Tag: LLC

LLC Vs C Corporation For Startups: A Short Explanation

On By crowdfundattnyIn C corporations, LLCsLeave a comment

Like COVID, the questions around choosing a limited liability company or C corporation for startups never seem to go away.

For lots of details see the article I wrote here. Except for making you the center of attention at the party, however, those details don’t matter very much. So I’m offering this short version.

In a limited liability company you pay only one level of tax upon a sale of the company, while with a C corporation you pay two levels. That can make an enormous different to the IRRs of founders and investors.

Yet many startups are formed as C corporations. Why?

In Silicon Valley successful startups are funded by venture capital funds. Indeed, the most common measure of “success” in Silicon Valley is which venture capital funds have funded a startup, for how much, and how many times.

Venture capital funds are themselves funded, in part, by deep-pocketed nonprofits like CALPERS and Harvard.

All nonprofits are subject to tax on business income, as opposed to income from their nonprofit activities. For example, Harvard can charge a billion dollars per year in tuition without paying tax, but if it opens a car dealership it pays tax on the dealership’s profits. The car dealership income is called “unrelated business taxable income,” or UBTI.

Now suppose Harvard owns an interest in a VC fund, which is structured as a limited liability company or limited partnership (as all are). If the VC fund invests in an LLC operating a car dealership, then the income of the dealership flows through first to the VC fund and then from the VC fund to Harvard, where it is again treated as UBTI, subjecting Harvard to tax and reporting obligations.

Harvard doesn’t want to report UBTI! So Harvard tells the VC fund “Don’t invest in LLCs or partnerships, only C corporations, where the income doesn’t pass through.” And because Harvard writes big checks, the VC fund does what Harvard wants.

That’s why the Silicon Valley ecosystem uses C corporations. Everyone knows about the extra tax on exit, but everyone is willing to pay it on exit to get the big checks from Harvard.

I will pause to note that in many cases the nonprofit’s concern about UBTI is illusory. Many startups never achieve profitability, including startups sold for big numbers. So there would never have been any UBTI in the first place.

(Yes, I know that there’s no extra tax in an IPO or tax-free reorganization, but those are small exceptions to the general rule.)

Because Silicon Valley is the center of gravity in the American startup ecosystem, like the black hole at the center of the Milky Way, it exerts a force that is not always rational. Many investors, including funds with no nonprofit LPs and hence no possibility of UBTI, will tell startups “I only invest in C corporations,” simply based on the Silicon Valley model.

This creates a dilemma for founders, especially in the Crowdfunding space. If I’m an LLC and list my company on a Reg CF platform, how do I know I’m not losing investors who think, irrationally, that they should only invest in C corporations?

In any case, that’s where we are. LLCs are better in most cases because of the tax savings on exit. But because of the disproportionate influence of the Silicon Valley ecosystem in general and deep-pocketed nonprofit investors in particular, many investors and founders think they’re supposed to use C corporations.

Questions? Let me know.

Yes, A Parent Company Can Use Title III Crowdfunding

On By crowdfundattnyIn Title III, Title III Crowdfunding, Uncategorized1 Comment

Title III Crowdfunding

We know an “investment company,” as defined in the Investment Company Act of 1940, can’t use Title III Crowdfunding. For that matter, an issuer can’t use Title III even if it’s not an investment company, if the reason it’s not an investment company is one of the exemptions under section 3(b) or section 3(c) of the 1940 Act. By way of example, suppose a a company is engaged in the business of making commercial mortgage loans. Even if the company qualifies for the exemption under section 3(c)(5)(C) of the 1940 Act, it still can’t use Title III.

We also know that, silly as it seems, a company whose only asset is the securities of one company is generally treated as an investment company under the 1940 Act. That’s why we can’t use so-called “special purpose vehicles,” or SPVs, in Title III Crowdfunding, to round up all the investors in one entity and thereby simplify the cap table.

Put those two things together and you might conclude that only an operating company, and not a company that owns stock in the operating company, can use Title III Crowdfunding. But that wouldn’t be quite right.

A company that owns the securities of an operating company – I’ll call that a “parent company” — can’t use Title III if it’s an “investment company” under the 1940 Act. However, while every investment company is a parent company, not every parent company is an investment company. Here’s what I mean.

Section 3(a)(1) of the 1940 Act defines “investment company” as:

  • A company engaged primarily in the business of investing, reinvesting, or trading in securities; or
  • A company engaged in the business of investing, reinvesting, owning, holding, or trading in securities, which owns or proposes to acquire investment securities having a value exceeding 40% of the value of its assets.

Suppose Parent, Inc. owns 100% of Operating Company, LLC, and nothing else. If Parent’s interest in Operating Company is treated as a “security,” then Parent will be an investment company under either definition above and can’t use Title III. However, it should be possible to structure the relationship between Parent and Operating Company so that Parent’s interest is not treated as a security, relying on a long line of cases involving general partnership interests.

These cases arise under the Howey test, made famous by the ICO world. Under Howey, an instrument is a security if and only if:

  • It involves an investment of money or other property in a common enterprise;
  • There is an expectation of profits; and
  • The expectation of profits is based on the efforts of someone else.

Focusing on the third element of the Howey test, courts have held that a general partner’s interest in a limited partnership generally is not a security because (1) by law, the general partner controls the partnership, and (2) the general partner is therefore relying on its own efforts to realize a profit, not the efforts of someone else.

If Operating Company were a partnership and Parent were its general partner, then the arrangement would fall squarely within this line of cases and Parent wouldn’t be treated as an investment company. As a general partner, however, Parent would be fully liable for the liabilities of Operating Company, defeating the main purpose of the parent/subsidiary relationship, i.e., letting the tail wag the dog.

