Partnership Equity Compensation (memorandum)

TAX ISSUES IN CONNECTION WITH PARTNERSHIP EQUITY COMPENSATION, OPTIONS AND RESTRICTED INTERESTS

by Roger Royse

1.         Introduction.  Limited liability companies (LLC)[1] have become a popular choice of operating entity in recent years due to (among other reasons) the recognition of limited liability companies by all 50 states, the “check-the-box” regulations, and the shareholder and single-class-of-stock limitations on S corporations.  In order to compete for labor and capital, while retaining the benefits of a pass through entity, LLC’s are more frequently implementing capital structures that mimic traditional venture backed C corporations, including equity compensation arrangements. Unlike corporate equity compensation, the treatment of compensatory LLC interests (or options on LLC interests) is uncertain, possibly unfavorable to the members, and may require complicated special allocations.  Warrants and convertibles also raise special issues in a partnership context. This Article describes some of those structures and discusses the tax issues that arise out of the integration of corporate startup structures into an LLC world.

2.             Employee/Partner Issues.             
                        a.         Employee vs. Partner.  A threshold issue concerns whether an employee who receives an interest in an LLC (an “employee/member”) will be treated for tax purposes as a partner, an employee, or both.  There may at times be a fine line between an employee with a bonus based on profits and a true partner. Significant factors[2] include:

i.          Entrepreneurial risk.  A serious entrepreneurial risk that a partner will not receive payments, or will lose his capital, indicates partner status. The lack of entrepreneurial risk may suggest an employer-employee relationship.  The holder of a capital interest (as opposed to only a profits interest) probably has entrepreneurial risk; however, the issue is less clear when the interest is subject to vesting or other restrictions.[3]
Because the grant of a profits interest represents only a right to future profits and appreciation, the receipt of a mere profits interest (as opposed to a capital interest) may be indicative of an employment rather than partnership relationship. The IRS has, however, treated holders of profits interests as partners. See GCM 36346.

ii          Transitory status.  An employee relationship is indicated if partner status is not permanent. A continuing partner status, however, does not prove otherwise.

iii.        Timing.  An employee relationship is indicated if payment is closely related in time to the performance of services.

iv.        Tax motivation. Another factor that would support employee characterization is that the employee became a partner primarily for tax benefits.

v.         Relative size. An employee relationship is indicated if the member’s interest in the LLC is small in relation to the payment or allocation in question.

An attempt to reconcile the authorities might lead to the conclusion that an employee/member is probably more likely a partner for tax purposes if he or she has a right to vote on LLC matters, has an interest in capital as well as profits and losses, is liable to the other members for breach of fiduciary duties, and is not terminable at will or on short notice for non-performance.  In practice, persons treated as partner-employees might not have all (or any) of those attributes.

b.         Tax Consequences.  Upon issuance of the partnership interest, the former employee will find him or herself in a totally different tax regime. Some significant differences in tax treatment between a partner and employee are as follows:

                                    i.          Timing and Amount of Income.  A member is taxed on his or her distributive share of the LLC’s income, whether or not it is distributed. Distributions are not taxable to members except to the extent that the money distributed exceeds the member’s adjusted basis in their partnership interest. An employee is taxed on payments actually or constructively received from the employer, regardless of the income of the LLC. 

                                    ii.         Character.  The character (capital gain or ordinary income) of a member’s income passes through from the LLC and retains its character in the hands of the member. Compensation, however, is ordinary income. A member’s distributive share of self employment income from the LLC is generally subject to self-employment tax, and one-half the self-employment tax is deductible.

                                    iii.        Withholding and Payments.  A member’s share of LLC income is not subject to withholding, except in the case of foreign members, but a member must make quarterly estimated tax payments. An employee’s compensation is subject to withholding.

                                    iv.        Reporting.  Even if the LLC continues to treat a holder of a very small income interest as an employee for the purposes described above, the LLC will still be obligated to provide the employee/partner with a K-1 showing their share of the LLC’s distributive share income.  The complexity of the K-1 may itself be a disincentive to granting LLC interests to employees.

                                    v.         Health Insurance. The value of health insurance provided to a member by the LLC is included in the member’s income as a guaranteed payment.[4] The member is generally allowed an above-the-line partial deduction for health insurance. An employee is not subject to tax on health insurance provided by his employer.

                                    vi.        Meals and Lodging. An employee can exclude from income the value of meals and lodging as a fringe benefit or furnished for the convenience of the employer if, in the case of meals, the meals are furnished on the employer’s business premises, and in the case of lodging, the employee is required to accept such lodging on the employer’s business premises as a condition of his employment.[5]

                                    vii.       Cafeteria Plan. Only employees may participate in a cafeteria plan.

                                    viii.      Group-Term Life Insurance. The cost of the first $50,000 of group-term life insurance on the life of an employee provided by the employer may be excluded from his income.

                        c.         Dual Status Employee/Partners. The IRS has consistently maintained that a person cannot simultaneously be an employee and a partner.  Nevertheless, Code[6] Section 707(a) seems to allow for the possibility of a dual status partner/employee.  Section 707(a) contemplates that a partner may engage in transactions with the partnership in a capacity other than as a partner – as an employee, for example. Section 707(a) focuses the analysis on the nature of the services rather than the overall nature of the relationship, but it would seem to be difficult to distinguish services rendered by an employee in his or her capacity as an employee from those rendered in his or her capacity as a partner.  However, situations can be envisioned in which a person is clearly acting as a partner or as an employee, for example, a receptionist who also has a profits interest. Because of the current IRS position, however, the careful tax planner should determine whether the person is more partner-like or employee-like, and structure the relationship consistently. The receptionist in the example above could be given a compensatory bonus based on profitability rather than a profits interest, thereby preserving the economic deal (except for tax issues) without creating tax risk.

