, L3Cs and New Tax and LLC Laws

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WEDNESDAY, JANUARY 9, 2013

Presenting a live 110-minute teleconference with interactive Q&A

Joseph C. Mandarino, Partner, Stanley Esrey & Buckley, Atlanta

Christopher McLoon, Partner, Verrill Dana, Portland, Maine

L. Andrew Immerman, Partner, Alston & Bird, Atlanta

Saba Ashraf, Partner, McKenna Long & Aldridge, Atlanta

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LLCs: Latest Developments in Federal and State Tax Treatment Seminar

Joseph Mandarino, Stanley Esrey & Buckley

[email protected]

Jan. 9, 2013

Christopher McLoon, Verrill Dana

[email protected]

L. Andrew Immerman, Alston & Bird

[email protected]

Saba Ashraf, McKenna Long & Aldridge

[email protected]

Today’s Program

Evolutions In LLC Structures

[Christopher McLoon]

Limited Partner Status For LLCs

[Joseph Mandarino]

Developments In Congress And State Legislatures

[Joseph Mandarino and L. Andrew Immerman]

Issues Arising From LLCs Seeking S Corporation Treatment

[Saba Ashraf]

Trends With LLC Usage In Dealmaking

[Saba Ashraf]

Slide 8 – Slide 28





Notice

ANY TAX ADVICE IN THIS COMMUNICATION IS NOT INTENDED OR WRITTEN BY

THE SPEAKERS’ FIRMS TO BE USED, AND CANNOT BE USED, BY A CLIENT OR ANY

OTHER PERSON OR ENTITY FOR THE PURPOSE OF (i) AVOIDING PENALTIES THAT

MAY BE IMPOSED ON ANY TAXPAYER OR (ii) PROMOTING, MARKETING OR

RECOMMENDING TO ANOTHER PARTY ANY MATTERS ADDRESSED HEREIN.

You (and your employees, representatives, or agents) may disclose to any and all persons,

without limitation, the tax treatment or tax structure, or both, of any transaction

described in the associated materials we provide to you, including, but not limited to,

any tax opinions, memoranda, or other tax analyses contained in those materials.

The information contained herein is of a general nature and based on authorities that are

subject to change. Applicability of the information to specific situations should be

determined through consultation with your tax adviser.

EVOLUTIONS IN LLC STRUCTURES

Christopher McLoon, Verrill Dana

Adopting States

Delaware Illinois

Iowa Kansas

Nevada Oklahoma

Tennessee Texas

Utah Wisconsin

9

Key Points

A series of a series LLC generally is not an entity under local law; it is

an association formed by contract.

A series of a series LLC is likely an entity, for federal tax purposes. Pay

close attention to definitions of a series and of a series organization.

The series of a Series LLC is likely to be characterized under the check-

the-box regulations.

Proposed regulations contain transition rules that might cause adverse

tax consequences for certain series existing on or before Sept. 14, 2012.

The proposed regulations only cover the tip of the federal tax issues

iceberg.

10

Series LLC: What Is It?

Delaware LLC Act, Sect. 18-215

Permits members of LLC to establish or provide for establishment of

one or more designated series of:

Members

Managers

LLC interests

Assets

Series established permitted to have separate rights, powers or duties

as to:

Specific assets

Obligations

Profits and losses associated with specified property or obligations

11

Series LLC: What Is It? (Cont.)

Delaware LLC Act, Sect. 18-215 (Cont.)

Series may have separate business or investment objective

Establishing series according to prescribed rules

Properly established series may has power and capacity to, in its own

name, contract, hold title, grant liens/security interests, sue/be sued

12

Series LLC: A Little Tax History

Delaware and several other states have adopted series LLC statutes.

No clear guidance about how a series is treated, for federal income tax

purposes

Treasury issues Notice 2008-19, asking for comments.

Several comments received

Treasury issues proposed regulations on Sept. 14, 2010.

13

Series LLC: Proposed Regulations

Key definitions

Series organization

A juridical entity (as opposed to a natural person)

Establishes and maintains one or more series

Series

Segregated assets and liabilities

Established by agreement of series organization

14

Series LLC: Proposed Regulations (Cont.)

Key definitions (Cont.)

Series statute

Statute that:

Permits an juridical person to establish/maintain a series having

separate rights, powers and duties as to specified property or

obligations

Permits organization to segregate assets and liabilities

None of the debts and liabilities of the series organization or

any other series of the series organization are enforceable

against assets of a particular series.

15

Tax Classification

A domestic series is a separate entity, for tax purposes.

A series generally is not a separate entity, for local law purposes. It is

a contractual association of persons with assets and liabilities.

Federal tax law – not local law – governs.

Other example: Joint ventures (partnership though no local law

entity)

Castle Harbor and Historic Boardwalk (local law entity but no

partnership, for federal income tax purposes)

16

Tax Classification (Cont.)

Certain factors do not matter in determining whether a domestic series is

a separate entity.

Agreement to make the series organization or one or more series

liable for debts and obligations of a series

Failure of the series organization to follow requirements for

maintaining liability shield

Maintaining separate records for assets of series

A series that meets the definition of a series will be respected, for

federal tax purposes.

17

Tax Classification (Cont.)

Each separate entity must be classified, for federal tax purposes.

Is it a business entity?

Treated as separate from its owners, and

Not a trust under Reg. §301.7701-4 or otherwise subject to special

treatment under the Internal Revenue Code (e.g., REMIC)

If a business entity, is it a corporate entity?

If not a corporate entity, default to:

Partnership, if more than one owner

Disregarded entity if one owner

18

Tax Ownership Of Interests And Assets

Tax ownership is determined under federal tax law.

Benefits and burdens of ownership

Ownership is not determined by title to assets.

Series organization may hold title, but not necessarily the owner.

Partner status

Culbertson and Tower

Sect. 704(e)

19

Transition Rules

Conditions

Series in existence and operating on or after Sept. 14, 2010 but before

regulations are finalized

Series are not treated as separate tax entities.

