Business Law Institute May 2011Equity Compensation in a Pass-through World Presented by: David D. Brauer Lurie Besikof Lapidus & Company Kevin W. Kaiser Lindquist & Vennum
Equity Compensation in a Pass-through WorldANY TAX ADVICE CONTAINED IN THIS COMMUNICATION IS NOTINTENDED OR WRITTEN TO BE USED, AND CANNOT BE USED FORTHE PURPOSE OF (i) AVOIDING PENALTIES THAT MAY BEIMPOSED ON ANY TAXPAYER OR (ii) PROMOTING, MARKETING ORRECOMMENDING TO ANOTHER PARTY ANY MATTERSADDRESSED HEREIN.The information contained herein is general in nature and based onauthorities that are subject to change. Applicability to specific situations isto be determined through consultation with your tax adviser.
Equity CompensationCorporations have long used equity to compensate employeesDuring the 1990s and early 2000s, stock options became increasinglyimportant method of compensating corporate executives andemployeesTotal compensation of executives of the largest public companies In recent years, increasing proportions of total compensation have been represented by equity, including various forms of employee stock options and restricted sharesLLCs want in on the action…
Equity CompensationDirect issuance of ownership interest Equity Common stock Preferred stock Partnership interest (general or limited) LLC membership interest Compensatory options Options on equity interest A type of call option, although in the employment context special rules apply Equity Appreciation Rights Cash compensation designed to mirror compensatory options
Terminology - AuthorityLLC/Partnership rules (Subchapter K) – Partner’s percentage interest Capital interest This is where the analysis between LLCs and corporations part company Profits interest Contrast with interest in a corporation – Partner capital account rules
Equity CompensationCorporate treatment, generally… Equity interest (unrestricted) Income to employee when issued Deduction to corporation Note – If restricted, recognition occurs when restrictions lapse Unless elect otherwise Stock options Two types of compensatory options - Incentive stock options (ISOs) – nontaxable/nondeductible - Nonqualified options – taxable/deductible
Partnership Equity CompensationThe early cases… Diamond v. Commissioner, 492 F.2d 286 (7th Cir. 1974) Campbell v. Commissioner, 943 F.2d 815 (8th Cir. 1991)
Diamond v. Commissioner (1974)1. K acquires option to purchase building2. K asks D to arrange financing in exchange for 60% profits Sold interest in P/S3. P/S formed and K D building acquired with D arranged financing 40% P & L4. No D cash outlay 60% P & L 100% Capital5. D sells 60% profits interest for $40K (three weeks later)6. Court rules D must K&D recognize receipt of P/S interest
Campbell v. Commissioner (1991)1. C negotiates employment contract providing that C will receive a % of partnership profits in exchange for services2. C treats the receipt of S C the profits interest as nontaxable3. IRS challenges 15% P & L 85% P & L nontaxable treatment 100% Capital4. Tax Court held taxable5. Appellate Court held nontaxable because S&C P/S interest had no ascertainable value
The 40 Year Saga of Taxing Partnership Profits Interests for Services• Diamond v. Commissioner (1971)• Proposed Partnership Regulation (1971)• Campbell v. Commissioner (1991)• Revenue Procedure 93-27• Revenue Procedure 2001-43• Proposed Regulation on noncompensatory options (2003)• Private Letter Ruling 200329001 (only PLR on p/s interest for services)• Proposed Partnership Regulations (2005)• Proposed Revenue Procedure 2005-43 What’s the problem? Why is this so hard?
What’s the problem? Why is this so hard?• Valuation – Capital Account Interest – Profits-only Interest• Partner Issues – Amount of income – Timing of income – Character of income• Partnership Issues – Partnership deduction – When? How much? – When is the service provider considered a partner? – How are capital accounts maintained?
Current Guidance Revenue Procedure 93-27Generally, the receipt of a partnership profits interest forservices is tax free to the recipient – “Profits interest” defined as an interest that would not give the holder a share of the proceeds if the partnership sold all of its assets for FMV and liquidated immediately upon issuance of the profits interest. – Exceptions Predictable stream of cash flow (i.e., bonds, rents) Partner disposes of partnership interest within two years Publicly traded partnership
Current Guidance Revenue Procedure 93-27Conflicts with Section 83 (remember the rules for corporatestock) Rev. Proc. 93-27 measures taxability of the interest at the time of issuance Section 83 measures the taxability of a transfer of property at the later of the time of the transfer or the vesting of the property Example Ifan unvested partnership profits interest were issued which was a profits interest under Rev. Proc. 93-27 on the date of transfer but a capital interest on the date of vesting, Rev. Proc. 93-27 and section 83 could be in direct conflict.