Another way of dealing with the benefits issues is to form a separate entity that employs the employee/partners and leases them to the LLC, as illustrated in Diagram 3.  Since the employees would be employees (and not partners) of the employer entity, they can draw their salaries and obtain their benefits through that company. A variation on this theme involves the establishment of a separate entity, which is owned by the employees, to hold the LLC interests. In both structures, the employment and ownership relationships are separated into two entities. In all of these types of structures, one potential significant issue will be whether the LLC or the special entity will be treated as the technical “employer” under Code section 3401(d).

                        d.         Bonus Plans.  Another way to retain the benefits of employee status while providing the employees with a share in the success of the venture is to implement a bonus plan or nonequity appreciation arrangement. Such arrangements may be based on the earnings or increase in value of the LLC, similar to stock appreciation rights and phantom stock plans in the corporate context.

                        e.         Compensatory vs. Non-Compensatory Grants.  As discussed below, the tax analysis differs depending on whether the instrument is compensatory or non-compensatory.  That distinction is sometimes blurred. For example, the company that gives an investor warrants or options along with their equity or debt interest may be bargaining not only for the investor’s dollars, but also his contacts, advice, association, or informal consulting.  Does that make the grant (or exercise) taxable?  A common (but unsatisfactory) approach that at least has simplicity and consistency going for it is to piggyback on the characterization adopted for corporate and securities law purposes. In other words, treat options granted under the company’s option plan as compensatory and warrants issued outside the plan as non-compensatory.

           3.         Restricted Profits Interests.  Under Rev. Proc. 93-27, the receipt of a profits interest is generally not a taxable event for the partner or the partnership. The revenue procedure uses a hypothetical distribution model to determine whether an interest is a profits or capital interest.[7]  Under this model, a member has a capital interest if he or she has a share of unrealized appreciation in the LLC’s assets.  This determination is made at the time of receipt of the interest.  Since a vesting restriction delays the receipt of the interest, and the assets could appreciate before an interest vests, until Rev. Proc. 2001-43 was issued in August, 2001, there was some uncertainty as to whether an employee could be treated as receiving a capital interest on vesting of a profits interest.  In Rev. Proc. 2001-43, the IRS stated that it would not tax the employee or the partnership on grant of a non-vested profits interest if:

*          The partnership and the service provider treat the service provider as the owner of the partnership interest from the date of grant;

*          Neither the partnership nor any of the partners deducts any amount (as wages, compensation, or otherwise) for the fair market value of the interest; and

            *          All other conditions of Rev. Proc. 93-27 are satisfied.[8]

            Rev. Proc. 2001-43 further stated that the employee need not make a section 83(b) election with respect to a profits interest. Prior to the revenue procedure, there was some uncertainty as to whether a member would be treated as an owner of the non-vested profits interest absent an 83(b) election and whether a section 83(b) election was even available for a profits interest.[9] The revenue procedure allows that the recipient of the non-vested profits interest can be treated as the owner of the interest even without the 83(b) election.

            Rev. Proc. 2001-43 also raises some issues. It does not answer the threshold question of whether the holder of the profits interest is a partner at all (or a non-partner service provider), but seems to imply that the IRS will treat him or her as a partner if the partnership does so.  More significantly, the IRS treatment apparently depends heavily on the interest being a profits and not a capital interest. Thus, if the holder of the interest has a right to some of the LLC’s appreciation in its assets as of the date of acquisition of the interest, it is a capital and not a profits interest.  Because of this factual issue, holders of profits interests may continue to make protective section 83(b) elections.

4.         Restricted Capital Interests.  Service providers to corporations often purchase stock subject to vesting restrictions (e.g., in the form of a repurchase right in favor of the corporation that lapses over time as the services are performed). Under Code section 83, the service provider would recognize compensation income equal to the difference between the amount paid and the value of the stock. That income would be recognized as the stock vests, unless the service provider elects under Code section 83(b) to include in current income the excess of the stock’s fair market value, determined without regard to restrictions, over the amount paid for the stock.

            In the LLC context, subjecting LLC interests to vesting restrictions has some unique implications.

                        a.         No Section 83(b) Election.  If a section 83(b) election is not made, the following consequences may result:

                                    i.          Amounts distributed with respect to nonvested property (absent a section 83(b) election) may be treated as additional income to the employee/member and deductible to the partnership as section 707(c) guaranteed payments.

                                    ii.         Profits or losses allocable with respect to the interest prior to vesting must be re-allocated among the other partners.

This characterization problem can have some timing differences. If the Service member is not a partner (by virtue of not having made a section 83(b) election), his share of income will not be allocated to him in the year it is earned, but, instead, the LLC will have a deduction in the year of that the Service Member is paid.

                        b.         Section 83(b) Election Made.  The tax result of a section 83(b) election is not difficult in a corporate context, but raises issues in the case of partnerships. If a section 83(b) election is made with respect to an LLC interest, the service partner is treated as the owner of (and is allocated the income attributable to) the restricted interest. The forfeiture of the service provider’s interest, however, results in a capital shift to the other partners. Under Treasury Regulation 1.721-1(b) and 1.83-6(c), those other partners are probably required to recognize income equal to any deduction previously taken on the grant of the interest to the service partner, if any.

            The service partner may get whipsawed on the repurchase or forfeiture of his capital interest.  Diagram 13 illustrates the repurchase of all of a partner’s interest at cost after he has been allocated income but before he has received a distribution of that income.  The service partner has a capital loss on repurchase under Treasury Regulation 1.83-2(a), and the remaining partners have a capital shift.  Regulation 1.721-1(b) should not require the remaining partners to pick up income on repurchase, since section 721 is not implicated here and because the capital shift does not arise as a result of a compensatory transfer (or to satisfy any other obligation).

            If the partner leaves when he is partially (and not wholly) vested, he may have a much different result than in the case of a corporate employer.  Diagram 14 illustrates a repurchase at cost of 80% of the service partner’s interest, leaving him with 20%.  Because he is still a partner, he might have no deductible loss under section 731(a), and would end up with an outside tax basis that exceeds his capital account.