Deemed transaction

Sect. 708 division of partnership (if a partnership)

Sect. 355 divisive reorg (if a corporate series organization and

(presumably) election made for series

20

Miscellaneous Matters

Tax collection

If local law permits creditors to collect on series judgments from

assets of series organization or other series, then tax of a series may

also be collected from these entities.

Information statements

Series organization must file certain information about each series.

Possible changes to SS-4

21

Key Issues

Document drafting

Clarify desired associations with assets, liabilities and interests

Careful attention to recordkeeping

Allocate debt shares

Transactions with series LLC or other series

22

Key Issues (Cont.)

Proposed regulations do not address whether the series organization is a

separate entity, for federal tax purposes.

An entity under local law may not be an entity, for federal tax law

purposes. Reg. §301.7701-1(a)(4)

23

Key Issues (Cont.)

Proposed regulations do not cover employment tax issues or employee

benefits issues.

Whether the series is an employer, for federal employment tax

Whether an employee employed by both a series and a series LLC

would be subject to FICA and FUTA taxes, for wages paid by the

series LLC and the series

24

Key Issues (Cont.)

Profits interests and the series

Rev. Proc. 93-27 only applies to interests granted to a person who

performs services.

To or for the benefit of the issuing partnership

In its capacity as a partner or in anticipation of being a partner

Issues

Can the series issue an interest?

If not, and the interest can only be issued by the series LLC, will

this issuance be treated as the issuance by the series, for purposes

of Rev. Proc. 93-27?

Helpful language in proposed regulations about ownership of

interests determined under burdens-and-benefits test

25

Slide Intentionally Left Blank

Low-Profit Limited Liability

Companies (L3Cs)

Key Points

L3Cs were designed to attract program related investments for LLC

ventures promoting social good.

L3C attractiveness depended on federal legislation that established an

approval process similar to the process used to obtain a tax exemption.

The federal legislation never received much support.

Without federal legislation, the L3C provides little, if any, advantage.

28

LIMITED PARTNER STATUS FOR LLCs


Disclaimer

IRS Circular 230 Disclosure

Unless explicitly stated to the contrary, this outline, the presentation to which it relates and any other documents or attachments are not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing, or recommending to another party any transaction or matter addressed herein.

30

Passive Activity Background

• Passive activity loss (PAL) rules significantly limit a taxpayer’s use of losses from passive activities.

• Exception: The PAL rules do not apply if a taxpayer “materially participates” in a passive activity.

• Generally, a taxpayer must satisfy one of seven tests to establish material participation.

• However, Sect. 469(h)(2) provides that if a taxpayer holds an interest solely as a “limited partner,” then only three of the seven tests apply.

• In the case of an LLC, there has been considerable discussion of whether and how an LLC interest could be treated as a “limited partner” interest, for these purposes.

31

Passive Activity Background (Cont.)

• Historically, the IRS has taken the position that all LLC interests were limited partner interests.

• In a series of cases, this position was rejected by the courts:

– Gregg v. U.S., 186 F. Supp. 2d 1123 (D. Or. 2000)

– Thompson v. U.S., 87 Fed. Cl. 729 (2009)

– Garnett v. Comm’r, 132 T.C. 368 (2009)

– Hegarty v. Comm’r, T.C. Summary Opinion 2009-153 (2009)

– Newell v. Comm’r, T.C.M. 2010-23 (2010)

32

Limited Partner Status For LLCs

• Proposed regs issued in November 2011 provide that an owner

of an LLC interest is treated as a limited partner, for purposes of

the PAL rules, if two requirements are met:

– The entity is classified as a partnership for federal income tax

purposes; and

– The holder of the interest does not have rights to manage the

entity at all times during the entity’s taxable year under the

law of the jurisdiction in which the entity is organized and

under the governing agreement.

Prop. Reg. 1.469-5(e)(3)(i)

33

Management Rights

34

• The test now turns on management rights and not limitation of

liability.

• The preamble to the proposed regs states that “[r]ights to

manage include the power to bind the entity.”

• Most LLC acts by default provide that LLC members can bind the

LLC, with respect to third parties.

• Curtailing such rights can result in LLC members being treated

as limited partners, for PAL purposes.

Interaction With New 3.8% Tax

On Net Investment Income

35

• Gains from a passive activity may be subject to the new 3.8% tax

on net investment income.

• However, this tax may not apply to gains from a trade or

business in which a taxpayer materially participates.

• Avoiding limited partner status may help a taxpayer, because

gains from such activity will generally not be subject to the 3.8%

tax on net investment income.

Interaction With Self-

Employment Tax Rules

36

• If a taxpayer is not a “limited partner,” for purposes of the PAL

rules with respect to a trade or business, is the taxpayer subject

to self-employment tax on the earnings of that activity?

• Under the SECA rules, a limited partner’s earnings from an

activity are not subject to self-employment tax.

• However, the test for limited partner status under the PAL rules

and the test under the SECA rules are different.

• Thus, it is possible to be a limited partner for self-employment tax

purposes, but not for PAL purposes.

SECA Limited Partner Exception

• There is specific statutory relief from SECA taxes for “limited partners.”

• The Code does not define the term “limited partner,” for these purposes

• The IRS issued proposed regulations in 1997 to interpret the term “limited partner,” for purposes of Sect. 1402(a)(13).

• These regulations take a broad interpretation and are useful for planning purposes and for users of LLCs.

• However, the proposed regulations are not effective until finalized and have been out there for 15 years

• Although the proposed regulations do not constitute authority and are not binding on any court, compliance with them is likely to be viewed as reasonable. It seems unlikely that any penalties could be assessed for structuring partnership arrangements in such a way as to comply with these regulations.

37

Overview Of Proposed

SECA Regulations

• The regulations apply to any entity that is classified as a partnership, for federal income tax purposes.

