INCENTIVE COMPENSATION IN BUSINESS ENTITIES, PART …INCENTIVE COMPENSATION IN BUSINESS ENTITIES,...

INCENTIVE COMPENSATION IN BUSINESS ENTITIES, PART 1 & PART 2

First Run Broadcast: February 16 & 17, 2016

Live Replay: December 27 & 28, 2016

1:00 p.m. E.T./12:00 p.m. C.T./11:00 a.m. M.T./10:00a.m. P.T. (60 minutes each day)

Companies of every type, whether operated as C or S Corporations, LLCs or partnerships, often

prefer to offer their managers and other employees incentive compensation as part of their

overall compensation packages to provide real and tangible incentives to help grow the company.

The range of incentive compensation tools and techniques available to these companies depend

on the type of entity involved but are generally extensive. Corporate entities have stock options,

restricted stock and other forms of profit or capital appreciation rights. LLCs are even more

flexible and can award a variety of forms of profit or capital rights. These alternatives, together

with voting and vesting restrictions, provide companies alternatives for virtually every

circumstance. But each alternative comes with tradeoffs – practical, tax and financial. This

program will provide you with a real world guide to the incentive compensation alternatives to C

and S corporations, LLCs and partnerships.

Day 1 – December 27, 2016:

Incentive compensation in C and S corporations, LLCs and partnerships

How incentive compensation differences between corporate and pass-through entities

Framework of incentive compensation alternatives in each type of entity

Advantages and drawbacks of stock options, restricted stock, and profit participation

rights

How IRC Section 83 impacts corporate stock options, the award of restricted stock and

other rights

Use of vesting to impact the tax consequences of incentive compensation

Special incentive compensation issues in S Corps

Day 2 – December 28, 2016:

Use of profit interests and capital interest in LLCs, partnerships

Exchanging incentive compensation for services

Incentive compensation in single member LLCs

Impact of IRC Section 409A and deferred compensation

Employment tax considerations

Role of the 3.8% tax on net investment income

Understanding how “carried interests” in incentive compensation

Speakers:

Norman Lencz is a partner in the Baltimore, Maryland office of Venable, LLP, where his

practice focuses on a broad range of federal, state, local and international tax matters. He

advises clients on tax issues relating to corporations, partnerships, LLCs, joint ventures and real

estate transactions. He also has extensive experience with compensation planning in closely held

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

Columbia University School of Law.

Leon Andrew Immerman is a partner in the Atlanta office of Alston & Bird, LLP, where he

concentrates on federal income tax matters, including domestic and international tax planning

and transactional work for joint ventures, partnerships, limited liability companies and

corporations. He formerly served as chair of the Committee on Taxation of the ABA Business

Law Section and as chair of the Partnership and LLC Committee of the State Bar of Georgia

Business Law Section. He is also co-author of “Georgia Limited Liability Company Forms and

Practice Manual” (2d ed. 1999, and annual supplements). Mr. Immerman received his B.A.,

magna cum laude, from Carleton College, his M.A. from the University of Minnesota, and

another M.A. and his Ph.D. from Princeton University, and his J.D. from Yale Law School.

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Incentive Compensation in Business Entities, Part 1 Teleseminar

December 27, 2016 1:00PM – 2:00PM

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Incentive Compensation in Business Entities, Part 2 Teleseminar

December 28, 2016 1:00PM – 2:00PM

1.0 MCLE GENERAL CREDITS

PAYMENT METHOD:

Check enclosed (made payable to Vermont Bar Association) Amount: _________ Credit Card (American Express, Discover, Visa or Mastercard) Credit Card # _______________________________________ Exp. Date _______________ Cardholder: __________________________________________________________________

VBA Members $75 Non-VBA Members $115

NO REFUNDS AFTER December 21, 2016

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CERTIFICATE OF ATTENDANCE

Please note: This form is for your records in the event you are audited Sponsor: Vermont Bar Association Date: December 27, 2016 Seminar Title: Incentive Compensation in Business Entities, Part 1 Location: Teleseminar - LIVE Credits: 1.0 MCLE General Credit Program Minutes: 60 General Luncheon addresses, business meetings, receptions are not to be included in the computation of credit. This form denotes full attendance. If you arrive late or leave prior to the program ending time, it is your responsibility to adjust CLE hours accordingly.

Vermont Bar Association

CERTIFICATE OF ATTENDANCE

Please note: This form is for your records in the event you are audited Sponsor: Vermont Bar Association Date: December 28, 2016 Seminar Title: Incentive Compensation in Business Entities, Part 2 Location: Teleseminar - LIVE Credits: 1.0 MCLE General Credit Program Minutes: 60 General Luncheon addresses, business meetings, receptions are not to be included in the computation of credit. This form denotes full attendance. If you arrive late or leave prior to the program ending time, it is your responsibility to adjust CLE hours accordingly.

SUMMARY OF TYPES OF EQUITY AWARDS IN A CORPORATE EMPLOYER

Norman LenczVenable LLP – Baltimore, Maryland

(o) (410) [email protected]

STOCK OPTIONS RESTRICTED STOCK STOCK APPRECIATIONRIGHTS (“SAR”)

PHANTOM STOCK

Description A right (but not an obligation)to purchase a certain numberof shares of company stock ata specified price for a certainperiod of time. The right isgenerally exercisable after theoption vests. However, someoptions allow exercise beforevesting, with the sharespurchased subject to forfeitureuntil the option would havevested.

A grant of companystock, generally withoutpayment by the employee,subject to forfeiture ifvesting conditions are notmet. The stock is issuedin the employee's name atthe grant date, butgenerally held by thecompany with a stockpower in blank until theshares vest.

A right to receive the excessof the value of a certainnumber of shares of companystock over a specified basevalue (generally the value ofcompany stock on the grantdate) at a certain time in thefuture after the SAR vests.The payout may be in cash orin an equivalent number ofshares.

A right to receive the full valueof a certain number of shares ofcompany stock at a certain timein the future after the grantvests. The payout may be incash or in an equivalent numberof shares. (If the payout ismade in shares, this istantamount to what is known asa "Restricted Stock Unit").

FederalIncomeTaxation

1. Regular Federal IncomeTax Treatment

Nonqualified Option –Employee is taxed at exerciseof the option on the excess ofthe then value of the stock overthe amount paid. In the case ofan employee, the income issubject to tax withholding andreported on Form W-2. Thecompany gets a correspondingdeduction.

1. Regular FederalIncome Tax Treatment

Employee is taxed on theexcess of the then valueof the stock over theamount paid (if any) atone of the followingtimes.

The taxation occurs atreceipt of the stock if an"83(b)" election is filedwithin 30 days of receipt.