            It would seem that a departing partner who forfeits their rights to future profits would or should receive his or her unvested capital account balance (or some approximation) on departure to avoid the above disparities.

                        c.         Rev. Proc. 2001-43. Rev. Proc. 2001-43, supra, has resulted in some uncertainty on the effect of a section 83(b) election in the context of capital interests. As discussed above, the Rev. Proc. provides that an employee need not make a section 83(b) election with respect to a profits interest. Since it does not refer to a capital interest, presumably a section 83(b) election is required.  Most economic interests in partnerships and LLC’s, however, consist of both capital and profits interests. If the Rev. Proc. Treats the unvested profits portion of the interest as vested, it would seem that the holder of the interests should be treated as a partner (and report his or her share of profits) under the Rev. Proc. even without making the election.  If this is true, the member is in the confusing position of being the owner of the unvested profits interest, but not the unvested capital interest.  The well advised LLC member should make a protective election in that situation to avoid this uncertainty.

            5.         Options and Grants. LLC Options may become more common in California since Section 25102(o) of the California Corporations Code now expressly covers options on LLC interests.[10] In recognition of the growing popularity of the substitution of LLC’s for corporations, the IRS has issued Notice 2000-29, which solicits comments on the tax treatment of the exercise of an option to acquire a partnership interest, the exchange of convertible debt for a partnership interest, and the exchange of a preferred interest in a partnership for a common interest in that partnership.  2000-23 I.R.B. 1241.  Specific guidance may be forthcoming from the IRS. Until that time, all the tax consequences of the exercise of an LLC option are not clear.

           a.         Consequences to Optionee. Under Code section 83, a service provider generally does not have a taxable event upon grant of an option because the option’s value is not readily ascertainable at the time of grant.[11] Upon exercise, the service provider will include as ordinary income the difference between the property’s fair market value and any price paid upon exercise.

            In the partnership context, the exercise of an option may shift capital from the old members to the option holder, which could result in immediate income to the exerciser, under section 83 or section 721, in an amount equal to the excess of the value of the interest acquired over the amount paid for it. As noted above, section 721, which would normally treat the acquisition of a partnership interest as a non-recognition transaction, does not apply to the extent that capital shifts to another partner as compensation for services.  Treas. Reg. Section 1.721-1(b)(1).  Thus, in the case of an option that is exercised when the value of the interest (and the underlying capital) is greater than the exercise price, as will often be the case, capital may shift from the existing partners to the optionee.

            If the difference between value and exercise price (“spread”) is equal to the capital shift, regulation 1.721-1(b)(1) and section 83 are happily in agreement on the amount of income recognized by the optionee. This, however, will hardly if ever be true since the valuation of the LLC interest should probably be discounted for marketability, minority and transferability factors. In that case, should the optionee recognize income equal to the capital shift or the value of the interest received?  The better answer is that the section 721 regulation should be read as deferring to section 83, which determines the amount of the optionee’s income.

If the optioned interest is a profits (and not a capital) interest, and the optionee receives an initial capital account balance equal to the amount paid, the exercise of the option should not result in income to the optionee.  If the LLC does not “book up” its assets on exercise, however, the purported profits interest may actually be an interest in capital.

                        b.         Consequences to the LLC.

                                    (i)        Deduction.  Under section 83(h), the LLC would be entitled to a deduction for the amount of income recognized by the optionee on exercise. This result is consistent with regulations under section 721, which treat the value of an interest transferred as compensation as a guaranteed payment under section 707(c).  The varying interests rule of section 706(d) would seem to require the deduction to be allocated to the members immediately before the issuance of the interest to the optionee.  The deduction is sometimes specially allocated to the optionee, subject to the operating agreement and compliance with the substantial economic effect rules under Regulation section 1.704-1(b)(2).[12]  One theoretical problem with this allocation is that a partners generally may not be allocated items accruing before they became partners.[13]  Code section 706(c)(1), which provides that a partnership’s tax year stays open upon the admission of a partner, may provide some authority for the special allocation. An alternative would be to allocate future income and deductions in such a way as to reach the same economic result, and hope for sufficient future income and deduction.  If the parties do not somehow allocate deduction to (or income away from) the Service Provider, the LLC has a deduction with no cash outlay, and the Service Provider has income, with no cash received, much like the consequences of the exercise of an NSO.

                        (ii)       Gain Recognition.  Regulations under section 1032 shield a corporation from gain recognition when it issues stock for services. The tax result to a partnership that issues an interest for services is not clear. Under section 721, a partnership would not generally recognize income on a transfer of a partnership interest in exchange for a contribution of property.  Regulations 1.721-1(b)(1), however, states: “To the extent that any of the partners gives up any part of his right to be repaid his contributions (as distinguished from a share in partnership profits) in favor of another partner as compensation for services (or in satisfaction of an obligation), section 721 does not apply.”  The unanswered question is: if section 721 does not apply, what does?

The transaction could be viewed as (i) a taxable exchange of a zero basis partnership interest for services, (ii) a sale by the partnership of a pro rata share of some or all of its underlying property to the service provider in exchange for services, (iii) a transfer by the partnership of cash to the service provider in exchange for services, or (iv) a nontaxable transfer of a partnership interest.

            One might view the LLC as having paid the employee/member with cash, with which the employee then contributes to the LLC (the “cash compensation” model). Under the cash compensation model, the LLC has not transferred any appreciated assets requiring gain recognition.  Alternatively, the employee could be viewed as having received a proportionate share of each LLC asset and then recontributed them in return for a membership interest the (“asset recontribution” model).  Under the asset recontribution model, the LLC has “paid” its service provider with appreciated assets in a taxable transaction.  It remains to be seen which fiction (if either) the IRS adopts as its model.