• Does not matter what the entity is under state law

• The regulations apply to limited partnerships, LLLP, LLCs and any other state law entities that can be classified as a partnership, for federal income tax purposes.

• A member of a tax partnership is treated as a “limited partner” (and thus escapes SECA taxation) only if the proposed regulations are satisfied. The fact that a person is a “limited partner” for state law purposes is irrelevant.

• The structure of the proposed regulations is to treat an individual partner as a “limited partner” by default. An individual loses this favorable position only if he/she fails certain tests.

38

Service Partner Exception

• A “service partner” cannot be a limited partner, for these purposes.

• A “service partner” is – generally – any member of a “service partnership.” However, a member of a service partnership is not treated as a “service partner” if he or she provides only de minimis services to or on behalf of the service partnership.

• A “service partnership” is a partnership in which substantially all the activities involve the performance of services in the fields of health, law, engineering, architecture, accounting, actuarial science or consulting.

• Important: The general partner of a service partnership cannot be a limited partner, even if he or she performs no services. That is not because of the service partnership rules, but rather because of the tests described in the next slide (a general partner will ordinarily have authority to contract on behalf of the partnership and therefore fail test No. 2 on the next slide).

39

Three Tests

The regulations set out three tests. Failing any of the three tests pushes a partner out of the default classification, and he or she is treated as other than a limited partner.

Test No. 1: A partner loses limited partnership status if the partner has personal liability for the debts of the partnership by reason of being a partner.

Test No. 2: A partner loses limited partnership status if the partner has authority to contract on behalf of the partnership.

Test No. 3: A partner loses limited partnership status if the partner participates in the partnership’s trade or business for more than 500 hours during the partnership’s taxable year.

40

Multiple Interest Exception

• A person hold more than one class of interest in a partnership.

• For example, an individual may be the general partner of a limited partnership, but may also hold some limited partnership interests. Similarly, some LLCs have manager and non-manager interests.

• Typically, such a person would fail tests nos. 1 and 2, depending on state law, and Test No. 3 depending on the facts of the case.

• The person is nonetheless treated as a limited partner with respect to a class of partnership interests that he or she holds that meets the following test:

– People otherwise classified as limited partners own a substantial, continuing interest in that specific class of partnership interest (for these purposes, at least 20% of the class must be owned by such other limited partners); and

– The person’s rights and obligations with respect to that specific class of interest are the same as the rights and obligations in that class of partnership interest held by such other limited partners.

41

Multiple Interest Exception (Cont.)

Example

• Adams is the sole manager-member of Newco LLC. Newco has manager and non-manager LLC interests. Adams also owns 49% of the non-manager interests. Bryant owns the remaining 51% of the non-manager interests.

• Assume Adams does not flunk the 500 hour test (Test No. 3)

• Ordinarily, Adams would flunk Test No. 1, and all his income from Newco, LLC would be subject to SECA.

• However, Bryant owns a substantial interest in a separate class of interests (the non-manager interests) that Adams also owns, and they have identical rights. Therefore, Adam’s income attributable to his 49% non-manager interest is not subject to SECA.

42


500-Hour Exception • An individual can lose limited partnership status solely because he or she

fails Test No. 3 (i.e., participates in the trade or business for more than 500 hours in a year).

• Exception: The person is nonetheless treated as a limited partner with respect to a class of partnership interests that he or she holds that meets the following test:

• The person only fails the 500-hour test (i.e., fails Test No. 3 but not tests nos. 1 or 2);

• The person holds only one class of partnership interest;

• People who are otherwise classified as limited partners own a substantial, continuing interest in the same class of partnership interest; and

• The person’s rights and obligations with respect to that class of interest are the same as the rights and obligations in that class of partnership interest held by such other limited partners.

44

Application Of Rules To LLCs

• In the case of manager-managed LLCs, the non-manager members typically will not flunk Test No. 1 (liability for LLC’s debts) or Test No. 2 (authority to contract on behalf of the LLC). However, they may flunk Test No. 3 (more than 500 hours of work). In addition, if the LLC is classified as a “service partnership,” they may lose limited partnership status regardless of what tests they fail.

• The manager of a manager-managed LLC will typically flunk Test No. 2. In addition, he or she may flunk Test No. 3. Also, if the LLC is classified as a “service partnership,” he or she may lose limited partnership status.

• Note that in some cases, it may be possible to mitigate any tax effects by using multiple classes of interests.

• In the case of member-managed LLCs, the members typically will flunk Test No. 2 (authority to contract on behalf of the LLC). They may also flunk Test No. 3 (more than 500 hours of work). In addition, if the LLC is classified as a “service partnership,” they may lose limited partnership status.

45

DEVELOPMENTS IN CONGRESS AND STATE LEGISLATURES


L. Andrew Immerman, Alston & Bird

Tax On Net Investment Income

• Variously referred to as the “unearned income Medicare contribution tax” or the “net investment income tax” (NIIT)

• Applied to individuals, estates and trusts

• The NIIT starts in 2013 and was enacted as part of the 2010 Health Care Act.

47

Tax On Net Investment Income (Cont.)

• The tax equals 3.8% of the tax base.

• Tax base is the lesser of:

– The net investment income of the taxpayer, or

– The excess of the modified AGI of the taxpayer over the threshold amount.

48


• Modified AGI for these purposes is identical to AGI for most taxpayers.

• For taxpayers who utilize the foreign earned income exclusion under Sect. 911, there are additional adjustments to be made.

49


• The “threshold amount” is:

– $250,000 for joint returns and surviving spouses

– $125,000 for separate return filers

– $200,000 in all other cases

50


• The NIIT and the additional 0.9% Medicare tax may apply to the same taxpayer in the same tax year, but not to the same items of income.

– NIIT only applies only to net investment income.

– The 0.9% additional Medicare tax applies only to wage and self-employment income.

• Estimated tax rules apply.