Employee is generally taxedon the appreciation in theshares covered by the SARwhen payment is received. Inthe case of an employee, theincome is subject to taxwithholding and reported onForm W-2. The company isentitled to a correspondingdeduction.


Employee is generally subjectto income tax on the value ofthe number of shares coveredby the Phantom Stock awardwhen payment is received.However, FICA taxes applywhen the phantom shares arevested. In the case of anemployee, the income is subjectto tax withholding and reportedon Form W-2. The company is

Incentive Stock Option –Employee is not taxed atexercise of the option, but the"spread" is a tax preference forthe alternative minimum tax.The employee is taxed on thegain upon disposition of thestock. The income on sale iscapital gain if the stock hasbeen held for 2 years from theoption grant date and 1 yearfrom option exercise.Otherwise a portion of the gainup to the "spread" at exercise isordinary income. The companygets a corresponding deductiononly as to the portion of thegain taxed as ordinary incometo the employee.

Otherwise taxation occursupon vesting

In the case of anemployee, the income issubject to tax withholdingand reported on a W-2.

The company gets acorresponding deductionat the same time as theemployee recognizesincome.

entitled to a correspondingdeduction.

2. Section 409A Implications

Stock options for "servicerecipient" stock are exemptfrom Code Section 409A if theoption is an incentive stockoption or, if a nonqualifiedoption:(i) the exercise price maynever be less than the fairmarket value at the grant date,(ii) the stock transferred uponexercise is subject to taxation,and(iii) there are no deferralfeatures under the option otherthan deferral until exercise.(If Section 409A applies to astock option, the option would

2. Section 409AImplications

Generally restricted stockof the service recipient isnot subject to Section409A if it is taxableimmediately uponvesting.


SARs in service recipientstock are exempt from CodeSection 409A if:(i) Compensation under theSAR cannot be greater thanthe difference between the fairmarket value of the stock onthe exercise date over the fairmarket value on the grant dateof a fixed number of shares,(ii) The exercise price cannever be less than the fairmarket value of theunderlying stock on the grantdate, and(iii) The SAR does notinclude any feature for the


Phantom shares are generallysubject to Code Section 409Aand thus must comply with therules as to elections regardingdeferral and payment. (Anexception would be if payout isset to occur within 2½ monthsof the end of the employee’s orservice recipient’s tax year inwhich the phantom shares vest.)

Failure to comply with the rulesof Section 409A results inincome taxation at vesting,potential interest payments anda 20% penalty tax.

have to meet the requirementsof Section 409A. Otherwise,the option would be taxable atvesting, with a 20 percentpenalty tax.)

deferral of income other thandeferral until the SAR’sexercise.

STOCK OPTIONS RESTRICTED STOCK SAR PHANTOM STOCKPros No shareholder rights until

exercise

Taxation delayed until exercise

Conveys only appreciation inshares

No immediate accountingexpense

Greater value to employeeper share awarded

Typically used for only acore founder group

Provides for more "skin inthe game" to align toplevel executives withshareholders

No shareholder rights untilexercise

No shareholder rights afterexercise if payable in cash

Conveys only appreciation inshares

No shareholder rights untilpayment

No shareholder rights afterpayment if paid in cash

Greater value to employee perphantom share awarded

Cons Possibility that option will beexercised before company sale

Immediate shareholderrights

Taxation immediate orupon vesting

Dilutes existingshareholder value

If paid in cash, entails cashoutlay at payoutIf payable in cash results inmark-to-market compensationexpense on financials. (Needto check with accountant).

If paid in cash, entails cashoutlay at payout

If payable in cash, results inmark-to-market compensationexpense on financials. (Need tocheck with accountant).

Dilute existing shareholdervalue

FICA taxation at vesting

Strict rules as to payout datesunder Section 409A.

The above is merely a brief overview of certain types of equity compensation. The tax and legal consequences of equity compensationare complex and may vary based on individual circumstances. Therefore, companies and executives must consult their own legal andtax advisors regarding these matters.

LLC IncentiveCompensation

L. Andrew ImmermanAlston & Bird LLP(o) (404) 881-7532

[email protected]

22

LLC = Partnership

In this outline:Any LLC (other than a single-member LLC) is

assumed to be classified as a partnership forincome tax purposes. So in most of this outline, “partnership” and “LLC” are

interchangeable.

A single-member LLC is assumed to be“disregarded” as an entity separate from its ownerfor income tax purposes (but not, as explainedbelow, for employment tax purposes).

Classifying LLC members as “limited partners” forcompensation purposes is discussed below.

33

An employee or other service provider istaxable on the receipt of C Corp or S Corpstock as compensation for services,although the tax can be deferred until thestock is vested. Code § 83.

As explained below, a service provider isgenerally not taxable on receipt of a vestedor unvested "profits interest" in an LLC ascompensation for services to or for the LLC.

Equity for Services: Corp vs. LLC

44

Example: Equity for Services

A and B form X. Each hasan equal interest.

A contributes property witha fair market value of$1,000 and a basis of zero.

B contributes futureservices that he willperform for X, and receivesan unrestricted interest inX.

A B

FMV = $1,000Basis = 0 Services

X

55

Equity for Services: X is a Corp

If X is a corporation:

A and B both have taxable gain.

A has gain, equal to $1,000, because he is not incontrol of X immediately after the exchange (and isnot part of an 80% control group). § 351. This problem for A can often be avoided with proper planning

B has taxable ordinary income equal to $500(assumed to be the value of his interest in X).

However, X may have a $500 deduction for thecompensation to B.

66

Equity for Services: X is an LLC

If X is an LLC:

A has no taxable gain. § 721 (no

requirement of 80% control).

As explained below, in general B also will

have no taxable gain if he receives only a

profits interest in X.

However, if B receives a capital interest B will

be taxable.

77

Property Transfers

A challenge in determining the taxconsequences of compensatory LLC interestsis coordinating and reconciling two perhapsirreconcilable sets of rules:

§ 83 (transfer of property in connection with theperformance of services), based on fair marketvalue concepts.

Subchapter K (partnership tax), based on capitalaccount concepts.

88

Property Transfers

General rules of § 83 (not specific topartnerships):

Taxable event occurs at grant, or when propertyis transferable or no longer subject to substantialrisk of forfeiture (i.e., when it is substantiallyvested).

Amount included in income of service provider isfair market value of property over amount paid (ifany).

Deduction allowed to business for amountincluded in income by service provider.

99

Property Transfers

§ 83(b) election:

Service provider may elect to includevalue of unvested property incompensation income at time oftransfer.

Subsequent appreciation in value isgenerally capital gain.