            Diagrams 25 – 27 illustrates the effect on the LLC of an exercise of an option under the cash compensation model.  Diagrams 22-24 illustrate the asset recontribution model.  

            As noted above, if the LLC does not book up assets on exercise, there will be a disparity between relative capital accounts and profits percentages, and pre-existing appreciation may (unless drafted around) be allocated to the service provider.  If the assets are sold for $2,000 and the $1,000 gain is allocated to the partners 90/10, their ending capital accounts will not be in the same proportion as their percentages.  A book up solves that problem by allocating all pre-existing appreciation to the Founders, but deprives the Service Provider of a share of that pre-existing appreciation.

            Diagram 22 illustrates the effect on the LLC of an exercise of an option with spread, under the asset recontribution model, assuming that the entire transaction is outside of section 721 by virtue of the compensation element.  A more reasonable view would bifurcate the transaction and treat the cash contribution of $100 by the service provider as a tax free section 721 transaction, and the receipt of an interest for $100 with of services as  a taxable sale, resulting in a taxable gain to the LLC of $50 ($100 less basis of $50) rather than $100 ($200 less basis of $100). The asset recontribution model with no book up is illustrated in Diagram 23. The asset recontribution model with a book up is illustrated in Diagram 24. 

6.         Warrants and Convertible Interests in LLC’s.  Creditors of corporations commonly receive warrants and conversion rights with respect to their debt instruments, and the tax consequences of warrants and conversion rights in a corporate context is well understood.  The treatment of such interests in the case of partnerships is not as clear.

            As noted above, an initial issue concerns whether a warrant is a non-compensatory warrant or a compensatory option. Warrants are often granted to investors who bring not only capital but also connections, expertise and business acumen to the venture. At some point, the investor crosses the line from warrant holder to optionee, and the tax consequences of crossing that line differ dramatically.

                        a.         Issuance of Warrant.  

                                    i.          Treatment of Warrant Holder.  The initial question is whether a warrant holder is treated as a partner for tax purposes.  This issue arises in the case of a deep in the money warrant or option, which may be “deemed exercised” for tax purposes.  In the case of a partnership warrant, even if the warrant is not in the money, it must also be analyzed under partnership principles: i.e. does it result in a sharing of profits and losses, joint ownership of capital, etc.  A typical warrant transaction does not generally involve a large cash payment or nominal exercise price, and although the warrant holder shares some of the upside, the loss is limited to the purchase price of the warrant.  Even if the warrant holder were a de facto partner, it would not seem that he or she should be taxed as a partner before exercise, since he or she would not be allocated any income under the partnership agreement until that time (unless the IRS allocates income based on the proceeds that would be received in a constructive liquidation).

                                    ii.         Treatment of LLC.  The issuance of a warrant is not generally taxable, if at all, to the issuer of the warrant until the warrant is exercised or lapses. Rev. Rul. 57-40; Rev. Rul. 58-234. The premium received by the issuer for granting a warrant is an additional amount received in the year of exercise.  There is no reason why the general rule with respect to warrants should not apply to a warrant issued by an LLC.

                        b.         Lapse of Warrant.  If the warrant lapses, it is deemed to have been sold on the date that it expires and the warrant holder’s loss is characterized by reference to the character of the property to which the warrant relates.[14] The character of a loss on the sale of a partnership interest is generally capital, except as otherwise provided under sections 741 and 751.
Section 1032 shields a corporation from the recognition of taxable income on the lapse of a warrant.[15] The partnership analogue to section 1032, section 721, does not mention options or warrants.  In addition, there would be no issuance of a partnership interests under section 721 in the case of a lapse. The LLC would probably recognize ordinary income on the lapse of the warrant, but there may be an argument that the lapse premium is a forfeited capital contribution.[16]

                        c.         Exercise of Warrant.  
                                    i.          Treatment of Warrant Holder.  A warrant holder does not recognize taxable income upon the exercise of a favorable warrant. The holder takes a basis in the acquired property equal to the exercise price plus the amount of premium paid for the warrant.  This rule should also apply in the partnership context.

                                    ii.         Treatment of LLC.  Section 721 generally provides for nonrecognition in the case of a contribution of property to a partnership in exchange for a partnership interest.  As noted above, section 721 does not apply to a shift of capital to a partner in satisfaction of an obligation.  Treas. Reg. 1.721-1(b)(1).  In the case of an “in the money” warrant on a partnership capital interest, there would generally be a capital shift from the existing partners to the warrant holder.  One reading of the rules would treat the warrant exercise as outside of section 721 (as a transfer in satisfaction of an obligation), and consequently treat the LLC as having sold an undivided interest in partnership property to the warrant holder.  This reading may have more appeal in the case of warrants granted to third parties not acting in their capacities as partners, such as vendors or lessors than passive investors, since the partnership is satisfying its obligations with capital.

For investors, the warrant obligation does not seem much different than the obligation of a partnership to issue an interest to a partner in exchange for cash under its partnership agreement.  In this case, the transaction should be non-taxable under section 721, on the basis that the warrant is not an “obligation” as contemplated by the regulation 1.721-1(b)(1).  As with compensatory options, the area is not entirely free from doubt since IRS guidance is lacking on this issue.  Diagram 29 illustrates the effect of a hypothetical warrant exercise. Diagram 30 illustrates the effect on capital accounts if the LLC books up immediately before exercise.

                        d.         Exercise of the Warrant After a Sale of the LLC’s Assets. The advantage of a warrant is that the holder need not immediately pay for his or her equity interest, but can wait until the company is closer to liquidity. In order to avoid a discrepancy between inside and outside basis, a reverse section 704(c) adjustment should be made when a warrant holder exercises the warrant. That allocation is not possible if an LLC sells all its assets for cash (at a gain) before the warrant is exercised, and has only cash at the time of exercise. The parties may be able to make curative allocations going forward, but a well drafted warrant should require the warrant to be exercised before (or expire on) a sale of substantially all the assets of the LLC.