51

Net Investment Income: General “Net investment income” (NII) means the excess, if any, of:

• The sum of:

– Gross income from interest, dividends, annuities, royalties and rents, unless derived in the ordinary course of a non-NIIT trade or business;

– Other gross income derived from a trade or business to which NIIT applies; and

– Net gain (to the extent taken into account in computing taxable income) attributable to the disposition of property other than property held in a non-NIIT trade or business;

• Over the sum of deductions that are allocable to the above items.

52

Net Investment Income: Examples

• The following gains are common examples of items taken into account in computing NII (subject to offset by capital losses):

– Gains from the sale of stocks, bonds, and mutual funds

– Capital gain distributions from mutual funds

– Gain from the sale of investment real estate (including gain from the sale of a home that isn't a primary residence)

53

Net Investment Income: Trade/Business

• NIIT will apply to a trade or business that is:

– A passive activity with respect to the taxpayer, within the meaning of Sect. 469

– A trade or business of trading in financial instruments or commodities, as defined in Sect. 475(e)(2)

• Recently proposed regs provide guidance on the application of NIIT to these businesses, including definitions for the terms “financial instruments” and “commodities.”

• Under the proposed regulations, NIIT does not apply to any other trades or businesses.

54

Net Investment Income: Exclusions

• General income tax principles and rules apply to NIIT. Thus, net

investment income doesn’t include items that are excluded from

gross income, for income tax purposes.

• Examples:

– Tax-exempt bond interest

– Certain government benefits

– Gain excluded from the sale of a principal residence

– Certain life insurance proceeds

– Inside buildup of the cash surrender value of life insurance

55

Net Investment Income: Miscellaneous

• Qualified retirement plan distributions aren’t included in NII.

However, such distributions can increase modified AGI and push the

taxpayer over the threshold for the NIIT.

• For purposes of the definition of “net investment income,” a rule

similar to the rule of Sect. 469(e)(1)(B) applies and treats income,

gain or loss attributable to an investment of working capital as not

derived in the ordinary course of a trade or business. Thus, items

attributable to the investment of working capital are potentially

subject to the NIIT.

56

Net Investment Income: Timing

• Because income tax principles apply to NIIT, gain that is deferred for

income tax purposes is also deferred for NIIT purposes.

• Conversely, disallowance provisions applicable in determining

adjusted gross income (AGI) (e.g., the limitations on investment

income or the passive activity loss limitations) also apply to the

computation of NII.

57

NIIT: Asset Vs. Entity Sale

• Gain from a disposition of an interest in a partnership or S

corporation is “net investment income” to the extent of the net gain

that the seller would take into account if the partnership or S

corporation had sold its assets at FMV immediately before the

disposition.

• Thus, NIIT only takes into account gain attributable to property held

by an entity that isn't property attributable to an active trade or

business.

• The same rule applies to loss from the disposition of an interest in a

partnership or S corporation.

58

Debt-For-Equity Exchange

When a creditor discharges debt, the debtor generally has cancellation

of indebtedness (COD) income.

What if the creditor of a partnership gives up debt and takes equity in

the partnership in exchange?

Before a 2004 amendment to Code

108(e)(8), some taxpayers took

the position that the creditor’s contribution of debt to the partnership

was tax-free under Code

721, and the partnership had no COD

income, regardless of the value of the partnership interest received in

the exchange.

For exchanges occurring on or after Oct. 22, 2004, the amendment

clarified that the contribution is not tax-free to the extent the debt is

paid off at a discount.

59

Debt-For-Equity Exchange (Cont.)

The Code now provides that the partnership is treated as satisfying the

debt with an amount of money equal to the fair market value of the

partnership interest given to the creditor.

To the extent the partnership interest is worth less than the debt, the

partnership has COD income.

The COD income is passed through to the taxpayers who were

partners immediately before the discharge.

Before the amendment, Code 108(e)(8) by its literal terms applied

only to corporate COD.

60

New Regulations

Final regulations implementing the 2004 amendments were issued on

Nov. 17, 2011. T.D. 9557, adopting Treas. Reg.

1.108-8

One favorable aspect of the regulations is that the parties may, if they

choose, use the liquidation value of the partnership as the fair market

value. Treas. Reg.

1.108-8(b)(2)

Outside of the liquidation value safe harbor, fair market value

depends on all the facts and circumstances.

Assets, of course, include goodwill, going concern value and other

items that may not appear on a balance sheet.

The liquidation value safe harbor is optional; the parties

presumably will not choose it unless they believe that liquidation

value is greater than fair market value.

61

Liquidation Value Safe Harbor: Requirements

The creditor, the partnership and all of its partners must report

consistently.

If even one partner fails to report consistently, the safe harbor

vanishes.

The creditor should not have a stake in the tax reporting.

The partnership must apply a consistent valuation methodology to all

equity issued in any exchange that is part of one overall transaction.

Although the exchange may be between related parties, the terms of

the exchange must be comparable to terms that would be agreed to by

unrelated parties negotiating with adverse interests.

Neither the partnership nor anyone related to the partnership can

redeem/purchase the new interest as part of a plan that has a principal

purpose of avoiding COD income.

62

Lender’s Loss Deferred/Converted

Even though the partnership has COD income, the lender is not

entitled to an immediate loss or bad debt deduction.

Instead, the lender has a higher basis in the partnership interest.

Loss on the sale of the high-basis partnership interest is likely to be a

capital loss, even if the lender otherwise would have had an ordinary

bad debt deduction.

The lender does not get any step-up in its share of partnership assets

(inside basis) corresponding to the high basis in the partnership

interest (outside basis).

63

Lender’s Loss Deferred/Converted: Example

Partnership borrows $1,000 cash from an unrelated lender.

Before any principal is repaid, the value of the partnership sinks.

Partnership issues an interest assumed to be worth $600 to the lender, in

exchange for $1,000 debt.