Election must be made within 30 days oftransfer – no exceptions.

1010

Profits Interest Defined

Rev Proc 93-27, 1993-2 CB 343, definestwo types of partnership interests, asdetermined at time of issuance:Capital Interest: partnership interest that

would entitle the holder to a share ofliquidation proceeds if partnership assetswere sold at FMV.

Profits Interest: partnership interest that is nota capital interest; generally entitles holderonly to a share of post-issuance partnershipincome and gain.

1111

If an individual provides services “to or for the benefit of thepartnership in a partner capacity or in anticipation of being apartner,” the IRS will accept that the receipt of a profits interest forservices is not a taxable event for the partnership or the recipient,if:

The interest isn’t related to a substantially certain and predictablestream of income from partnership assets.

The interest is not disposed of within two years.

The interest is not a limited partnership interest in a publicly tradedpartnership.

IRS apparently is taking the position that the safe harbor isinapplicable if one party performs the services and anotherparty receives an associated allocation and distribution.

IRS treats § 83 as irrelevant for this purpose.

Receipt of Profits Interest

1212

Unvested Profits Interest

Rev Proc 2001-43, 2001-2 CB 191, says that RevProc 93-27 applies to a profits interest that issubject to a substantial risk of forfeiture ifpartnership and recipient treat the recipient as theowner of the partnership interest from the date ofgrant.

§ 83(b) election is not required, although is oftenrecommended by advisors as a protectivemeasure.

In effect, the two Rev Procs give precedence toSubchapter K principles over § 83.

1313

Unvested Profits Interest

If the partnership grants an unvested profitsinterest, the service provider will not be taxedon receipt or vesting if:Conditions of Rev Proc 93-27 are met.

Partnership and service partner treat and reportservice partner as tax owner of the interest andservice partner includes its distributive share ofpartnership tax items for tax purposes.

Upon grant or vesting of interest, neitherpartnership nor any partner takes deductionsbased on the profits interest at grant or vesting.

1414

Safe Harbor vs. Substantive Law

Rev Proc 93-27 and Rev Proc 2001-43 aresafe harbors; follow them and the IRS won’tchallenge you.

They are not substantive rules of law, butdepart from them and you are thrown backto a confusing jumble of authorities.

For example, § 83 seems irrelevant under thetwo Rev Procs, but how does § 83 apply outsideof them?

1515

2005 Proposals

Proposed regulations under several Code sections, andaccompanying proposed revenue procedure, Notice2005-43, issued in May 2005. REG-105346-03.

In the unlikely event they ever become effective, theywould obsolete current guidance, including Rev Proc93-27 and Rev Proc 2001-43.

However, the proposals would generally allowpartnerships to achieve the same favorable results asunder current guidance, if the right elections are made:

“Safe harbor” liquidation value election.

§ 83(b) election for unvested interests.

1616

FMV or Liquidation Value

Default rule (no election):

Service partner taxable on fair market value ofpartnership interest.

Value of partnership interest is the amount a willingbuyer would pay a willing seller.

Even a pure profits interest has some fair marketvalue, and is taxable at grant.

Thus the default rule follows § 83 rather than thetwo Rev Procs.

1717

FMV or Liquidation Value

“Safe Harbor” election:

Value of partnership interest equals “liquidation value.”

Thus the election more or less permits the parties to follow the RevProcs, and to sidestep § 83 .

However, there are many obstacles to making an election:

Partnership agreement must contain provisions, legally binding on all ofthe partners, that all partners agree to comply with the safe harbor.

Alternative: Each partner in the partnership must execute a legallybinding document agreeing to the safe harbor.

Effective date of election cannot be prior to execution date.

IRS has informally acknowledged that the proposed requirementsfor the election were overly strict.

Proposed legislation may make “liquidation value” the default rule,so no election would be necessary.

1818

2005 Proposals: Unvested Interests

Under the proposals, an unvested compensatorypartnership interest in itself does not make theholder a partner for tax purposes.

Vesting of the interest makes the holder apartner.

The holder has compensation income.

Other partners have compensation deduction(subject to possible capitalization).

§ 83(b) election is treated like vesting; it makesthe holder a partner for tax purposes.

1919

2005 Proposals: Capital Shift

On issuance of a capital interest, some of the capital of theexisting partners shifts, in effect, to the new partner.

Similarly, on vesting of an unvested profits interest, capitaloften shifts from the existing partners to the new one.

If a service provider gets a capital interest without putting incapital, then the only place that the service provider’s capitalcan be coming from is the other partners.

Generally if property is transferred as compensation forservices, the transferor recognizes gain as if it sold the propertyto the service provider?

Issue: Do the existing partners recognize gain on a capital shift,as if they had sold an interest in the assets of the LLC to thenew partner?

2020

2005 Proposals: Capital Shift

The 2005 proposals take the pro-taxpayer (butsomewhat controversial) position that the existingpartners do not recognize gain. Prop Reg 1.721-1(b)(2)(i) and -1(b)(3).

Trap: Gain would be recognized by the LLCmember on the issuance or vesting to a newmember of an interest in a “disregarded” LLC thatbecomes a partnership for tax purposes as a resultof the issuance or vesting.

2121

Final Regulations?

Treasury reportedly is not working onfinalizing the 2005 proposals.

Treasury, very sensibly, is waiting tosee what Congress comes up with.

Proposed legislation is discussedbelow.

2222

Fee vs. LLC Equity

For one illustration of the stakes incharacterizing amounts as fees rather thanas the return on an LLC equity interest,see Rigas v. United States, 2011-1 USTC50,372 (S.D. Tex. 2011), aff’d per curiam,2012-2 USTC 50,530 (5th Cir. 2012)

Even in what appears to be a simplecontract for services, tax advice on dealstructure can sometimes make a bigdifference.

2323

Example: Fee for Services

B manages $1,000 ofinvestments for A.

B is entitled to 20% offuture profits.

A earns $2,000 capitalgain.

A pays $400 to B. B

$400

Services

A has $2,000 capital gain less $400 expense = $1,600taxable income.

A (a corporation) pays 35% of $1,600 = $560.

B (an individual) pays 39.6% of $400 = $158.40.

B also pays self-employment tax.

A

2424

Example: Equity for Services Suppose instead A and B form X

LLC.

A contributes $1,000 for 80% offuture profits.

B contributes services for 20% offuture profits.

X earns $2,000 capital gain.

A pays 35% of $1,600 = $560.

B pays 20% of $400 = $80.

No self-employment tax on capitalgains.

However, 3.8% net investmentincome tax may apply.