Diagram 32 illustrates the book/tax capital accounts of an exercise after the sale of the LLC’s assets followed by a liquidation.  In the diagram, there is a disparity between book and tax accounts that is not resolved until liquidation (capital loss and capital gain). If the exercise (and reverse section 704(c)) allocation had been made before sale of assets, the book and tax capital accounts would have been in agreement.

7.         Convertible Debt.  Investors often seek to protect their downside by the use of convertible debt rather than immediately taking equity. The use of debt allows the investor to have the status of a creditor until conversion, if ever, and defers the valuation decision until the valuation facts will have more fully played out or the debt holder can piggyback on the valuation obtained by a lead investor.  

Convertible debt is usually issued either (i) as an investment unit, with a warrant, or (ii) with only a conversion feature.  The cost of an investment unit consisting of debt and warrants must be allocated between the debt and the warrant, with the result that the debt will have original issue discount (OID).  That OID will result in interest deductions to the LLC and income inclusions to the lender.[17]  Unlike investment units, if the debt is issued with only a conversion feature, the law does not generally require an allocation of the cost of the instrument to the conversion feature.  

Generally, the conversion of debt to equity should be tax free under section 721, except to the extent of accrued interest.  In the case of a convertible debt instrument, there may be an issue as to the taxation of that portion of the debt allocable to the conversion feature (even though an allocation is not required for OID purposes), on the theory that there has been a capital shift in satisfaction of the LLC’s contractual conversion obligation.  It would seem that this is not the type of obligation contemplated by Reg. Section 1.721-1(b)(1) for the same reasons that a warrant should not trigger that section, as discussed above.

8.         Convertible Preferred LLC Interests.  To complete the corporate analogue, the LLC might issue a class of LLC interests that mimics preferred stock, i.e., is limited and preferred as to its share of earnings and capital but may convert to common interests at some point in the future.   
Section 721 should protect both the LLC and the member on the issuance of the interest.  On conversion, however, several issues arise.  First, there may likely be a capital shift. For the reasons discussed above in connection with the exercise of warrants, that capital shift should not be taxable since the conversion privilege should not be included in the term “obligation” as used in the regulation. As with warrants, however, administrative guidance is as of yet lacking.

            The conversion may change the allocation of nonrecourse liabilities under section 752, and cause there to be a book tax disparity that must be taken into account under the section 704(c) regulations.  If the conversion results in a capital shift of more than 50%, there may be a termination of the partnership under section 708.

9.         Incorporation of LLC’s.

                        a.         General Issues.  There are three basic methods of incorporating an LLC: (i) the members may contribute their interests in the LLC to a newly formed corporation (“NewCorp”) in exchange for stock; (ii) the LLC may distribute its assets to the members in liquidation and the members then contribute those assets to the NewCorp; and (iii) the LLC may contribute its assets to the NewCorp in exchange for stock and then liquidate.  The method chosen by the parties will generally be respected by the IRS.  Rev. Rul. 84-111.  

            The form of incorporation can have some significant implications. Section 704(c)(1)(B)[18] and 737[19] do not apply to an incorporation of a partnership by any method of incorporation (other than a method involving an actual distribution of partnership property to the partners followed by a contribution of that property to a corporation), provided that the partnership is liquidated as part of the incorporation. 

            The LLC liquidation followed by a contribution to NewCorp could trigger gain under section 731(a) if a member receives cash in excess of basis.  This concern is not present in the other methods.  The possibility of section 357(c) gain (liabilities in excess of basis) and gain triggered by negative capital accounts requires a review of the LLC’s balance sheet before incorporation.

            An ordinary loss deduction under section 1244 may not be available if the LLC contributes property in exchange for stock which it then distributes to the members in liquidation.  There is authority that only the person to whom the stock was originally issued (the LLC in the scenario described here) can claim section 1244 treatment.

The LLC’s transitory ownership of stock would satisfy the ownership prong of section 542 (Personal holding company) and may raise issues if NewCorp makes an S election.  The IRS has been willing, in private rulings, to ignore transitory stock ownership by a liquidating partnership in determining whether the corporation could make an S election. To be safe, the LLC might want to incorporate under a different method if the NewCorp will elect to be taxed as an S corporation.

An incorporation in anticipation of a section 368 merger with a corporation may be treated as a taxable sale under step transaction principles, since only a corporation (and not a partnership) can participate in a merger (as defined by Code section 368(a).  Similar issues arise with respect to obtaining tax free incorporation treatment under Code section 351 if the NewCorp is to be sold immediately after the incorporation.[20]

                        b.         Incorporation in Accordance with Capital Interests.   The amount of common stock to be received by the members on incorporation may be set forth in the operating agreement.  This may become the norm in view of recent SEC Staff letters that permit tacking (back to the original issuance date of the LLC) of the Rule 144[21] holding period for LLC’s if the following conditions are met: (i) the LLC operating agreement originally and expressly contemplates reorganization into a corporation; (ii) the incorporation does not cause a shift in the members’ economic interests that was not contemplated in the operating agreement; and (iii) the LLC members have no veto or other voting rights over the transaction.  Ideally, each member would receive stock in NewCorp in proportion to their capital account balances. In the not so unlikely event that capital account balances are not in the same ratios as the stock to be received in the incorporation, the LLC might contemplate a book up or adjustment of capital accounts to the appropriate amounts under Treasury Regulation Section 1.704-1(b)(2)(iv)(f).  A book-up may not result in the desired capital accounts if the LLC has no unrealized appreciation or depreciation.  In that case, a capital shift will be required to end up with the desired capital accounts. The tax consequences of a capital shift are discussed above.

c.         Incorporation in Accordance with Profits Interests. 

