One drawback of private companies is they’re not liquid, meaning you can’t sell your shares easily. That’s why lots of people are spending lots of time and money creating secondary markets for private companies. These secondary markets typically take the form of an “alternative trading system,” or ATS, owned and operated by a broker-dealer. More on secondary markets here.
If you’re raising money for an LLC it’s attractive to have the interests traded on an ATS because you can tell prospective investors they’ll have liquidity, in theory if not in practice. But there’s a drawback, too: if interests of in the LLC are traded on an ATS then the LLC might be treated as a corporation for tax purposes, not as a partnership, with potentially bad consequences.
If you’re interested in the differences between partnerships and corporations you can read this, but suffice it to say that (i) if you’re an LLC you probably made that choice intentionally, and (ii) a corporation is subject to two levels of tax on exit, significantly reducing the anticipated after-tax return to investors.
Under section 7704 of the Internal Revenue Code, a partnership (including an LLC taxed as a partnership) will be treated as a corporation for tax purposes if either:
- Interests in the partnership are traded on an established securities market; or
- Interests in the partnership are readily tradable on a secondary market “or the substantial equivalent thereof.”
The interests in a private LLC typically aren’t going to be traded on NASDAQ or any other established securities market, so we don’t worry about the first rule. But we do worry about the second rule. Interests in a partnership will be deemed readily tradable on a secondary market or the equivalent if:
- Interests in the partnership are regularly quoted by any person, such as a broker or dealer, making a market in the interests; or
- Any person regularly makes available to the public (including customers or subscribers) bid or offer quotes with respect to interests in the partnership and stands ready to effect buy or sell transactions at the quoted prices for itself or on behalf of others; or
- The holder of an interest in the partnership has a readily available, regular, and ongoing opportunity to sell or exchange the interest through a public means of obtaining or providing information of offers to buy, sell, or exchange interests in the partnership; or
- Prospective buyers and sellers otherwise have the opportunity to buy, sell, or exchange interests in the partnership in a time frame and with regularity and continuity.
Focus on the third bullet point. The whole point of listing LLC interests on an ATS is to give investors a readily available, regular, and ongoing opportunity to sell or exchange the interest. Hence, listing your LLC’s interests on an ATS will automatically turn your partnership into a corporation for tax purposes – unless you satisfy one of the exceptions.
This is the Internal Revenue Code so there are exceptions and exceptions to the exceptions and so on. How else would lobbyists put food on the table?
These are the primary exceptions:
- Exception for Private Placements: Your LLC raised capital in a private offering (including Rule 506(c) and Reg CF) and has no more than 100 members.
- No Actual Trading: Interests in your LLC are listed on an ATS but no more than 2% of all interests are traded each year.
- Exception for Passive Income and the Oil & Gas Industry: At least 90% of your LLC’s income is from interests, dividends, rent, gains from the sale of real estate or capital assets, or the oil & gas business.
- Qualified Matching Service: Interests in your LLC are traded only through a “qualified matching service” and no more than 10% of the interests are traded each year. A qualified matching service is where:
- The service consists of a system that lists bid and/or ask quotes in to match sellers to buyers;
- Matching occurs either by matching the list of buyers with the list of sellers or through a bid and ask process;
- The selling partner cannot enter into a binding agreement to sell the interest until the 15th day after the date information regarding the offering of the interest for sale is made available to potential buyers;
- The closing of the sale does not occur prior to the 45th day after the date information regarding the offering of the interest for sale is made available to potential buyers;
- The matching service displays only quotes that do not commit any person to buy or sell a partnership interest at the quoted price or quotes that express interest in a partnership interest without an accompanying price and does not display quotes at which any person is committed to buy or sell a partnership interest at the quoted price;
- The selling partner’s information is removed from the matching service within 120 days after the date information regarding the offering of the interest for sale is made available to potential buyers and, following any removal (other than removal by reason of a sale of any part of such interest) of the selling partner’s information from the matching service, no offer to sell an interest in the partnership is entered into the matching service by the selling partner for at least 60 days.
Many real estate LLCs will satisfy the exception for passive income (real estate rent), although they should be careful with other sources of income, like income from a parking lot or laundry facility. Most LLCs in the oil & gas business will satisfy the same exception because it was written for them. An LLC formed to hold treasury bonds is obviously okay.
But the large majority of LLCs raising money in Crowdfunding conduct other businesses, everything from technology to baby wipes. These companies must weigh the benefit of trading on an ATS – theoretical liquidity – against the cost of being treated as a corporation for tax purposes.
NOTE: You could list the interests of your LLC on an ATS but limit trading to stay below the allowed annual thresholds. But of course that limits liquidity for your investors, taking some of the air out of your marketing message.
2 thoughts on “Publicly-Traded Partnerships: The Trap for LLCs Traded on ATS”
The keywords are established and readily.
Without a market maker in the loop I fully expect interests to trade occasionally and in the low single digits.
I agree with you.