Category: Tax

Proposed Changes To Taxation Of Carried Interests

On By crowdfundattnyIn JOBS Act, TaxLeave a comment

The Inflation Reduction Act of 2022 promises big changes to how America responds to global warming, aka climate change. But if enacted in its current form, it will also change how real estate sponsors and hedge fund managers are taxed on carried interests.

A “carried interest” or “promote” is what the sponsor gets for putting the deal together. In a typical hedge fund, the manager receives a 2% annual management fee plus 20% of the profits. In the syndication of an apartment building, the deal sponsor might receive 30% of the profits after investors have received a preferred return of 7% and all their money back. The 20% of the hedge fund manager and the 30% of the real estate sponsor are the “carried interest.”

For many years gains from carried interests were taxed as capital gains rather than ordinary income. This favorable tax treatment attracted widespread criticism, from Warren Buffett among others, and is often referred to derisively as the “carried interest loophole.”

As described here, section 1061 was added to the Internal Revenue Code to close, or at least narrow, the loophole. Under section 1061, gains from carried interests generally are treated as ordinary income if the interest is held less than three years. But in a loophole within a loophole, capital gain was preserved for most real estate syndications by excluding from section 1061 gains from the sale of property used in a trade or business, such as the ownership and operation of an apartment building.

The Inflation Reduction Act of 2022 includes two important changes to section 1061. One, the three year holding period will be extended to five years. Two, the exception for property used in a trade or business will be eliminated.

As someone famous once said, one man’s loophole is another man’s castle (or something like that). For many real estate sponsors, the carried interest is the primary source of income: annual management fees pay the bills, but the carried interest sends the kids to college. Increasing the tax rate on the carried interest by 20 percentage points or more is not trivial.

The capital gain rate is still available if the property is held for five years, but many real estate projects contemplate shorter holding periods.

If the changes are enacted in their current form, I expect sponsors will adjust the economic deal with investors. Most likely, we will see the carried interest percentage increase from around 30% to around 50%, at least for transactions where the holding period will be less than five years. For that matter, we will probably see longer holding periods for both hedge funds and real estate, as the market adjusts.

Senator Sinema of Arizona is a longtime fan of the carried interest loophole and hasn’t yet weighed in on the Inflation Reduction Act. You can bet she’s getting lots of phone calls as we speak.

Questions? Let me know.

Tax Alert for Sponsors and Fund Managers: IRS Issues Final Regulations for Carried Interests

On By crowdfundattnyIn TaxLeave a comment

Every real estate syndication and private investment fund involves a “carried interest” for the sponsor, also known as a “promoted interest.” The IRS just issued final regulations on how those interests are taxed.

A carried interest is what the sponsor gets for putting the deal together. For example, a typical waterfall might provide that on sale of the project investors receive a preferred return, then investors receive a return of their capital, then the balance is divided 70% to investors and 30% to the sponsor. That 30% is the sponsor’s carried interest.

For as long as anyone can remember the sponsor’s 30% carry has been taxed as capital gain. This favorable tax treatment has been the subject of considerable controversy given that the carry is paid to the sponsor not for an investment of capital but for the performance of services. Why should fund managers and deal sponsors be taxed at capital gain rates while hardworking Crowdfunding lawyers are taxed at ordinary income rates? Or so the issue has often been posed.

As a gesture in the egalitarian direction, the Tax Cuts and Jobs Act of 2017 – the same law that gave us qualified opportunity zones – added section 1061 to the Internal Revenue Code. Section 1061 provides that while carried interests are still taxed at capital gain rates, the threshold for long-term rates is three years rather than 12 months.

That means if an investment fund buys stock in a portfolio company and flips it at a profit after two years, the investors are taxed at long-term capital gain rates while the sponsor is taxed at ordinary income rates, a big difference.

IMPORTANT NOTE:  In the real estate world section 1061 applies to vacant land or a triple-net lease, but not to a typical multifamily rental project. (The issue is whether the asset constitutes “property used in a trade or business” under Code section 1231.)