                        i.          As noted above, under Rev. Proc. 93-27, the IRS will not generally tax the receipt of a profits interest in exchange for services.  This rule does not apply to interests disposed of within two years of receipt.  If the incorporation of an LLC is viewed by the IRS as a disposition of the profits interest, incorporation within 2 years of the grant of a profits interest may raise issues as to whether the service partner is taxable on incorporation, LLC formation, or both events.  

                                    ii.         If the profits interest holder does not have a capital account at the time of incorporation, there may be an issue as to whether he is really a partner, or merely a service provider.  If he is only a service partner, the receipt of his shares would probably be taxable and (if he receives more than 20% of the stock) may result in the transaction failing to qualify under section 351.  Under the pre-check the box Kintner regulations, the IRS required (for ruling purposes) a partner to have a substantial investment in a partnership or a makeup obligation in order to be treated as a partner.  The Kintner rules are gone, and Rev. Proc. 2001-43 (discussed above) may give some comfort that a holder of a profits interest will be treated as a partner for tax purposes, but the IRS may still examine whether a purported partner is a bona fide partner.

                                    iii.        The receipt of stock by profits partners also raises issues under the capital account maintenance rules, which require liquidating distributions to be made in accordance with the partners’ capital account balances.   See Treas. Reg. Sec. 1.704-1(b)(2)(b)(2).   In order to address this concern, unrealized book income could be allocated to the partners to result in the desired ending capital account balances.

                        d.         Preferred Interests. If the LLC has attempted to mimic preferred stock by issuing preferred LLC interests, additional complexity is introduced due to the factual issues that are raised by preferred interests as well as special corporate tax rules.

                                    i.          Valuation.  Common stock, and options on common stock, tend to be valued much lower than the value of the corporation as a whole, on a fully diluted, as exercised, as converted basis, to account for the value of the preferred shareholders’ liquidation preference.  To avoid valuing the common stock in NewCorp at too high a value, but at the same time not ending up with the preferred LLC interests taking a disproportionate share of the corporation, NewCorp will probably exchange common stock for the common interests (which may be the residual, the non-preferential or the profits interest) and preferred stock for the preferred interests.  Rules of thumb are risky here, and a more thorough analysis of justifying the valuation difference may be required.

                                    ii.         NQPS.  The issuance of debt or nonqualified preferred stock would be treated as boot.  Nonqualified preferred stock is, subject to certain exceptions, any preferred stock if: (1) the holder has the right to require its redemption, (2) the issuer (or related person) is required to redeem, (3) the issuer has a right to redeem and it is more likely than not that the right will be exercised, or (4) the dividend rate on the stock varies with reference to interest rates or other indices. Code section 351(g).  The economic terms of the preferred interest may require some revision to avoid a taxable result to the preferred shareholder. For example, a redeemable LLC interest may have to convert into non-redeemable preferred.

                        e.         Convertible Debt.  LLC convertible debt should present no particular problems on incorporation – it either converts to stock as part of the section 351 transaction or is assumed by the corporation.  Note, however, that Code section 351(d)(2) provides that certain debt of the transferee corporation is not property for section 351 purposes. The change of the obligor on a debt instrument, however, may be a significant modification of a debt instrument. Treas. Reg. Section 1.1001-3(c)(1)(i).  If so, the debt will be treated as having been transferred in a realization event.[22]

                        f.          Options and Warrants.   Since LLC’s cannot grant ISO’s, the assumption of the LLC’s options by NewCorp would probably be treated as the grant of a new option by NewCorp. If the NewCorp options are to be ISO’s, they must be granted at fair market value, and any spread in the LLC options would be lost.  If the NewCorp options are to be NSO’s, a significant spread in the options may result in a deemed exercise and an immediate taxable event to the optionees. As a result, it may be advantageous for an LLC optionee (subject to the tax issues noted above) to exercise before the incorporation and exchange his or her LLC interest for (nonvested) stock in NewCorp.

10.      Use of Stock of a Corporate Partner.  When an LLC is a joint venture between corporations, the corporate members can avoid the above LLC level option issues by using its own stock to compensate employees of the LLC.  Rev. Rul. 99-57, 1999-51 IRB 678 provides for non recognition when an LLC uses the stock of a corporate member to compensate an LLC employee. Also, under recent regulations under Section 1032, a partnership does not recognize gain on the use of its corporate partner’s stock, provided the partnership immediately disposes of such stock.  Treas. Reg. Sec. 1.1032-3. Under the regulations, the LLC is deemed to purchase the corporation’s stock for fair market value with cash contributed by the corporate member.  However, an employee of an LLC cannot be granted an ISO of a corporate member, even if the LLC is controlled by such member. 

11.      Conclusion.  The tax issues surrounding compensatory interests, warrants and convertibles in LLC’s can be complex and involved. Hopefully, the IRS will issue guidance as LLC’s become more prevalent. Until, then sophisticated LLC instruments should be used cautiously.

Internal Revenue Service (I.R.S.)

Notice

PARTNERSHIP OPTIONS AND CONVERTIBLE INSTRUMENTS

Released: May 11, 2000

Published: June 5, 2000

  Partnership options and convertible instruments. This notice invites public comment on the federal income tax treatment of the exercise of an option to acquire a partnership interest, the exchange of convertible debt for a partnership interest, and the exchange of a preferred interest in a partnership for a common interest in that partnership.

PURPOSE

  This notice invites public comment on the federal income tax treatment of the exercise of an option to acquire a partnership interest, the exchange of convertible debt for a partnership interest, and the exchange of a preferred interest in a partnership for a common interest in that partnership.

BACKGROUND

  In a variety of situations, partnerships issue options or convertible debt that allow the holder to acquire by purchase or conversion an equity interest in an entity classified as a partnership for federal tax purposes. Partnerships also issue convertible preferred partnership interests that allow a partner to acquire a materially different interest in the partnership upon conversion. Often, these instruments are exercised or converted when the partnership interest to be received is more valuable than the sum of consideration previously transferred to the partnership plus any consideration transferred upon exercise or conversion. In addition, convertible preferred partnership interests often are converted at a time when the partnership interest to be received is more valuable than the interest being converted (disregarding the value of the conversion right). Taxpayers have noted significant uncertainties as to the federal income tax consequences of using such instruments and have expressed a need for guidance.