B

$1,000 Services

X

A

2525

Fee vs. LLC Equity

As discussed above, neither A nor B is taxed on receiving theLLC interest. If the tax treatment of LLC compensation were comparable to the tax

treatment of corporate compensation, B would pay tax on receipt.

However, Congress has not shown much inclination to change thatresult.

Because A is a corporation, A pays the same amount of taxwhether B gets a fee or LLC equity.

However, B pays about half as much tax on his share of theLLC income than on the service fee ($80 vs. $158.40). Arguably, B’s capital gain on future appreciation is no different than the

corporate employee’s capital gain on future appreciation in stockreceived as compensation.

However, for many years now there has been a push in Congress totax B at ordinary rates (plus self-employment tax), at least if B is aninvestment manager of some kind.

2626

Taxation of Manager: Profits Interest

The manager, as the holder of a profits interest, reports hisor her distributive share of income, gain, loss, deduction andcredit.

No one deducts any amount as wages, compensation orotherwise with respect to the manager’s share of income.

If the partnership recognizes long-term capital gain, themanager (or individual owners of the manager entity) istaxed on its share of the gain at capital gain rates.

Maximum long-term capital gain rate for individuals isgenerally 20%, rather than 39.6% (not counting netinvestment tax).

2727

Taxation of Manager: Fee for Services

If a payment for services is determined without regard tothe net income of the LLC, it is a “guaranteed payment”as defined under Code § 707(c), which does not mean itis “guaranteed” in any normal sense of the word. It is determined without regard to the partnership’s income.

It is made to the partner in its capacity as a partner.

It is ordinary income to the partner and generally deductible bythe partnership.

“Salary” to service providers of an operating business aregenerally “guaranteed payments” if made to a partner.

If the management fee is paid to an affiliate of the partner(rather than to the member) it is generally just a businessexpense of the partnership.

2828

Non-Partner Capacity Payments

Payments made to a partner who is not acting inhis capacity as a partner are generally treated as ifmade between the partnership and a non-partner.Code § 707(a).

In some contexts, the difference between a 707(a)payment and guaranteed payment is not of greatimportance.

But if allocations of capital gain under a profitsinterest could be recharacterized as 707(a)payments, the tax consequences would beenormous.

2929

Carried Interests: Proposed Legislation

Several bills have been introduced in Congress to add new“Section 710” to the Code.

There are differences among the bills but all would: Characterize allocations attributable to certain carried interests as

ordinary income, subject to:

Ordinary income tax rates plus,

Self-employment tax.

Tend to apply to many entities besides private equity funds,although private equity funds are the main target.

Deny any compensation deduction to the other LLC members.

Continue to permit carried interests to be received free of initial tax,unlike compensatory corporate stock.

3030

Carried Interests: Proposed Legislation

All versions have some exception for investedcapital.

To the extent managers receive a return on theirown invested capital, § 710 does not apply.

However, the exception is likely to be draftednarrowly.

Versions have been passed several times by the Housebut not enacted.

The idea has been showing up every year recently inthe President’s budget proposals, including theproposals for fiscal year 2017.

3131

What Won’t Section 710 Affect?

The scope of § 710 – if enacted -- isimpossible to predict.

However, although the versions that havepassed the House are overbroad, Congress’target has been investment managers.

LLC members active in operatingbusinesses are perhaps less likely to beaffected.

However, no one really knows what futurelegislation will say.

3232

Profits Interests vs. Options

Corporate options and carried interests both enableworkers to participate in future growth.

The strike price of the corporate option usually must beat least the fair market value of the stock on the date ofgrant. Thus the option holder does not have a share of the existing fair

market value, value, but can profit from future increases in value.

The profits interest by definition does not entitle themember to share in any of the liquidation value that theLLC has on the date of grant. Thus the option holder does not have a share of the existing

liquidation value, but can profit from future increases in value.

Compensatory options – in corporations or LLCs – donot result in capital gains for the holders when exercised.

Profits interests often generate capital gains for theholders.

3333

Profits Interests vs. Options

For partnerships, carried interests traditionally (and deservedly) havebeen more popular than options.

Options are familiar in the corporate world, and are sometimes used byLLCs primarily because of this familiarity.

LLC clients who want to issue options sometimes will prefer profitsinterests once they understand how profits interests work.

One difference between profits interests and options is that the holder ofa profits interest is considered a partner but the holder of only an option isnot.

The 2005 proposals have little detail on compensatory options, but dotake the position that the existing partners recognize no gain on issuing apartnership interest on the exercise of a compensatory option.

Final regulations on noncompensatory options were issued a few yearsago (T.D. 9612, Feb. 5, 2013) but final regulations on compensatoryoptions are still not in sight.

3434

LLC Options

If the LLC does grant options, then the following treatmentseems reasonable (assuming that the optionholder istreated only as an optionholder and not as a partner): The optionholder continues to be treated as an employee.

The employee should not have any income on receipt of the option.

The employee has ordinary compensation income (presumablybased on “fair market value”) on exercising the option.

The partnership should have a deduction (or in some cases acapitalized cost) when the employee exercises the option.

The partnership should not recognize income on the granting orexercise of the option (but gain is likely recognized on the exerciseof a an option on an interest in a single-member LLC).

35

Fee Waivers (Conversions) If the management fee is a source of income for the

manager, and not just a mechanism for covering the LLC’sexpenses, it is tempting to convert management fees(always ordinary income) into carried interests (often capitalgain). These transactions are called “waivers” or “conversions.”

Another advantage of the waiver or conversion is deferral becausethe income from the carried interest generally will be recognized laterthan the fee would have been

However, the management fee is a fixed amount, andtherefore is more certain to be realized than an interest inprofits. There is a tension between the manager’s desire to be assured of

receiving the amount and the manager’s desire for capital gains.35

36

Fee Waivers – Structures

Depending on the particular arrangement, there may bemore or less risk that the fee the manager attempted toconvert will still be treated as a management fee, ratherthan as a carried interest.

Many advisors believe a waived management fee maybe exchanged for a profits interest if: The conversion is done before the right to the payment of the

management fee accrues.

The right the manager receives in exchange for the waivedmanagement fee is the right to future profits, if any.

There is a realistic risk that the future profits will not materialize,although commonly the manager does have a priority claim withrespect to the amount of the waived fee.

36

37

Fee Waivers - Issues

If the manager has already earned the fee before makingthe waiver, the manager may already be in “constructivereceipt” of the fee and it may too late to avoid tax onordinary fee income.

Even if the waiver is effective, there may be a questionwhether the profits interest qualifies under Rev. Proc. 93-27. For example, if the profits interest gives the manager a share of

future gross income, is the interest a “guaranteed payment”?