The final regulations just issued by the IRS clarify a few points:

  • They clarify that the three-year holding period doesn’t apply to an interest the sponsor acquires by investing capital along with other investors.
  • They clarify that if the sponsor receives a distribution with respect to its carried interest and reinvests the distribution, the interest the sponsor receives as a result of the reinvestment is not subject to the three-year holding period.
  • They provide that if the sponsor sells its carried interest, you “look through” the partnership to determine the holding period of the partnership’s assets.
  • They provide that if the sponsor transfers the carried interest to a related party, the sponsor can recognize taxable phantom gain.
  • They deal with in-kind distributions of assets to the sponsor with respect to the carried interest.

Section 1061 is one more tripwire for deal sponsors and their advisors. Be aware!

Opportunity Zone Funds in Crowdfunding

On By crowdfundattnyIn Opportunity Zone Funds, Qualified Opportunity Zone Funds, Tax2 Comments

businessman stack of coins.jpg

Everywhere you look, there’s another opportunity zone fund. What are these things and why are they suddenly so popular?

The Tax Savings

It’s all about taxes, specifically capital gain taxes. Added to the Internal Revenue Code by the 2017 tax act, new section 1400Z-2 allows investors to reduce their capital gain taxes in four increasingly-generous levels:

  • Level One Savings: If you sell property (including property sold through a partnership or limited liability company) and recognize a capital gain, then you don’t have to pay tax right away on the gain to the extent you invest in a “qualified opportunity zone fund,” or QOZF, within 180 days. Instead, the gain is deferred until the earlier of (i) the date you sell your interest in the QOZF, or (ii) December 31, 2026.

EXAMPLE:  You bought stock two years ago for $1,000, and sell it during 2018 for $1,100, recognizing a $100 capital gain. If you invest $75 in a QOZF within 180 days, you pay tax in 2018 only on $25 of the gain. You pay tax on the $75 on the earlier of the date you sell your interest in the QOZF or 12/31/2026.

It gets better.

  • Level Two Savings: If you hold your investment in the QOZF for at least five years, you get to increase your tax basis in the QOZF by 10% of the gain you deferred, further reducing your tax bill.

EXAMPLE:  In the example above, if you hold your investment in the QOZF for at least five years, you get to increase your tax basis by 10% of $75, or $7.50.

And better.

  • Level Three Savings: If you hold your investment in the QOZF for at least seven years, you get to increase your tax basis in the QOZF by another 5% of the gain you deferred.

And better.

  • Level Four Savings: If you hold your investment in the QOZF for 10 years, you pay no capital gain tax on the appreciation in the QOZF.

EXAMPLE:  If, in the original example, you invested $75 in the QOZF and sold it after 10 years for $195 (10% appreciation per year, compounded), you would pay no tax on the $120 of appreciation. 

What if the Value of the QOZF Goes Down?

If you lose money on the QOZF, then your tax on the original capital gain also goes down. 

EXAMPLE:  You sell appreciated stock for a $100 profit, and invest $75 in a QOZF. Three years later, you sell your interest in the QOZF for $50 (I’m assuming your tax basis in the QOZF hasn’t changed). You pay tax on only $50 of capital gain, not the whole $75.

Thus, it’s heads-you-win, tails-the-government-loses. 

What’s A Qualified Opportunity Zone Fund?

A qualified opportunity zone fund means a corporation or partnership that holds 90% of its assets in any mix of the following assets:

  • Stock of a corporation that is a “qualified opportunity zone business.”
  • An interest in a partnership that is a “qualified opportunity zone business.”
  • “Qualified opportunity zone property.”

A “qualified opportunity zone business” is a business substantially all of the assets of which are qualified opportunity zone property.”

”Qualified opportunity zone property” means property that is:

  • Located in a “qualified opportunity zone”;
  • Used by the QOZF in a trade or business; and
  •  Either:
    • The property is brand new (g., ground-up construction); or
    • Within 30 months, the QOZF or the qualified opportunity zone business spends at least as much to renovated the property as it paid to buy it.