Partnership has current $400 COD income.

However, the lender does not have a current $400 loss or bad debt deduction.

Instead, the lender holds the partnership interest with a $400 built-in loss:

$1,000 basis but only $600 value.

Assuming value does not rebound, the lender should at some point recognize the

built-in loss.

However, the recognized loss is likely to be a capital loss.

Apart from a non-business bad debt of a non-corporate lender, a loss on the

debt might have been an ordinary deduction. See Code

166 64


Avoiding The Loss Deferral/Conversion

The preamble to the final regulations suggests that it may be possible

for a lender to take a bad debt deduction prior to the debt-for-equity

exchange, if it does so “in a transaction independent of and separate

from the debt-for-equity exchange.”

Thus, a lender with enough foresight might be entitled to a partial bad

deduction before the COD event, and thereby avoid the loss deferral

and the possible change in character.

This technique will not work with non-business debts of non-corporate

lenders, because no partial worthlessness deduction is permitted for

such debts.

However, the technique would also be less valuable in the case of

such debts, because the worthlessness loss on such debts is a capital

loss anyway.

66

The Insolvency Exception: New Ruling

• Code

108(a)(1)(B) excludes COD from income to the extent, but only

to the extent, that the taxpayer is insolvent.

• For these purposes, insolvency means the excess of liabilities over

fair market value of assets immediately before the discharge.

Code

108(d)(3).

• However, when partnership debt is discharged, the solvency of the

partnership itself is irrelevant. Code

108(d)(6).

• Instead, the COD income is passed through from the partnership to

the partners, and each partner may exclude its share of the

income to the extent the partner is insolvent.

67

Measuring Insolvency In General

Rev. Rul. 92-53, 1992-2 C.B. 48, had ruled that the amount by which

a nonrecourse debt exceeds the fair market value of the property

securing the debt (the “excess nonrecourse debt”) is treated as a

liability in measuring insolvency, to the extent that the excess

nonrecourse debt is discharged.

If, however, the nonrecourse debt is not being discharged, then the

debt is treated as a liability for these purposes only to the extent of

the fair market value of the property securing that debt.

Rev. Rul. 92-53 did not address excess nonrecourse debt in the

partnership context.

68

Measuring Partner Insolvency

• How should a partner take into account the partnership’s nonrecourse

debt in determining the extent of the partner’s insolvency?

• The partnership’s nonrecourse debt is not debt of the partner.

• However, the partner's “share” of the partnership’s liabilities, as

determined under the Code

752 regulations, is treated as a

contribution of money in that it increases the partner’s basis in its

partnership interest (although it does not increase the partner’s

capital account).

• Rev. Rul. 2012-14, 2012-24 I.R.B. 1012, applies Rev. Rul. 92-53 to

partners.

69

Measuring Partner Insolvency (Cont.)

• Under the 2012 ruling, the amount of the discharged excess

nonrecourse debt treated as a liability of the partner is based on

the allocation of the COD income to the partner under Code 704(b).

• In most instances, the COD will be allocated to the partner that was

required to include the debt in its basis under Code

752. See Rev.

Rul. 99-43, 1999-2 C.B. 506, and Rev. Rul. 92-97, 1992-2 C.B. 124.

70

Passive Activity Loss Rules

Losses passed through to a partner from a partnership may be limited

by the “passive activity loss” rules, if the partner is subject to those

rules and does not “materially participate” in the activity of the

partnership.

Under the passive activity loss rules, it may be better to be a

general partner than a limited partner.

Under the self-employment rules, the opposite is true.

A general partner materially participates if the general partner

meets any one of seven tests (listed on the next slide).

A limited partner is presumed to be passive, but may overcome the

presumption by satisfying one of three of these tests (in bold on

the next slide).

71

Material Participation: Reg. § 1.469-5T

1. Participates for more than 500 hours.

2. Individual’s participation is substantially all the participation of

anyone.

3. Participates for more than 100 hours, and no one participates more.

4. If a “substantial participation activity,” participates more than 500

hours in all substantial participation activities (generally activities in

which the individual participates more than 100 hours for the year) .

5. Materially participated for five out of last 10 years.

6. If a service activity, participated for any three previous years.

7. “Facts and circumstances” show regular, continuous and substantial

participation.

72

Is An LLC Member A Limited Partner? An LLC member is not literally a “limited partner.”

The current regulations (Treas. Reg.

1.469-5T(e)(3)) define a limited

partnership interest as:

An interest designated as such in the partnership agreement or certificate

of limited partnership, without regard to the limited liability of the holder;

or

An interest that limits the liability of the holder to a determinable fixed

amount.

An LLC interest is arguably more like a traditional general partner interest than

a limited partner interest, in the sense that state law does not prohibit the LLC

member from fully participating in management.

The IRS has been unsuccessful in court in its attempts to treat an LLC member

as a limited partner. See, for example, Newell v. Comm’r, T.C. Memo. 2010-23

(2010).

73

New Proposed 469 Regulations

The IRS and Treasury have issued new proposed regulations. Prop. Reg. 1.469–5(e), REG-109369-10 (Nov. 28, 2011).

The proposed regulations abandon the current approach, which has been

based on the state law designation of an interest, or on limited liability.

Instead, a limited partner would be defined as someone who does not

have rights to manage the entity.

Rights to manage include the power to bind the entity.

Limited liability would become irrelevant, for this purpose.

No inference is intended about the distinction between general and

limited partner, for any other purposes.

Proposed to apply to taxable years beginning on or after the date

final regulations are published

74

State Law Development: “RULLCA”

As the discussion of “general partner” and “limited partner” shows,

state law concepts can be intertwined with the tax rules.

The Revised Uniform Limited Liability Act (2006) (RULLCA or Re-ULLCA)

is increasingly influential in state LLC law.

Until 2011, only Idaho, Iowa, Nebraska, Utah and Wyoming had

enacted RULLCA.