Current Guidance Revenue Procedure 93-27Conflicts with Section 83 (remember the rules for corporatestock) Rev. Proc. 93-27 measures taxability of the interest at the time of issuance Section 83 measures the taxability of a transfer of property at the later of the time of the transfer or the vesting of the property
Current Guidance Revenue Procedure 93-27Conflicts with Section 83 (remember the rules for corporatestock)ExampleIf an unvested partnership profits interest were issued whichwas a profits interest under Rev. Proc. 93-27 on the date oftransfer but a capital interest on the date of vesting, Rev. Proc.93-27 and section 83 could be in direct conflict.
Current Guidance Revenue Procedure 2001-43Rev. Proc. 2001-43 issued to resolve this conflict between section 83 andRev. Proc. 93-27The time for testing whether the interest qualifies as a profits interest is,under certain circumstances, when the interest is granted (Note – section83(b) election not required, see PLR 200329001) The service provider must be treated as a partner from the time of grant Neither the partnership nor the other partners could deduct any amount in respect to the vesting of the interest, and The interest otherwise must qualify as a profits interest under Rev. Proc. 93-27
ValuationWhat is the correct method for valuing a capital interest forservices?Under current law: Relinquishment of capital Value added Cost of services Discounted value
Valuation of Capital interestExample: X and Y each contribute $10,000 to a newly formed LLC, inexchange for 50% capital interest in LLC. Shortly thereafter, Z is issueda 33 1/3% vested capital partner interest solely in exchange forservices being rendered to the partnership at that time. X’s and Y’scapital interests are each reduced to 33 1/3% to reflect this change.Query – What is the proper amount for Z to include in compensationincome (and LLC to deduct for Z’s services)?
Valuation of Capital interest Y X Z $10K Service Partner$10K X&Y&Z
Carried InterestDefinition of "Carried Interest"The Carried Interest is a share of fund net profits allocated to theGeneral Partner that is disproportionate to the General Partner’s capitalcommitment to the fund.The total compensation received by an investment advisor to a privateinvestment fund ordinarily will comprise a management fee and theperformance fee. A traditional arrangement will award the advisor amanagement fee of 2% of net assets under management, and a 20%performance fee, or "Carried Interest".
Carried InterestFund Capitalization Capital Committed by Investors: 99% Capital Committed by General Partner: 1%
Carried InterestTypical Allocation of Fund Net Profits• Proportionate Allocation: 80% to all Partners (including the General Partner) in proportion to their respective capital commitments• Carried Interest Allocation: 20% to the General Partner
Simple Fund Structure General U.S. Taxable Investors (limited partners) Partner 99% 1% 20% Carried Interest Investment Limited Partnership Prime Broker Advisor (U.S.) 2% Mgmt Fee Administrator
Carried InterestCarried Interest under scrutiny by Congress:The previous Congress proposed legislation designed to treat theCarried Interest income as ordinary income received as compensation. Why the proposed change? Whats the problem?
Carried InterestCarried Interest under scrutiny by Congress:• Congress views the Carried Interest arrangement as abusive Compensation income can be characterized as capital Compensation income can deferred
Carried InterestCarried Interest under scrutiny by Congress:• Legislative changes have been proposed since 2007• Targeted primarily at partners performing investment management services• Easy to discuss, hard to design a law that addresses the issue
Carried InterestCarried Interest under scrutiny by Congress:• Recent proposed legislation was introduced in September 2010 In addition to other changes, the proposal directed ordinary income treatment at any person (including corporation or partnership) that holds an investment services partnership interest ("ISPI"). The proposal included: o ISPI related income must be treated as ordinary o Dispositions of ISPIs treated as ordinary and must be taxable o Property distributions treated as ordinary o Deferring losses allocated to ISPI holders o Subjecting ISPI income to self-employment taxes
Carried InterestCarried Interest under scrutiny by Congress:Questions and concerns about "Carried Interest" changes. • How will Carried Interest rules be applied to real estate partnerships? Does the ISPI definition extend to real estate? • Corporate joint ventures? • Normal return on invested capital? • Mergers and Acquisitions (M&A) transactions?
Plans To Mirror EquityPhantom Stock or Phantom Equity Financial Rights No Voting AuthoritySection 409A Scared Many Away
Plans To Mirror EquitySection 409A Merely Adds HurdlesDocumentation Is The KeyNo Acceleration But Lots Of Creativity