Boiled down version:  A qualified opportunity zone fund means a fund that, directly or indirectly, owns new or substantially renovated business assets in a qualified opportunity zone.

Only New Businesses or Assets Count

In figuring out whether a fund is a qualified opportunity zone fund, you take into account only property acquired after 12/31/2017.

Does it Matter Where the Capital Gain Came From?

No. The capital gain you’re deferring could come from the sale of appreciated stock, the sale of real estate, the sale of artwork, or anywhere else.

An Alternative to A Like-Kind Exchange

Under section 1031 of the Internal Revenue Code, the owner of appreciated real estate (only real estate) can defer paying tax on sale by exchanging the real estate for different real estate. In fact, a whole industry has grown up around these so-called “like-kind exchanges.”

For as long as it lasts, the QOZF provides a simpler and possibly better alternative.

What is a Qualified Opportunity Zone?

A “qualified opportunity zone” means a low-income area that has been nominated as such by the Governor of a state and approved by the U.S. Treasury. A list is of current qualified opportunity zones is available here.

No Massage Parlors

In a crippling blow to my own business plans, a “qualified opportunity zone business” does not include massage parlors or hot tub facilities. Nor does it include golf courses, country clubs, suntan facilities, racetracks or other facilities used for gambling, or liquor stores.

Can I Use an LLC?

Section 1400Z-2 itself defines “qualified opportunity zone fund” as a “corporation or partnership.” However, section 7701(a)(2) of the Internal Revenue Code defines “partnership” follows:

The term “partnership” includes a syndicate, group, pool, joint venture, or other unincorporated organization, through or by means of which any business, financial operation, or venture is carried on, and which is not, within the meaning of this title, a trust or estate or a corporation; and the term “partner” includes a member in such a syndicate, group, pool, joint venture, or organization.

Based on that definition, a limited liability company should work.

What if I Invest More in a QOZF?

Suppose you sell appreciated stock for a $100 capital gain, and within six months invested $150 in a QOZF. The favorable tax rules apply only to two-thirds of your investment. The other one-third is just a regular investment.

Who Can Form a Qualified Opportunity Zone Fund?

Anyone, literally. If you sell appreciated stock and want to defer or avoid tax on all or part of the gain, you can form your own QOZF.

Conversely, large companies, including large investment managers and large real estate developers, have already formed QOZFs, taking advantage of the tax benefits and the media buzz to raise capital.

Investment Company Act Limits

When Congress enacted the tax benefits for qualified opportunity zone funds, it could have created an exception to the investment company rules at the same time, making the funds even more appealing and effective. But it didn’t.

Consequently, and perhaps paradoxically, larger QOZFs — those with more than 100 investors — will have to own property directly, or take controlling interests in other businesses, to avoid being treated as investment companies. They will not be allowed to hold minority, non-controlling interests in businesses owned by others, such as, say, the residents of the qualified opportunity zone. 

How Can I Raise Capital for My QOZF?

You can raise capital using any method you like, including Title II Crowdfunding (Rule 506(c)), Title III Crowdfunding (Regulation CF), Title IV Crowdfunding (Regulation A), or Rule 506(b).

Qualified opportunity zone funds are about saving taxes, specifically capital gain taxes. They make less sense for non-accredited investors who, by definition, earn less money and pay tax at lower rates. Consequently, we will probably see fewer QOZFs using Title III or Regulation A to raise capital, and many using Rule 506(b).

More Rules to Come

The Internal Revenue Service hasn’t yet issued guidance on the details of this complicated legislation. Expect complicated regulations and at least a few surprises.

Waiting for the Other Shoe to Drop

How long will it take before a QOZF is sold using tokens?

Questions? Let me know.