If not a “guaranteed payment” does it still fall outside the safeharbor of Rev. Proc. 93-27 by virtue of being “related to asubstantially certain and predictable stream of income frompartnership assets”?

37

38

Proposed Fee Waiver Regulations

Regulations proposed in July 2015 would generally treata fee waiver in exchange for an income allocation asordinary compensation income, unless the manager issubject to significant “entrepreneurial risk” with respect tothe income allocation. Entrepreneurial risk is measured relative to the overall risk of the

partnership.

If the partnership as a whole is low-risk, then the fact that the partner’srisk is equally low will not be fatal.

Even if there is significant “entrepreneurial risk” thearrangement will be characterized as a disguised feebased on other factors, including (but not limited to)factors listed in the proposed regulations.

38

39

Proposed Fee Waiver Regulations

Listed factors besides entrepreneurial risk are: A “cap” on allocations of income, which is reasonably expected

to apply in most years.

The allocations are for a fixed number of years in which thepartner’s distributive share of income is reasonably certain.

Allocations of gross income.

Allocations that are “predominantly fixed in amount, reasonablydeterminable, or designed to ensure “that sufficient net profitsare highly likely to be available to make the allocation (e.g.,allocations from specific transactions or specific accountingperiods without regard to the overall performance of thepartnership.

Waiver is non-binding or the partner fails to timely andadequately notify the partnership and the partners of .the termsof the waiver. 39

40

Proposed Fee Waiver Regulations Some additional factors of “secondary” importance are

also specified: Partnership interest is transitory or of short duration.

The time frame of the allocation and distribution is comparable tothe time frame in which a non-partner service provider would bepaid.

Service provider was made a partner primarily for tax benefits.

Value of the service provider’s interest is general and continuingprofits is small relative to the allocation and distribution.

Terms of the allocations or distributions to a partner or relatedpartners are subject to significantly different levels ofentrepreneurial risk that vary significantly (e.g., some are subjectto a clawback and some are not).

The proposed regulations are not in force but the IRS thinksthat they generally reflect current law. 40

4141

Code § 409A

409A (enacted 2004) caused an upheaval in thetreatment of corporate executive compensation.

Under 409A, amounts deferred under anonqualified deferred compensation plan arecurrently includible in gross income to the extentnot subject to a substantial risk of forfeiture, unlessstrict requirements are met.

Failure to meet the requirements subjects theservice provider to interest plus a 20% penalty.

409A is not intended to apply to transfers of“property” that are subject to Code § 83.

4242

Code § 409A Partnerships are not exempt from 409A.

Preamble to the final 409A regulations: “taxpayers may apply the principles applicable to stock

options or stock appreciation rights under these finalregulations, as effective and applicable, to equivalentrights with respect to partnership interests.” TD 9321, 72Fed Reg 19234 (April 11, 2007).

There is not much authority on applying 409A toLLC compensation, but in general the impact of409A on equity-based LLC compensation has beenvery muted compared to its pervasive influence oncorporations.

4343

LLC Compensation Exempt from 409A

Profits interests that qualify under Rev Proc 93-27 are exempt from 409A . Notice 2005-1, 2005-1 CB 274, 279 (Q&A 7) Yet another reason to prefer profits interests over

other forms of LLC compensation.

Since capital interests seem to clearly be“property” subject to Code § 83, they areprobably not subject to 409A.

“Guaranteed payments” (Code § 707(c)) aregenerally not subject to 409A, unless paymentby a cash-basis LLC is delayed more than 2 ½months after the end of the year.

4444

LLC Compensation Exempt from 409A

Partnership “retirement payments” (described inCode § 736) are generally not subject to 409A.

Exception: 409A does apply to retirementpayments under Code § 1402(a)(10). Payments to an individual that continue at least until

death.Made after all capital has been returned. Individual provides no services to the LLC. The other partners have no obligations to the individual

except for these payments.

The advantage of 1402(a)(10) payments isexemption from self-employment tax.

4545

LLC Compensation Subject to 409A

Code § 707(a) payments are subject to 409A.

As noted above, these are payments made to a partner,other than in his capacity as a member of thepartnership.

They are generally treated as occurring between thepartnership and a non-partner.

Options are subject to 409A.

LLC options seem to treated under 409A much likecorporate options.

Most importantly, the option exercise price must not beless than the fair market value of the employer stock (orLLC interest) on the date of grant.

4646

LLC Compensation and 457A

Code § 457A (enacted 2008) is in some ways an expansion of 409A. It accelerates tax on deferred compensation paid by "nonqualified

entities,” even if the deferred compensation complies with 409A. The provision was directed at hedge fund managers who were deferring

compensation through foreign corporations; however, the provisionapplies much more broadly.

Nonqualified entity includes: A foreign corporation (unless substantially all of its income is effectively

connected with the conduct of a U.S. trade or business or subject to a"comprehensive foreign income tax“).

A partnership (unless at least 80% of its income is allocated to persons otherthan foreign persons not subject to a comprehensive foreign income tax, andorganizations that are exempt from U.S. federal income tax).

Partnerships that have substantial foreign or tax-exempt ownershipshould consider 457A carefully.

See Notice 2009-8, 2009-4 IRB 347, amplified, Rev Rul 2014-18, 2014-26 IRB 1104.

4747

Partners Cannot be Employees

Before the Internal Revenue Code of 1954, courts ruled that it wasimpossible for a person to serve the dual role of employer andemployee in a single transaction.

Each partner is in some sense the employer of the partnership’semployees, so if a partner were an employee the partner would be bothemployer and employee – which was (at least at that time) thought tobe an absurd result.

Under state law nowadays, it is often possible for a partner or LLCmember to be considered an employee, depending on the facts and theapplicable law.

However, tax law has not kept up, and technically the IRS considers itimpossible for a partner to be an employee of his or her ownpartnership.

The same rules apply to LLC members who are taxed as partners.

4848

Partners Cannot be Employees

The law seems reasonably well-settled that for taxpurposes partners are not considered employees oftheir own partnership. Rev Rul 69-184, 1969-1 CB 256. Instead, partners who work for their partnerships are considered

self-employed.

It is unclear how actively the IRS is enforcing this rule; somepractitioners are under the impression that the IRS is not.

IRS officials have informally expressed some interest inreconsidering this rule, but a change is unlikely in the near future.

Partners receive a Schedule K-1 each year and not a FormW-2.

4949

Guaranteed Payments

Fixed “salary” of partners is normally characterizedas a “guaranteed payment” for services under §707(c) rather than as wages.

As noted above, a guaranteed payment is made to apartner in his capacity as a partner, but is determinedwithout regard to the partnership’s income.

It is not really “guaranteed.”