RULLCA’s predecessor, the Uniform Limited Liability Company Act

(1995), had also attracted relatively little support.

Critics predicted a bleak future for RULLCA.

75

RULLCA (Cont.)

RULLCA recently picked up steam, having been enacted (subject to

transition rules) in:

New Jersey (2012)

California (2012)

District of Columbia (2011)

RULLCA and other state LLC acts, of course, do not deal directly with

federal income tax.

However, aspects of RULLCA and other state LLC acts have tax

implications or raise tax issues.

A few tax-related issues are noted on subsequent slides.

76

RULLCA: LLC Purposes

Under RULLCA, the LLC may have any lawful purpose.

The purpose need not be for-profit; for example:

To hold a family vacation home.

To function as a non-profit organization).

If an LLC claims a tax exemption, it will be classified as a corporation,

for tax purposes. Treas. Reg.

301.7701-3(c)(1)(v)(A)

How is a multi-member LLC classified for tax purposes when it has

no business purpose but is not claiming a tax exemption?

77

RULLCA: LLC Management

Determining management rights can matter for tax purposes, such as

designating the tax matters partner or determining who is authorized to

make a tax election on behalf of the LLC.

Under RULLCA, the authority of members and managers to bind an LLC

is determined by agency law and not by status.

A member is not an agent of the LLC solely by reason of being a

member.

Certificates of authority may be filed with the Secretary of State’s

Office (or where real estate records are kept), to provide notice that

only certain members or managers have authority to conduct business

on behalf of the LLC.

The operating agreement, rather than the certificate of organization,

determines whether an LLC is member- or manager-managed.

78

RULLCA: Charging Orders

RULLCA attempts to clarify and simplify the rules governing charging

orders.

The charging order under RULLCA is the exclusive remedy for a creditor

of a member to obtain a member's financial rights to distributions from

the LLC.

The creditor holding only a charging order generally should not be

considered a partner, for tax purposes.

RULLCA permits the creditor to foreclose on a charging order, but

leaves no doubt that the purchaser of a foreclosed interest only

obtains financial rights and does not become a member of the LLC.

The purchaser of a foreclosed interest generally would be

considered a partner, for tax purposes, even without becoming a

member.

79

RULLCA: Mergers And Conversions

RULLCA authorizes an LLC to merge with or convert into another

type of entity, or another type of entity to merge with or

convert into an LLC.

The tax consequences of a state law conversion may sometimes

differ from those of a more or less equivalent state law merger,

even though both may be referred to loosely as “conversions.”

State law conversion of corporation into partnership likely is

an “assets up” transaction. See Preamble to T.D. 8844, 64

Fed. Reg. 66580 (Nov. 29, 1999)

State law merger of a corporation into a partnership likely is

an “assets over” transaction. See PLR 200606009 (Dec. 21,

2001)

80

ISSUES ARISING FROM LLCs SEEKING S CORPORATION TREATMENT


State Law LLCs Taxed As S Corporations

• In the past few years, entities that are formed as state law

LLCs, but that elect to be taxed as S corporations, are became

more and more common.

• Non-tax benefits put forth for having a state LLC:

― Operational ease, from a corporate law perspective

― LLCs are not required to have formal meetings and keep

minutes.

― Fewer restrictions on profit-sharing within an LLC as

members distribute profit

82

State Law LLCs Taxed As S Corporations (Cont.)

• Benefits put forth for being taxed as an S corporation:

― Retain flow-through tax status of entity, similar to partnerships

(though different in some key respects)

― Generally, an owner of an LLC (taxed as a partnership) is considered

to be self-employed and must pay self-employment taxes with

respect to LLC income.

― In contrast, a shareholder of an LLC must pay payroll taxes with

respect to his/her “reasonable compensation.” However, distributions

that are not compensatory are not subject to employment taxes.

― Employment taxes are generally 15.3%. For 2013, for income above

$113,700, only the Medicare portion is levied at 2.9%. An additional

0.9% applies and raises the 2.9% to 3.8% for individuals with income

above $200,000 ($250,000 for joint filers).

83


• Treas. Reg. § 301.7701-3(c)(v)(C) provides:

An eligible entity that timely elects to be an S corporation under section

1362(a)(1) is treated as having made an election under this section to be

classified as an association, provided that (as of the effective date of the

election under section 1362(a)(1)) the entity meets all other

requirements to qualify as a small business corporation under section

1361(b). Subject to §301.7701-3(c)(1)(iv), the deemed election to be

classified as an association will apply as of the effective date of the S

corporation election and will remain in effect until the entity makes a

valid election, under §301.7701-3(c)(1)(i), to be classified as other than

an association.

• Thus, a state law LLC may elect to be taxed as an S corporation by timely

filing a completed IRS Form 2553 (assuming it meets the other requirements to

qualify as a small business corporation). The LLC need not undertake two steps

to be taxed as an S corporation: (1) file IRS Form 8832 to be taxed as a

corporation, and (2) file IRS Form 2553 to make an S election for such

corporation.

84

State Law LLCs Taxed As S Corporations: Potential Issues

• Unreasonable compensation. The IRS may recharacterize S

corporation distribution as wages subject to employment

taxes, when the compensation is less than reasonable.

• The IRS seems to be stepping up enforcement activity in this

area and often successfully challenges. See David E. Watson,

P.C., 668 F.3d 1008 (8th Cir. 2012)

• Recent high-profile examples of uses of S corporations to avoid

self-employment taxes: Former House Speaker Newt Gingrich,

Senator John Edwards.

• There have also been legislative proposals to treat an S

corporation’s distributive share of income from an S

corporation engaged in a personal service business as self-

employment income, for employment tax purposes.

85

State Law LLCs Taxed As S Corporations: Potential Issues (Cont.)

• S corporation carries certain restrictions:

― Under partnership taxation, profits and losses can be

allocated with some flexibility, but all S corporation profit

and loss distributions must be made pro-rata by shares.