 

The New 20% Deduction in Crowdfunding Transactions

On By crowdfundattnyIn Crowdfunding, Crowdfunding Laws, Crowdfunding Real Estate, Tax, Tax Reform, UncategorizedLeave a comment

Taxes and Income - iStock-172441475 - small.jpg

Co-Authored By: Steve Poulathas & Mark Roderick

The new tax law added section 199A to the Internal Revenue Code, providing for a 20% deduction against some kinds of business income. Section 199A immediately assumes a place among the most complicated provisions in the Code, which is saying something.

I’m going to summarize just one piece of section 199A: how the deduction works for income recognized through a limited liability company or other pass-through entity. That means I’m not going to talk about lots of important things, including:

  • Dividends from REITS
  • Income from service businesses
  • Dividends from certain publicly-traded partnerships
  • Dividends from certain cooperatives
  • Non-U.S. income
  • Short taxable years
  • Limitations based on net capital gains

Where the Deduction Does and Doesn’t Help

Section 199A allows a deduction against an individual investor’s share of the taxable income generated by the entity. The calculation is done on an entity-by-entity basis.

That means you can’t use a deduction from one entity against income from a different entity. It also means that the deduction is valuable only if the entity itself is generating taxable income.

That’s important because most Crowdfunding investments and ICOs, whether for real estate projects or startups, don’t generate taxable income. Most real estate projects produce losses in the early years because of depreciation deductions, while most startups generate losses in the early years because, well, because they’re startups.

The section 199A deduction also doesn’t apply to income from capital gains, interest income, or dividends income. It applies only to ordinary business income, including rental income*. Thus, when the real estate project is sold or the startup achieves its exit, section 199A doesn’t provide any relief.

Finally, the deduction is available only to individuals and other pass-through entities, not to C corporations.

*Earlier drafts of section 199A didn’t include rental income. At the last minute rental income was included and Senator Bob Corker, who happens to own a lot of rental property, switched his vote from No to Yes. Go figure.

The Calculation

General Rule

The general rule is that the investor is entitled to deduct 20% of his income from the pass-through entity. Simple.

Deduction Limits

Alas, the 20% deduction is subject to limitations, which I refer to as the Deduction Limits. Specifically, the investor’s nominal 20% deduction cannot exceed the greater of:

  • The investor’s share of 50% of the wages paid by the entity; or
  • The sum of:
    • The investor’s share of 25% of the wages paid by the entity; plus
    • The investor’s share of 2.5% of the cost of the entity’s depreciable property.

Each of those clauses is subject to special rules and defined terms. For purposes of this summary, I’ll point out three things:

  • The term “wages” means W-2 wages, to employees. It doesn’t include amounts paid to independent contractors and reported on a Form 1099.
  • The cost of the entity’s depreciable property means just that: the cost of the property, not its tax basis, which is reduced by depreciation deductions.
  • Land is not depreciable property.
  • Once an asset reaches the end of its depreciable useful life or 10 years, whichever is later, you stop counting it. That means the “regular” useful life, not the accelerated life used to actually depreciate it.

Exception Based on Income

The nominal deduction and the Deduction Limits are not the end of the story.

If the investor’s personal taxable income is less than $157,500 ($315,000 for a married couple filing a joint return), then the Deduction Limits don’t apply and he can just deduct the flat 20%. And if his personal taxable income is less than $207,500 ($415,000 on a joint return) then the Deduction Limits are, in effect, phased out, depending on where in the spectrum his taxable income falls.

Those dollar limits are indexed for inflation.

ABC, LLC and XYZ, LLC

Bill Smith owns equity interests in two limited liability companies: a 3% interest in ABC, LLC; and a 2% interest in XYZ, LLC. Both generate taxable income. Bill’s share of the taxable income of ABC is $100 and his share of the taxable income of XYZ is $150.

ABC owns an older apartment building, while XYZ owns a string of restaurants.

Like most real estate companies, ABC doesn’t pay any wages as such. Instead, it pays a related management company, Manager, LLC, $500 per year as an independent contractor. All of its personal property has been fully depreciated. Its depreciable real estate, including all the additions and renovations over the years, cost $20,000.