REQUEST FOR PUBLIC COMMENT

  The Internal Revenue Service and the Treasury Department request comments on the tax consequences to the recipient of the partnership interest as well as to the partnership upon the exercise of a partnership option or conversion of a debt or preferred equity interest in that partnership.

  Taxpayers may submit comments in writing to: 

    Internal Revenue Service 

    Attn: CC:DOM:CORP:R (Notice 2000-29, Room 5226) 

    P.O. Box 7604 

    Ben Franklin Station 

    Washington, D.C. 20044

  Alternatively, taxpayers may submit comments electronically at: sharon.y.horn @M1.IRSCounsel.treas.gov

  All comments should be received by September 15, 2000. The comments submitted will be available for public inspection and copying.

DRAFTING INFORMATION

  The principal author of this notice is Audrey W. Ellis of the Office of Assistant Chief Counsel (Passthroughs and Special Industries). For further information regarding this notice contact Ms. Ellis at (202) 622-3060 (not a toll-free call).

Notice 2000-29, 2000-23 I.R.B. 1241

Internal Revenue Service (I.R.S.)

Revenue Procedure

Released: August 3, 2001

26 CFR 601.201: Rulings and determination letters. (Also Part I, § §  61, 83, 721; 1.721-1.)

SECTION 1. PURPOSE

  This revenue procedure clarifies Rev. Proc. 93-27, 1993-2 C.B. 343, by providing guidance on the treatment of the grant of a partnership profits interest that is substantially nonvested for the provision of services to or for the benefit of the partnership.

SECTION 2. BACKGROUND

  Rev. Proc. 93-27 provides that (except as otherwise provided in section 4.02 of the revenue procedure), if a person receives a profits interest for the provision of services to or for the benefit of a partnership in a partner capacity or in anticipation of being a partner, the Internal Revenue Service will not treat the receipt of the interest as a taxable event for the partner or the partnership. For this purpose, section 2.02 of Rev. Proc. 93-27 defines a profits interest as a partnership interest other than a capital interest. Section 2.01 of Rev. Proc. 93-27 defines a capital interest as an interest that would give the holder a share of the proceeds if the partnership’s assets were sold at fair market value and then the proceeds were distributed in a complete liquidation of the partnership. Section 2.01 of Rev. Proc. 93-27 provides that the determination as to whether an interest is a capital interest generally is made at the time of receipt of the partnership interest.

SECTION 3. SCOPE

  This revenue procedure clarifies Rev. Proc. 93-27 by providing that the determination under Rev. Proc. 93-27 of whether an interest granted to a service provider is a profits interest is, under the circumstances described below, tested at the time the interest is granted, even if, at that time, the interest is substantially nonvested (within the meaning of §  1.83-3(b) of the Income Tax Regulations). Accordingly, where a partnership grants a profits interest to a service provider in a transaction meeting the requirements of this revenue procedure and Rev. Proc. 93-27, the Internal Revenue Service will not treat the grant of the interest or the event that causes the interest to become substantially vested (within the meaning of §  1.83-3(b) of the Income Tax Regulations) as a taxable event for the partner or the partnership. Taxpayers to which this revenue procedure applies need not file an election under section 83(b) of the Code.

SECTION 4. APPLICATION

  This revenue procedure clarifies that, for purposes of Rev. Proc. 93-27, where a partnership grants an interest in the partnership that is substantially nonvested to a service provider, the service provider will be treated as receiving the interest on the date of its grant, provided that:

  .01 The partnership and the service provider treat the service provider as the owner of the partnership interest from the date of its grant and the service provider takes into account the distributive share of partnership income, gain, loss, deduction, and credit associated with that interest in computing the service provider’s income tax liability for the entire period during which the service provider has the interest;

  .02 Upon the grant of the interest or at the time that the interest becomes substantially vested, neither the partnership nor any of the partners deducts any amount (as wages, compensation, or otherwise) for the fair market value of the interest; and

  .03 All other conditions of Rev. Proc. 93-27 are satisfied.

SECTION 5. EFFECT ON OTHER DOCUMENTS

  Rev. Proc. 93-27 is clarified.

SECTION 6. DRAFTING INFORMATION

  The principal author of this revenue procedure is Craig Gerson of the Office of the Associate Chief Counsel (Passthroughs and Special Industries). For further information regarding this revenue procedure contact Craig Gerson on (202) 622-3050 (not a toll free call).

Internal Revenue Service (I.R.S.)

Revenue Procedure

Published: June 8, 1993

26 CFR 601.201: Rulings and determination letters.

(Also Part I, Sections 61, 83, 721; 1.721-1.)

SECTION 1. PURPOSE

  This revenue procedure provides guidance on the treatment of the receipt of a partnership profits interest for services provided to or for the benefit of the partnership.

SEC. 2. DEFINITIONS

  The following definitions apply for purposes of this revenue procedure.

  .01 A capital interest is an interest that would give the holder a share of the proceeds if the partnership’s assets were sold at fair market value and then the proceeds were distributed in a complete liquidation of the partnership. This determination generally is made at the time of receipt of the partnership interest.

  .02 A profits interest is a partnership interest other than a capital interest.