For key purposes, a guaranteed payment is nottreated as a distribution or allocation; it does notdirectly affect the recipient’s capital account.

5050

Guaranteed Payments

Includable in income of recipient partner(§ 61(a)) and deductible (§ 162(a)) bypartnership unless required to becapitalized under § 263.

Inclusion occurs in partner’s taxableyear in which or with which thepartnership’s tax year ends.

Deduction to partnership when paidor accrued.

5151

Withholding

Federal Insurance Contributions Act (“FICA”) andincome taxes are withheld from employees’ paychecks. Employee generally does not file quarterly estimated income tax.

FICA is not paid with annual Form 1040.

For FICA taxes, the employee pays a portion and the employerpays a portion.

There is no payroll tax withholding on partners. Partner typically files quarterly estimated income tax and annual

Form 1040.

Self-Employment Contributions Act (“SECA”) is also paidthrough quarterly tax and on annual Form 1040.

Partner pays 100% of SECA.

5252

SECA Compared to FICA

SECA and FICA are intended to be equal:

Both comprise:

Old-age, survivor and disability insurance (“OASDI”), known as the“social security” component, plus

Hospital insurance (“HI”) or Medicare component.

SECA rates:

OASDI rate of 12.4%, on the first $118,500 (in 2016), plus

HI rate of 2.9% on all amounts -- no ceiling.

Partners are allowed a deduction for ½ of the self-employment tax paid. §164(f).

SECA equals combined rate of employer's and employee's share ofFICA.

Beginning in 2013, additional 0.9% Medicare tax above a threshold($250,000 for married taxpayers filing jointly).

535353

Income Subject to SECA

Self-employment tax is payable on net earningsfrom self-employment. § 1402(a).

Generally includes all business income. Does not include:

Dividends.

Rental from real property.

Capital gain.

Interest on any bond, debenture, note, certificate, orother evidence of indebtedness, issued with interestcoupons or in registered form.

§ 1402(a)(10) payments to retired partners.

5454

SECA and Profits Interests

Capital gain is not subject to SECA.

However, if capital gain isrecharacterized as ordinary incomeunder § 710 (the legislative proposalon carried interests discussed above)the recharacterized income would besubject to SECA.

5555

Comparing SECA and FICA

Since partner pays 100% of SECA, butemployee pays only part of FICA, a partner in aservice partnership will pay more on a givenamount of net earnings from self-employmentthan an employee will pay on the same amountof wages.

Should a partner be paid more than acomparable employee, to take SECA intoaccount?

565656

SECA and “Limited Partners”

“Limited Partners” are subject to SECA only on“guaranteed payments” for services. Code §1402(a)(13).

Are LLC members “general partners” or “limitedpartners”? Proposed regulations from 1997 would have provided

guidance on when LLC members (and also partners inpartnerships) would be treated as limited partners forpurposes of self-employment tax. Prop Reg § 1.1402(a)-2.

The proposed regulations became a political hot potato;they won’t be finalized without direction from Congress.

5757

LLC Members as “Limited Partners”

Under the 1997 Proposed Regulations, a partner is nottreated as a limited partner if the partner:

Has personal liability for the debts of or claims againstthe partnership by reason of being a partner;

Has authority to contract on behalf of the partnershipunder the statute or law pursuant to which the partnershipis organized; or

Participates in the partnership's trade or business formore than 500 hours during the taxable year.

However, for service partnerships (in health, law,engineering, architecture, accounting, actuarial science, orconsulting), any individual who provides services as part ofthe partnership’s trade or business will not be considered alimited partner.

585858

LLC Members as “Limited Partners”

In the absence of final regulations, LLCs takedifferent positions. The most conservative LLCs assume LLC

members are never limited partners. Reasonably conservative LLCs follow the 1997

proposed regulations. More aggressive LLCs exclude amounts above

“reasonable compensation” from self-employment tax.

The most aggressive LLCs assume all LLCmembers are limited partners.

595959

LLCs vs. S Corps

S Corp shareholder/employees are subject to FICA andnot SECA.

A portion of earnings that would be subject to self-employment taxes if earned by a sole proprietor orpartner may in some cases escape employment tax ifgenerated by an S Corp.

Dividends from S Corps are not subject to employmenttax, even if paid to a shareholder/employee.

However, the IRS has been actively challenging closely-held S Corps for failure to pay reasonablecompensation.

606060

LLCs vs. S Corps

From time to time Congress has considered proposals tosubject many S Corp shareholders to the same treatmentas general partners.

If you are choosing an S Corp over an LLC taxed as apartnership in order to save employment taxes, considerthat: Saving may be illusory even under current law.

Congress may amend the rules to ensure that many S Corpshareholders/employees pay the same amounts as generalpartners.

Unlike LLCs, S Corps generally cannot be liquidated tax-free (orconverted into partnerships); you likely will be stuck as an S Corp(or a C Corp) indefinitely, even if Congress changes the rules.

Many other disadvantages of S Corps over LLCs.

Reduced compensation may limit the opportunity for qualifiedretirement plan contributions.

616161

Tax on “Net Investment Income”

A special “Medicare” tax on net investment income of higher-incomeindividuals went into effect in 2013. Code § 1411; see TD 9644 (Dec.2, 2013) (adopting final regulations)

The tax is 3.8% of “modified adjusted gross income” above athreshold ($250,000 for joint returns).

Net investment income includes active business income of apartnership if the partner does not actively participate in the business.

Incorporates concepts from “passive activity loss” rules.

Benefit of “actively participating” would be lost under some legislativeproposals.

A partner is not subject to both self-employment tax and netinvestment income tax on the same income.

However, a higher-income partner most likely will have to pay oneor the other on income passed through from the partnership.

626262

Increased Medicare Tax

Effective in 2013, additional 0.9% Medicare(hospital insurance or HI) tax applies to wages inexcess of: $250,000 (joint return or surviving spouse).

$125,000 (married filing separate).

$200,000 (other cases).

Also applies to self-employment income inexcess of these amounts.

Previously, there had been no progressivity inthe rates of employment and self-employmenttax.

6363

Employee Benefits

Some favorable benefit rules do not cover partners.

For example, a partner may not exclude fromincome: Premiums paid by the partnership for accident and

health insurance. § 105.

However, a partner is entitled to deduct 100% of thepremium the partner pays. § 162(l).

Group-term life insurance. § 79; Reg § 1.79-1(b)(2).

Value of meals and lodging furnished for theconvenience of the employer. § 119.

Qualified transportation fringes or qualified movingexpense reimbursement. Reg § 1.132-1(b).

6464

Deduction of Business Expenses

One benefit of partner status is that apartner is entitled to deduct businessexpenses. § 162.