― S corporations are limited to 100 shareholders, whereas

partnerships do not have tax-related limitations on the

number of owners.

― S corporation shareholders must be individual U.S. citizens

or certain trusts, whereas members of LLCs taxed as

corporations may include corporations, other LLCs and

alien members.

86

State Law LLCs Taxed As S Corporations: Potential Issues (Cont.)

• Most LLC operating agreements are drafted to reflect

partnership taxation principles. Accordingly, conflicts can

easily arise between the governing documents and the actual

tax election.

• Biggest issue is whether there is more than one class of stock.

While S corporations shares may have differences in voting

rights, they must carry identical rights to distributions and

liquidation proceeds.

• If the LLC operating agreement provides for varying rights as

to distributions or liquidation proceeds at any time, the one-

class-of-stock requirement likely is violated.

87


• How is a state law LLC taxed, if its election to be taxed as an

S corporation is invalid for some reason?

― As a C corporation?

― As a partnership?

• What if the initial election is valid, but later there is failure to

meet one of the requirements to continue to qualify as an S

corporation?

88


TRENDS WITH LLC USAGE IN DEALMAKING


Using LLCs In M&A Transactions: Trends

Three situations

• Situation 1: Acquiring a less-than-80% interest in an S

corporation and still achieving a stepped-up tax basis

• Situation 2: Acquiring a business, and incenting management

by providing them an interest in the acquired business on a

tax-free basis

• Situation 3: Achieving stepped-up tax basis when a 338(h)(10)

election is not possible

91

Situation 1: Acquiring Less-Than-80% Interest In S Corp., Still Achieving Stepped-Up Tax Basis

Common problem

• Target is an S Corporation.

• Buyer wants to acquire a less-than-80% interest in the business of the S

corporation (for example, 50%).

• Seller wants to sell a 50% interest but also wants to be able to maintain

ownership in an entity that is a tax-flow through. Buyer, however, is not a

person that is an eligible S corporation shareholder.

• There are two problems presented by this common fact pattern:

1. Buyer cannot obtain a stepped-up tax basis with respect to its purchase

price. An election pursuant to §338(h)(10) is not possible, since less than

80% is being purchased.

2. Target will not be a flow-through entity once buyer acquires an interest

in the target, since target’s S election will terminate once it has an

ineligible shareholder.

92

Situation 1 (Cont.)

Solution

• Step 1: Target contributes all its assets and liabilities to a

newly formed subsidiary LLC.

• Step 2: Buyer purchases a 50% interest in the LLC from the

target.

• Seller remains a shareholder in the target. Target retains its S

corporation status, since its ownership has not changed.

• The direct members of the LLC will be the buyer and the

target.

93

Situation 1 (Cont.)

Target S corporation

Buyer C corporation

Seller

(individual)

94

Situation 1 (Cont.)


Seller

(individual)

Newco

100%

All assets and

liabilities of Target

Step 1: Target contributes all its assets and liabilities to an LLC.

95

Situation 1 (Cont.)

Step 2: Buyer purchases an interest in Newco from Target.


Newco

Buyer Cash

50% membership

interest in Newco

Seller

96

Situation 1 (Cont.)

End result:


Buyer

Newco

Seller

50%

50%

97

Situation 1 (Cont.)

• Under Rev. Rul. 99-5, Newco is initially disregarded as an entity

separate from the target.

• Newco is converted to a partnership for tax purposes, when the new

member, the buyer, purchases an interest in the disregarded entity

from the owner, the target.

• Buyer's purchase of 50% of the target’s ownership interest in the LLC

is treated as the purchase of a 50% interest in each of the LLC’s

assets, which are treated as held directly by the target, for federal

tax purposes. Immediately thereafter, the target and buyer are

treated as contributing their respective interests in those assets to a

partnership, in exchange for ownership interests in the partnership.

• Buyer obtains a stepped-up tax basis in the 50% interest in the assets

it is deemed to have purchased.

98

Situation 2: Incenting Management By Issuing Profits Interest in Acquired Business

Common problem

Buyer acquires stock or assets of a business. The buyer wants to incentivize

certain management members of the business. However:

1. Buyer does not want the management members to have current income

tax on the grant of an interest in the acquired business or entity; and

2. Buyer does not want to effectively give away any of the current value of

the company, which the buyer just paid for. Buyer only wants to provide

management with an interest if the value of the company grows. In

other words, the buyer wants to recoup its entire purchase price before

the management members begin to participate.

Solution

Buyer contributes the acquired entity’s assets (or the acquired assets, when it has

acquired assets) to a newly formed, wholly owned LLC and grants profits interest

in this new LLC to management members.

99

Situation 2 (Cont.)

Step 1: Buyer acquires all the assets of a business.

Seller Buyer

Assets and liabilities

of business

$1 million

100

Situation 2 (Cont.)

Buyer

Newco

Acquired

assets &

liabilities

101

Situation 2 (Cont.)

Buyer

Newco

- Capital interest = $1

million

- 90% of profits

interests

Management

- 0 capital

interests

- 10% profits

interests

102

Situation 2 (Cont.)

Fundamental concept: Difference between LLC unit and stock of corporation

I. Each share of a corporation within a particular class entitles its owner to a horizontal

slice of:

A. The corporation’s current value (the “capital interest”)

B. Future value – which includes (i) future appreciation beyond the date of the

acquisition, and (ii) future income (the “profits interest”)

A share, when 100 are outstanding

entitles owner to

1. 1/100 of the future income (by way

of dividends) of the corporation; and

2. 1/100 of the current value of the

corporation

3. 1/100 of the future value proceeds

on liquidation of the corporation

103

Situation 2 (Cont.)

Profits interest

• An interest in an LLC (whether evidenced by a unit or not) does not entitle a member to a horizontal slice of these.