SEC. 3. BACKGROUND

  Under section 1.721-1(b)(1) of the Income Tax Regulations, the receipt of a partnership capital interest for services provided to or for the benefit of the partnership is taxable as compensation. On the other hand, the issue of whether the receipt of a partnership profits interest for services is taxable has been the subject of litigation. Most recently, in Campbell v. Commissioner, 943 F.2d 815 (8th Cir. 1991), the Eighth Circuit in dictum suggested that the taxpayer’s receipt of a partnership profits interest received for services was not taxable, but decided the case on valuation. other courts have determined that in certain circumstances the receipt of a partnership profits interest for services is a taxable event under section 83 of the Internal Revenue Code. See, e.g., Campbell v. Commissioner, T.C.M. 1990-236, rev’d, 943 F.2d 815 (8th Cir. 1991); St. John v. United States, No. 82-1134 (C.D. Ill. Nov. 16, 1983). The courts have also found that typically the profits interest received has speculative or no determinable value at the time of receipt. See Campbell, 943 F.2d at 823; St. John. In Diamond v. Commissioner, 56 T.C. 530 (1971), aff’d, 492 F.2d 286 (7th Cir. 1974), however, the court assumed that the interest received by the taxpayer was a partnership profits interest and found the value of the interest was readily determinable. In that case, the interest was sold soon after receipt.

SEC. 4. APPLICATION

  .01 Other than as provided below, if a person receives a profits interest for the provision of services to or for the benefit of a partnership in a partner capacity or in anticipation of being a partner, the Internal Revenue Service will not treat the receipt of such an interest as a taxable event for the partner or the partnership.

  .02 This revenue procedure does not apply: 

    (1) If the profits interest relates to a substantially certain and predictable stream of income from partnership assets, such as income from high-quality debt securities or a high- quality net lease; 

    (2) If within two years of receipt, the partner disposes of the profits interest; or 

    (3) If the profits interest is a limited partnership interest in a  “publicly traded partnership” within the meaning of section 7704(b) of the Internal Revenue Code.

DRAFTING INFORMATION

  The principal author of this revenue procedure is Ann Veninga of the Office of the Assistant Chief Counsel (Passthroughs and Special Industries). For further information regarding this revenue procedure, contact Ann Veninga on (202) 622-3080 (not a toll-free call).

Rev. Proc. 93-27, 1993-2 C.B. 343, 1993-24 I.R.B. 63, 1993 WL 198229 (IRS RPR)

For additional information on legal issues, contact Roger Royse.

Please see www.RroyseLaw.com or contact Royse Law Firm, PC at rroyse@rroyselaw.com for additional information.

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[1]  The term “LLC” in this outline includes partnerships and LLC’s that are taxed as partnerships.  The terms “partnership” and “LLC;” and “partner” and “member” are used interchangeably throughout.

[2]  Staff of Jt. Comm. on Tax’n, General Explanation of the Revenue Provisions of the Deficit Reduction Act of 1984, 226 (1984).

[3] Dorman v. CIR, 296 F.2d 27 (9th Cir. 1961) (owner of nonvested ownership interest or option not a partner).  Contra. Rev. Proc. 2001-43 (discussed below).

[4]   Rev. Rul. 91-26, 1991-1 CB 184 treats health insurance provided to partners as Section 707(c) guaranteed payments. As an alternative, the Ruling permits the partnership to not take a deduction and to treat health insurance benefits as an in-kind distribution to the partner. 

[5]   Although the Fifth Circuit in Armstrong v. Phinney, 394 F2d 661 (5th Cir. 1968) found that it is legally possible for a partner to be considered an employee of his partnership for this purpose, the IRS does not follow that decision.  See TCM 1982-709; Rev. Rul. 53-80, 1953-1 CB 62.

[6]   Internal Revenue Code of 1986, as amended.

[7]   The Rev. Proc. states that a capital interest is an interest that would give the holder a share of the proceeds if the partnership’s assets were sold at fair market value and then the proceeds were distributed in a complete liquidation of the partnership. 

[8]  The Rev. Proc. does not exempt from tax interests relating to a substantially certain and predictable stream of income, interests disposed of within two years of receipt, and interests in publicly traded partnerships.

[9] Section 83 governs transfers of “property” in connection with the performance of services. It is not clear that a profits interest is “property” for this purpose.  See discussion contained in G.C.M. 36346 (profits interest not property for section 83).

[10] The recent changes to section 25012(o) allow LLC options to be qualified by notice (rather than by permit)

[11] An option’s value is readily ascertainable if it is traded on an established market, or if the taxpayer can demonstrate that, at the time of grant, (1) the option is transferable by the optionee; (2) the option is exercisable immediately; (3) neither the option nor the property subject to it is subject to restriction; and (4) the fair market value of the option is readily determinable.

[12]   There may be an issue as to whether the allocation has substantial economic effect if, for example, it is transitory, i.e. will be offset by other allocations. 

[13]   PLR 7937016 (May 31, 1979).

[14]   Treas. Reg. Section 1.1234-1(a)(1)-(3).

[15]    Code section 1032 provides that “…No gain or loss shall be recognized by a corporation with respect to any lapse or acquisition of an option to buy or sell its stock…”.

[16]  Section 1234 regulations characterize the income recognized by a grantor on the lapse of an option, but (arguably) does not itself trigger recognition.

[17]  Code section 1272; Treasury Regulation section 1.1273-2(h) requires an allocation of purchase price between the debt instrument and the warrant.

[18] Under Section 704(c)(1)(B), if a partner contributes property to a partnership, and within 7 years the partnership distributes that property to another partner, the contributing partner recognizes gain or loss in an amount equal to the gain or loss the partner would have been allocated under Section 704(c)(1)(A) on a sale of the property by the partnership at its fair market value at the time of the contribution. 

[19]   Section 737 taxes a distributee partner up to the amount of his pre-contribution gain.

[20]   Under Code section 351, the exchanging shareholders must be in control (i.e. 80% ownership) of NewCorp immediately after the exchange.

[21]   After a company has completed an IPO, Rule 144 requires a shareholder to have held his stock for at least one year before he can sell those securities without filing an SEC registration statement.

[22]   A “significant modification” of a debt instrument is treated as an exchange of the original debt instrument for a modified debt instrument that differs materially in kind or extent for purposes of Reg. 1.1001‑1(a).