An employee may only deduct businessexpenses to the extent they -- along withother “miscellaneous itemized deductions” --exceed 2% of adjusted gross income. § 67(and alternative minimum tax is a problemalso).

6565

Phantom Income Employees are generally not taxed on amounts

they don’t receive. However,

Some non-cash compensation may be taxable.

Sometimes deferred compensation may be taxablebefore it is received.

Partners holding profits interests are taxed on theirdistributive share of partnership income, whetheror not received.

The risk of “phantom income” (taxable incomewithout a corresponding payment to thepartner) can be reduced but never entirelyeliminated.

6666

State Tax

An employee is only taxable where the employee livesand/or works.

A partner may be taxable in every state in which thepartnership does business.

Tax credits in the partner’s home state can greatly reducethe financial burden, but do not necessarily eliminate it.

If the home state has no income tax, the tax the partnerpays to other states is a pure cost (no offsetting benefit athome).

“Composite returns,” filed by the partnership on behalf ofnon-resident partners, can greatly reduce the complianceburden, but sometimes increase the amount tax payable.

6767

Converting Partners to Employees

Many individuals prefer the simplicity of wagewithholding.

This preference is especially pronounced outsideprofessions -- like law and accounting -- thattraditionally operated in partnership form.

Sometimes there are more substantivedisadvantages of partner status, such as the statetax cost for individuals who live in low-tax states butare members of partnerships doing business in low-tax states.

6868

Converting Partners to Employees At the same time, it is often important for those individuals

to have an equity stake in the business.

As the partnership and LLC form of doing business keepsexpanding, this dilemma becomes more acute

Every proposed solution has a down side, but there aresome alternatives worth considering. One popular structure is the “tiered” partnership diagrammed on the

next slide.

If you have a profits interest in the upper-tier partnership but areemployed by the lower-tier partnership, did you receive the profitsinterest for service to or for the benefit of the lower tier?

6969

Converting Partners to Employees

“A” and “B” are partners in LLC Holdco.

Since A and B are no longer partners in LLC, they likely can be employees ofLLC.

LLC

Other OwnersLLC

Holdco

A B

7070

“Phantom” Equity

LLCs sometimes try to avoid reclassifying employees aspartners by giving them only some type of contractual rightthat is based in some way on equity (which might be called“phantom” equity). Designed to replicate or resemble the economic benefits of a

partner’s equity interest, but without the tax consequences of partnerstatus.

“Virtual options” or “equity appreciation rights” are a kind of“phantom” equity, intended to give the employee a share ofthe LLC’s appreciation in value, without turning theemployee into a partner for tax purposes.

“Phantom” equity likely needs to comply with the 409A rules

applicable to corporations.

7171


There is good authority that the holder ofcorporate stock appreciation rights (“SARs”) is nota stockholder for tax purposes. See, for example,Rev Rul 80-300, 1980-2 CB 165.

There is no comparable express authority that theholder of LLC equity appreciation rights is not apartner for tax purposes.

However, LLCs generally take the position that thecorporate precedents apply.

7272


There are not even proposed regs on “phantom”interests in partnerships.

However, the following treatment seems reasonable: Assuming the “phantom” interest is not treated as an

actual interest for tax purposes, the employee is not betreated as a partner.

The employee should not have any income on receipt ofthe interest.

The employee has ordinary compensation income equal tothe payments from the partnership.

The partnership should have a deduction (or at worst acapitalized cost) when it pays the employee.

The partnership should not recognize income on grantingthe interest.

7373

Single-Member LLCs

In most cases a single-member LLC isclassified as a disregarded entity (treatedmore or less like a branch or division of itsowner) for federal income tax purposes.

Effective January 1, 2009, disregardedLLCs are treated as corporations for federalemployment tax purposes.

Reg § 301.7701-2(c)(2)(iv), as amendedby TD 9356, 2007-39 IRB 675.

7474

Single-Member LLCs

If the single-member LLC hasemployees, it must report and payfederal employment taxes under its ownname and have its own taxpayeridentification number.This rule covers FICA, FUTA, and income

tax withholding on wages.

7575

Single-Member LLCs

Previously, Notice 99-6, 1999-1 CB 321, gavetaxpayers two reporting choices:

Single-member LLC is employer, or

Owner of single-member LLC is employer.

Excise tax is also now reported separately bysingle-member LLC.

Income tax treatment of single-member LLCsis not affected by employment tax and excisetax rules.

767676

Investment Funds

2% Service Fee

Investors

Investments

IndividualManagers

20% Profits Interest

1% CapitalManager,LLC

99% Capital

Affiliate, LLC

Fund,

LP

77

Income from Investment Funds

Fee/Salary: In private equity and many other types of investment

vehicles, the manager (who may be an LLC member or ageneral partner) is paid an annual fee (payable in quarterlyinstallments equal to a percentage (typically 2%) of thetotal amount of capital commitments.

While originally designed to cover day-to-day expenses ofthe fund manager, over time, it has come to be anindependent source of profits for the fund managers.

Managers receiving the annual fee are often affiliates ofthe LLC member or general partner, and not members orpartners directly.

77

78

Income from Investment Funds

Return on Capital:Most investment funds want the manager to

have some “skin in the game” and thusrequire a contribution of a specifiedpercentage of the invested capital (often just1%).

When capital is called from the investors,the manager is obligated to contribute itsspecific share of invested capital.

Capital contributions are sometimesrequired by operating businesses grantingprofits interests, but this is probably lesscommon.

78

7979

Allocations and Distributions

An LLC distribution is an amount that the LLC member receives.

An LLC allocation is an amount of profits, losses, or other items thatare attributed to the member on the LLC's books.

Typically -- although there are many exceptions -- the distribution istax-free and the allocation is taxable. The allocation is taxable whether or not there is a corresponding

distribution.

It may seem exactly backwards that you can receive distributions tax-free but must pay tax on accounting entries. However, for holders ofLLC equity interests, that is the normal pattern.

Contributions, distributions, and allocations are interrelatedconcepts. Over the life of the LLC, contributions plus or minus allocations equal

distributions.

Any time you change one of these items – contributions, distributions,and allocations – you must consider how the others may be affected.

8080

Two LLC Drafting Approaches

Layer-cake allocation (the more traditionalapproach).

Specifies the allocation of income and loss.

Liquidating distributions are made so as to matchallocations. More precisely, the distributions are made in accordance with

the capital accounts, which in turn reflect the allocations thathave been made.

Considered the safer approach under the taxregulations.

However, may give the members less certainty aboutthe way liquidating distributions will be made.