Restaurants pay lots of wages but don’t have much in the way of depreciable assets (I’m assuming XYZ leases its premises). XYZ paid $3,000 of wages and has $1,000 of depreciable assets, but half those assets are older than 10 years and beyond their depreciable useful life, leaving only $500.

Bill and his wife file a joint return and have taxable income of $365,000.

Bill’s Deductions

Calculation With Deduction Limits

Bill’s income from ABC was $100, so his maximum possible deduction is $20. The Deduction Limit is the greater of:

  • 3% of 50% of $0 = $0

OR

  • The sum of:
    • 3% of 25% of $0 = 0; plus
    • 3% of 2.5% of $20,000 = $15 = $15

Thus, ignoring his personal taxable income for the moment, Bill may deduct $15, not $20, against his $100 of income from ABC.

NOTE: If ABC ditches the management agreement and pays its own employees directly, it increases Bill’s deduction by 3% of 25% of $500, or $3.75.

Bill’s income from XYZ was $150, so his maximum possible deduction is $30. The Deduction Limit is the greater of:

  • 2% of 50% of $3,000 = $30

OR

  • The sum of:
    • 2% of 25% of $3,000 = 15; plus
    • 2% of 2.5% of $500 = $0.25 = $15.25

Thus, even ignoring his personal taxable income, Bill may deduct the whole $30 against his $150 of income from XYZ.

Calculation Based on Personal Taxable Income

Bill’s personal taxable income doesn’t affect the calculation for XYZ, because he was allowed the full 20% deduction even taking the Deduction Limits into account.

For ABC, Bill’s nominal 20% deduction was $20, but under the Deduction Limits it was reduced by $5, to $15.

If Bill and his wife had taxable income of $315,000 or less, they could ignore the Deduction Limits entirely and deduct the full $20. If they had taxable income of $415,000 or more, they would be limited to the $15. Because their taxable income is $365,000, halfway between $315,000 and $415,000, they are subject, in effect, to half the Deduction Limits, and can deduct $17.50 (and if their income were a quarter of the way they would be subject to a quarter of the Deduction Limits, etc.).

***

Because most real estate projects and startups generate losses in the early years, the effect of section 199A on the Crowdfunding and ICO markets might be muted. Nevertheless, I expect some changes:

  • Many real estate sponsors will at least explore doing away with management agreements in favor of employing staff on a project-by-project basis.
  • Every company anticipating taxable income should analyze whether investors will be entitled to a deduction.
  • Because lower-income investors aren’t subject to the Deduction Limits, maybe Title III offerings and Regulation A offerings to non-accredited investors become more attractive, relatively speaking.
  • I expect platforms and issuers to advertise “Eligible for 20% Deduction!” Maybe even with numbers.
  • The allocation of total cost between building and land, already important for depreciation, is now even more important, increasing employment for appraisers.
  • Now every business needs to keep track of wages and the cost of property, and report each investor’s share on Form K-1. So the cost of accounting will go up.

As for filing your tax return on a postcard? It better be a really big postcard.

New Tax Law Should Boost Crowdfunding

On By crowdfundattnyIn Tax, Tax ReformLeave a comment

Whatever you think of the new tax law as public policy, adding to the country’s fiscal deficit and favoring the wealthy over the poor and the middle class, it includes several provisions that should make Crowdfunding investments more attractive, especially for real estate:

  • Income from “pass-thru” entities like limited liability companies and limited partnerships is eligible for a 20% deduction, off the top. This immediately makes investing in a pass-thru interest more attractive than investing in a publicly-traded stock, despite the one-time increase in value for publicly-traded corporations (all of them “C” corporations for tax purposes) due to the decrease in corporate tax rates.
  • Real property may now be depreciated faster, resulting in higher depreciation deductions – and thus lower taxable income – in the early years.
  • Depreciation of personal property (equipment, etc.) is also accelerated.