• A profits interest in an LLC is one that entitles a holder to (a) future income of the LLC and (b) future appreciation in the assets of the LLC, BUT not to any of the current value of the LLC at the time the member gets its interest in the LLC.

• Management’s Interest: 10% profits interest entitles them to 10% of any future income and future appreciation in the value of the business, if any (in other words, if the business appreciates above $1 million, then they share in 10% of that. If it does not appreciate, and there is no income, there is nothing in which they can participate).

• Buyer’s interest: Capital Interest = $1 million. Thus, if the entity were to sell all its assets and liquidate tomorrow (i.e., have only $1 million to distribute), then the buyer would receive the entire $1 million, and the management would receive 0. So, the buyer only has to share with management if there is actual income and growth of the acquired business.

104

Situation 2 (Cont.)

Contrast tax results if Newco had been a corporation, and management had

been given 10% of shares in Newco

C corporation:

• Income to management = $100,000 (value of shares). See Sect. 83

• If Newco were to be sold tomorrow for $1 million (or were to sell assets

and liquidate), the management would be entitled to $100,000 of

proceeds (10%), and the buyer would be entitled to $900,000 (so the

buyer would not recover its initial investment).

LLC:

• No income to management on receipt of a profits interest; see Rev. Proc.

93-27 and 2001-43

• If Newco were to be sold tomorrow for $1 million (or were to sell assets

and liquidate), the management would be entitled to 0. The buyer would

be entitled to receive the entire $1,000,000 (so it would recover its

entire initial investment).

105

Situation 3: Achieving Stepped-Up Tax Basis When A 338(h)(10) Election Is Not Possible

Overview of classification rules

Partnership

A. Most multi-member LLCs are automatically treated as partnerships unless they specifically elect to be treated as corporations.

B. Acquisition of 100% of the interests in an LLC/partnership is treated for tax purposes by the purchaser as an acquisition of assets.

C. In most cases, when someone refers to an LLC, he means an LLC that is classified as a partnership.

Disregarded entity

A. Most multi-member LLCs are automatically treated as partnerships unless they specifically elect to be treated as corporations.

B. Acquisition of 100% of the interests in an LLC/partnership is treated for tax purposes by the purchaser and seller as an acquisition of assets.

C. Must have its own EIN if it has employees or pays excise tax

Corporation (sometimes an S corp)

106

Situation 3 (Cont.)

Common problem:

― Buyer wants to acquire assets rather than stock of the

target S corporation. An asset acquisition gives the buyer a

step-up in basis, and it may have little or no adverse

impact on the target.

― However, many assets (for example, rights under

contracts) are impractical to transfer.

― A §338(h)(10) election is the solution that first comes to

mind. The buyer acquires stock, but the parties elect to

treat the acquisition for tax purposes as if it were an asset

acquisition.

107

Situation 3 (Cont.)

― However, there may be reasons why the election is either

impossible or risky. For example:

― If even one S corporation shareholder refuses to

consent, there can be no 338(h)(10) election.

― If the buyer is an LLC taxed as a partnership, the

buyer is ineligible to participate in a 338(h)(10)

election.

― If it turns out for whatever reason that the S election

was invalid, so is the 338(h)(10) election.

108

Individuals and trusts

Target S Corp

100%

Initial situation:

Situation 3 (Cont.)

109

Target S Corp Newco

Newco is formed as a shell corporation.

The stock of the target is contributed to Newco.

An election is made to treat the target as a QSub (an entity

that is disregarded for federal income tax purposes).

100% 100%

Individuals and trusts

Step 1: Target forms QSub

Situation 3 (Cont.)

110

Individuals and trustss

Newco

Consequences of Step 1

The transaction is a reorganization under Sect.

368(a)(1)(F), which has virtually no federal income

tax effect.

The reorganization does not terminate the S

election; the S election remains in effect for Newco.

The QSub keeps the target EIN.

Newco must obtain a new EIN.

See Rev Rul 2008-18, 2008-1 CB 674

100%

100%

Situation 3 (Cont.)

111


Newco

100%

100%

Target LLC

Step 2: Conversion to LLC

QSub is converted into an LLC (by filing

with the Secretary of State’s Office or by

merging into a new shell LLC).

Since the LLC is wholly owned by Newco,

it is a disregarded entity.

The conversion of one disregarded entity

(QSub) to another (single-member LLC) is

of virtually no federal income tax

consequence.

Situation 3 (Cont.)

112


Newco Buyer

LLC interests

Step 3: Purchase of LLC

interests

Buyer acquires 100% of the LLC

interests, which is treated as an

asset purchase by both the

seller and the purchaser.

Situation 3 (Cont.)

Cash

Target LLC

113

Situation 3 (Cont.) Comparison to 338(h)(10) election

• No need for unanimous consent of the target’s shareholders

• No need for the buyer to be a corporation

• No need for any tax election after the acquisition; step-up is

automatic

• Purchaser’s basis step-up does not depend on the validity of the

target’s S election.

• Has essentially the same federal income tax consequences as a

338(h)(10) election or an actual asset sale

114

Situation 3 (Cont.)

Comparison to actual asset sale

• As in a 338(h)(10) election rather than an actual asset sale, historical

liabilities of S do not remain behind after the acquisition.

1. Liabilities of the target LLC after the acquisition might include

liabilities, if any, of the target for federal income tax (most

importantly, if it turns out that the target was not a valid S

corporation).

2. In this respect, the 338(h)(10) election and this alternative may be less

favorable to the purchaser than an actual asset acquisition.

• However, if there is any corporate-level tax on the sale itself (not merely

historical tax liability), then the liability for the tax ought to stay behind

with Newco.

1. In this respect, the alternative and an actual asset sale may have the

same advantage to the buyer. 115

Documents

LLCs: Latest Developments in Federal and State Tax Treatmentmedia.straffordpub.com/products/llcs-latest...Jan 09, 2013 · L. Andrew Immerman, Partner, Alston & Bird, Atlanta Saba