8181

Two LLC Drafting Approaches Targeted (forced) allocation.

Specifies the distribution of proceeds on liquidationof the LLC.

Allocations are made so as to match liquidatingdistributions. More precisely, allocations are made so that capital accounts

(subject to some adjustment) equal the amounts that would bedistributed on a liquidation of the LLC at book value.

Validity of approach under tax regulations is less clear.

However, it is now widely used, and may give themembers more certainty about the way liquidatingdistributions will be made.

This approach requires special care when dealing withprofits interests.

8282

Example: Layered Allocations

Investors put in $1,000 and get 50 Class A Units.

Workers put in services and get 100 Class B Units.

50 Class B Units are issued on the first day of Year One,when the net value of all the LLC's assets is $1,000.

Class B Unitholders receive nothing unless operatingprofits and/or appreciation in value increase the value ofthe LLC to more than $1,000, but above that pointdistributions are pro rata by unit.

50 Class B Units are issued on the first day of Year Two,when the net value of all the LLC's assets has increasedto $3,000.

Nothing else of relevance occurs during the year (i.e., nocapital contributions, distributions, profits, or losses).

8383


Allocation of Profit and Loss: Allocate profits to offset prior losses. Allocate all remaining profits pro rata by unit. Allocate losses in accordance with capital accounts.

Before the Year Two Class B Units areissued, the $2,000 of increased value istreated as profit for purposes of “booking up”(restating) capital accounts of all unit holders. Capital accounts for Class A Units and Year One

Class B Units are increased by $2,000/150 = $13.33per unit.

8484


Liquidating Distributions: Distribute proceeds in accordance with capital accounts.

Does this work? Greatly oversimplified, but generally yes.

On immediate liquidation after the Year Two units arereceived: Class A Units first get back $1,000. $2,000 is distributed pro rata between Class A Units and Year One

Class B Units. Holders of Year Two Class B Units get nothing. Even if all Class B Units looked the same on the surface, they in fact

carried different rights; they were associated with different capitalaccounts.

All Class B Units are profits interests

However, some Class B Units carry greaterdistribution rights than others.

8585

Example: Targeted Allocations

Same basic facts.



50 Class B Units are issued on the first day of Year One,when the net value of all the LLC's assets is $1,000.

Class B Unitholders receive nothing unless operatingprofits and/or appreciation in value increase the value ofthe LLC to more than $1,000, but above that pointdistributions are pro rata by unit.

50 Class B Units are issued on the first day of Year Two,when the net value of all the LLC's assets has increasedto $3,000. So there are now 150 Class B Units.

Nothing else of relevance occurs during the year (i.e., nocapital contributions, distributions, profits, or losses).

8686


Allocation of Profit and Loss: Allocate as needed so that capital accounts are equal to the

required liquidating distributions.

$2,000 of increased value is treated as Profit for purposesof “booking up” (restating) capital accounts of all unitholders, so that capital accounts equal amounts that wouldbe distributed on liquidation. Capital accounts for Class A Units and Class B Units are increased

by $2,000/200 = $10.00 per unit.

On liquidation, Class A Units get back their capital, andthen all distributions are pro rata by unit.

Does this work?

No.

8787


On liquidation, Class A Units get back anyunrecovered capital, and then all distributions arepro rata by unit. Class A Units first get $1,000. Additional $2,000 is shared pro rata by all units

($10.00 per unit), including Class B Units issued inYear Two.

Class B Units issued in Year One are profitsinterests, generally not taxable to the workers onreceipt. On immediate liquidation after the units were received,

Class B Units would get none of the $1,000. On liquidation after a year, Class B Units do get $10.00

per unit.

8888


On these facts, Class B Units issued in Year Twoare capital interests, generally taxable to theworkers on receipt. On immediate liquidation after the units are received,

these Class B Units get $10.0 per unit. The right to receive proceeds on a liquidation is the

definition of a capital interest. Class B Units issued in Year Two are capital interests;

they would share in a liquidating distribution even ifthere are no future profits or growth.

All Class B Units had equal distribution rights, but theYear Two Class B Units were taxable capital interests.

8989


Class B Units issued in Year Two should have had lowerdistribution rights than Class B Units issued in Year One,the same as in the layered allocation example.

It is possible to use targeted allocations even whenworkers receive profits interests at different times, but becareful. For example, LLC could have granted only “Class C Units” in Year

Two, and provided that Class C Units only share in liquidatingdistributions over $3,000.

Regardless of the allocation method, or the labels thatare given to the units, profits interests granted atwidely different times normally will not have the exactsame rights to receive LLC distributions; and if theydo have the exact same distribution rights they likelyare not strictly profits interests.

90

“Catch-Up” Allocations Assume same facts of the previous example.



50 Class B Units are issued on the first day of Year One, when the netvalue of all the LLC's assets is $1,000.

Class B Unitholders receive nothing unless operating profits and/orappreciation in value increase the value of the LLC to more than$1,000, but above that point distributions are pro rata by unit.

Assume that the only Class B Units are the ones issued at the outset.

If the LLC liquidates and distributes the proceeds and theproceeds are $3,000, Class A Unit get all of the first $1,000,and then proceeds are distributed pro rata by unit.

Class A Units have a permanent advantage over Class BUnits.

90

91

“Catch-Up” Allocations

There is a way for the Class B Units to eventually catch-up to, and beon a par with Class A Units, if that is what the parties want.

Under the first example, Class B Units are entitled to 2/3 of amounts abovethe first $1,000.

However, the parties could instead give the Class B Units a right to allamounts above the first $1,000, until Class B Units are entitled to the sameamount per unit as Class A Units.

Under this approach, Class B Units are entitled to all of the $2,000increase in value that accrued while they held their units.

Class B Units then receive 2/3 of all amounts distributed on liquidation, andthey have the same right per unit as the Class A Units.

All units receive $20 per unit.

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92

“Catch-Up” Allocations

Under the Catch-Up Allocation approach, Class BUnits still qualify as profits interests because theirright to anything above $1,000 is contingent onfuture profits.

If the LLC had liquidated on day one and the proceedswere only $1,000 – the amount the investor put in – theClass B Units would have been entitled to nothing.

Whether or not Class B Units should ever catch-upto Class A Units is a business decision – itdepends on the particular business deal.

92

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Operating Incomevs. Capital Appreciation

A profits interest typically gives the manager theright to a share of:

Future operating income.

Future appreciation or capital gain.

However, the parties often are more concernedabout giving the manager an equity stake incapital gain than in operating income.

It is possible to give the manager a larger share offuture capital gain than of future operating income.

Many advisors believe it is possible to give themanager a share only of future capital gain, with noshare of operating income. 93

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