Lucky for me, the new law also presents many opportunities to change the structure of your business to save taxes, penalizing some activities, rewarding others. If you’d like to talk about maximizing the benefits for your business, let me know.

Improving Legal Documents in Crowdfunding: New IRS Audit Rules

On By crowdfundattnyIn Crowdfunding, LLCs, Tax1 Comment

In the Crowdfunding world, almost every equity investment involves a limited limited liability company. Because (1) limited liability companies are treated as partnerships for tax purposes, and (2) Congress has just turned the law governing tax audits of partnerships on its head, all those LLCs will need to revise their Operating Agreements. And all new LLCs will have to follow suit.

Until now, tax disputes involving partnership were conducted at the partner level. That means the IRS had to pursue partners individually, based on each partner’s personal tax situation. With its budget cut and manpower reduced, the IRS was unable to pursue everybody.

Seeking to streamline partnership audits and ultimately collect more taxes, the (bipartisan) law just passed reverses that rule.  Now, the IRS conducts audits at the partnership level and no longer has to argue with all those partners and their accountants. In fact, even though partnerships are not normally subject to tax, under the new law the partnership itself must pay any tax deficiency arising from the audit, unless it makes a special election.

EXAMPLE: NewCo, LLC owns an apartment building. The IRS decides NewCo used the wrong method of depreciation, and adds $1 million to NewCo’s taxable income. Under the new law, NewCo itself is liable for tax on $1 million, calculated at the highest possible tax rate. However, NewCo may elect to make its members personally liable instead.

Under old law, every partnership had a “tax matters partner” with broad administrative responsibilities. The new law creates a much more powerful position, the “partnership representative,” with the power to bind the partnership and all of its partners on tax matters. The partnership representative doesn’t even have to be a partner, just a person or entity with a substantial U.S. presence:  an accounting firm, for example.

The law becomes effective in 2018. Between now and then, all existing limited liability companies should revise their Operating Agreements to:

  • Provide whether taxes due as a result of tax return audit will be paid at the partnership or partner level
  • If the tax is paid at the partnership level, how the economic cost will be shared by the partners
  • Designate a partnership representative
  • Describe the duties and powers of the taxpayer representative, within the statutory limits
  • Describe the obligations of the partnership and partners to share tax-related information

Obviously, all new limited liability companies should deal with those issues at the outset.

Questions? Let me know.

Improving Legal Documents In Crowdfunding: Tax Allocations

On By crowdfundattnyIn Crowdfunding, Crowdfunding Laws, JOBS Act, Legal Documents, Tax, UncategorizedLeave a comment

Because I started life as a tax shelter lawyer, I’m especially sensitive to how income and losses are allocated within partnerships and limited liability companies (limited liability companies are taxed as partnerships). Agreements in the Crowdfunding space leave something to be desired.

As we all know, partnerships are not themselves taxable entities. The items of income and loss of the dollar handshakepartnership “flow through” and are reported on the personal tax returns of the owners. Allocating income and losses is simple when you have one class of partnership interest and everything is pro rata, e.g., you get 70% of everything and I get 30%. It becomes a lot more complicated in the real world.

Say, for example:

  • The sponsor of a deal takes a 30% promote in operating cash flow after investors received an 8% annual preferred return.
  • On a sale or refinancing, the sponsor takes a 40% promote after the investors receive a 10% internal rate of return.
  • In the early years of the deal the project generates ordinary losses, then generates cash flow sheltered by depreciation deductions, then generates section 1231 gain.

The allocation of income and loss in a partnership is governed by section 704(b) of the Internal Revenue Code. Long ago, the IRS issued regulations under section 704(b) that use the concept of “capital accounts” to determine whether a given allocation has “substantial economic effect.” Rules within rules, exceptions within exceptions, definitions within definitions, the section 704(b) regulations are a delight for the kind of person (I admit it) who wasn’t necessarily the coolest in high school.

For years afterward, tax shelter lawyers vied with one another to include as many of the rules and definitions of the regulations as possible in their partnership agreements, verbatim. That lasted until we recognized that (1) no matter how hard we tried, it was impossible to be 100% sure that the allocations would come out right; and (2) there was a better way.

The better way is to give management the right to allocate income on a year-to-year basis, with the mandate that the allocation of income should follow the distribution of cash. To wit:

Company shall seek to allocate its income, gains, losses, deductions, and expenses (“Tax Items”) in a manner so that (i) such allocations have “substantial economic effect” as defined in Section 704(b) of the Code and the regulations issued thereunder (the “Regulations”) and otherwise comply with applicable tax laws; (ii) each Member is allocated income equal to the sum of (A) the losses he or it is allocated, and (B) the cash profits he or it receives; and (iii) after taking into account the allocations for each year as well as such factors as the value of the Company’s assets, the allocations likely to be made to each Member in the future, and the distributions each Member is likely to receive, the balance of each Member’s capital account at the time of the liquidation of the Company will be equal to the amount such Member is entitled to receive pursuant to this Agreement. That is, the allocation of the Company’s Tax Items, should, to the extent reasonably possible, following the actual and anticipated distributions of cash, in the discretion of the Manager. In making allocations the Manager shall use reasonable efforts to comply with applicable tax laws, including without limitation through incorporation of a “qualified income offset,” a “gross income allocation,” and a “minimum gain chargeback,” as such terms or concepts are specified in the Regulations. The Manager shall be conclusively deemed to have used reasonable effort if it has sought and obtained advice from counsel.

Even today, I see partnership agreements that devote pages to the allocation of tax items. The approach in the paragraph above is much simpler and, even more important, much more likely to achieve the right result.

Questions? Let me know.

Crowdfunding? Form a “C” Corporation

On By crowdfundattnyIn C corporations, Choice of Entity, Crowdfunding, JOBS Act, LLCs, TaxLeave a comment

One of the earliest decisions for every entrepreneur is the form of his or her company – whether a C corporation, an S corporation, a partnership, or a limited liability company. Designed as the perfect business entity, combining the flow-through tax treatment of a partnership with the liability protection of a corporation, the LLC is the first choice of many.

Things look different in the Crowdfunding universe, however. A company raising money on the Internet – whether in a true Crowdfunding offering or in a Rule 506 offering to accredited investors – will by definition end up with lots of investors, at least dozens, perhaps hundreds. Practically speaking, a company with dozens or hundreds of investors must be a C corporation.

Start with the tax filing requirements for partnerships, LLCs, and S corporations. At the end of each tax year the company must send a K-1 schedule to each owner. More exactly, two K-1 schedules, one for Federal taxes and one for state taxes. If a company has a dozen investors preparing all the K-1s is hard enough. For a small company with 100 investors the burden would be untenable.

On top of that, some states impose a per-head fee based on the number of owners. In New Jersey, for example, the fee is $150 per owner. Multiply that by 100 or more and we are talking about a serious cost for a startup company.

The lesson is unavoidable:  absent very unusual circumstances, a crowdfunded company must be a C corporation.

But that does not mean that all of the LLCs looking to the JOBS Act for funding will have to convert to C corporations. Instead, we anticipate that an existing LLC will form a separate C corporation as a member, and that the “crowd” investors will own stock in that company. The LLC will issue only one K-1 schedule and the separate C corporation will count as only one owner, despite having hundreds of stockholders.

For example, suppose Newco, LLC wants to raise $500,000 in exchange for 30% of its stock. Newco, LLC will issue 30% of its stock to a newly-formed C corporation, Investor Corp, Inc. Investors will purchase stock in Investor Corp, Inc., not Newco, LLC.

Using a C corporation will potentially impose a second level of tax if Newco, LLC is sold, and investors who purchase stock in Investor Corp, Inc. will not be entitled to write off “pass thru” losses for tax purposes. But in the Crowdfunding universe, that’s the lay of the land.

Questions? Let me know.