Fortunately, Parent should be able to achieve the same result even though Operating Company is a limited liability company. The key is that Operating Company should be managed by its members, not by a manager. That should place Parent in exactly the same position as the typical general partner:  relying on its own efforts, rather than the efforts of someone else, to realize a profit from the enterprise.

If Parent’s interest in Operating Company isn’t a “security,” then Parent isn’t an “investment company,” and can raise money using Title III.

Questions? Let me know.

Options Or Profits Interests For Key Employees of LLCs?

On By crowdfundattnyIn LLCsLeave a comment

Co-Authored By: Steve Poulathas & Mark Roderick

You own an LLC and want to compensate key contributors with some kind of equity. Do you give them an equity interest in the Company today or an option acquire an equity interest in the future?

Before we get to that question:

  • Make sure that equity is the right answer for this particular employee. It’s great for key contributors to have a stake in the company, but if this particular employee is your CMO, a cash commission on sales might make more sense because it provides a more targeted incentive.
  • Make sure you’re giving the employee equity in the right business unit. If you operate a Crowdfunding platform, for example, and want to incentivize an IT guy, maybe the IT should be held in a separate entity and licensed to the operating company.
  • To dispel some confusion, a limited liability company can issue options. In fact, here’s a Stock Incentive Plan drafted for a limited liability company. The only thing a limited liability company can’t do is offer “incentive stock options,” otherwise known as ISOs, which provide special tax benefits to employees but are also subject to lots of rules.

Okay, equity is the right answer for this particular employee and you’re giving her equity in the right company. Now, what kind of equity?

There are lots of flavors of equity. These are the three you’re most likely to consider:

  • Outright Grant of Equity: Your employee will become a full owner right away, sharing in the current value of the business, possibly subject to a vesting period.
  • Profits Interest: Your employee will become a full owner right away, but economically will share only in the future appreciation of the Company, not the current value.
  • Option: Your employee won’t become an owner right away, but will have the right to buy an interest in the future based on today’s value – again allowing her to share in future appreciation but not current value.

In making your choice, there are three primary factors:

  • Economics: How much value are you trying to transfer to your employee, and when?
  • Messiness of Ownership Interests: If your employee becomes an owner of the business, even an owner subject to vesting and/or an owner whose economic rights are limited to future appreciation, you have to treat her as an owner. You have to give her information, you have to return her email when she asks (as an owner) why your salary is so high and why your husband is on the payroll, you have to send her a K-1 every year, and so forth.
  • Taxes: For better or worse (mostly worse), tax considerations are the principal driver behind many executive compensation decisions, a great example of the tail wagging the dog. If you thought the JOBS Act was hard to follow, take a look at section 409A of the Internal Revenue Code!

So here’s where we come out.

An outright grant of equity might be a good choice for a real startup assembling a team to get off the ground, as long as there is little or no value. By definition the founder isn’t giving up much economically, and the outright grant achieves a great tax result for the employee, namely capital gain rates on exit. The main downside is that the employee is a real owner, entitled to information, etc. But that’s not the end of the world, especially if the employee is in the nature of a co-founder.

(If your company already has value, then you’re giving something away, by definition, and your employee has to pay tax.)

A profits interest is just like an outright grant except for the economics:  there is no immediate transfer of value. But the tax treatment is the same (no deduction for the company, capital gain at exit for the employee) and the employee is a full owner right away.

An option is economically very similar to a profits interest, because the employee shares only in future appreciation, not current value (for tax reasons, the option exercise price can’t be lower than the current value). But otherwise they’re the opposite. The employee isn’t treated as an owner until she exercises the option. And upon exercise, she recognizes ordinary income, not capital gain, while the company gets a deduction.

For a company with just a few key contributors a profits interest isn’t bad. You give your employees a great tax result and what the heck, what are a few more owners among close friends? But for a company with more than a few key contributors the option is better only because it’s so much easier to keep a tighter cap table. And while the tax treatment of the employee isn’t as favorable, I’ve never seen an employee refuse an option for that reason.

Improving Legal Documents in Crowdfunding: New Tax Audit Language for Operation Agreements

On By crowdfundattnyIn Legal Documents, LLCsLeave a comment

By: Steve Poulathas & Mark Roderick 

Last year I reported that Congress had changed the rules governing tax audits of limited liability companies and other entities that are treated as partnerships for tax purposes. The changes don’t become effective until tax years beginning on or after January 1, 2018, but because most LLCs created today will still be around in 2018, it’s a good idea to anticipate the changes in your Operating Agreements today.

Under the current rules, the IRS conducts audits of LLCs at the entity level through a “tax matters partner” (normally the Manager of the LLC), and collects taxes from the individual members. Under the new rules, the IRS will continue to conduct audits at the entity level, but will also collect taxes, interest, and penalties at the entity level. That puts the LLC in the position of paying the personal tax obligations of its members, a drain on cash flow every deal sponsor will want to avoid.

Naturally, there are exceptions to the new rules and exceptions to the exceptions. Trouble sleeping? I’ll send you a detailed summary.

Consult with your own tax advisors, of course, here’s some language for your Operating Agreements that gives the deal sponsor maximum flexibility:

Tax Matters.

  1. Appointment. The Manager shall serve as the “Tax Representative” of the Company for purposes of this section 1. The Tax Representative shall have the authority of both (i) a “tax matters partner” under Code section 6231 before it was amended by the Bipartisan Budget Act of 2015 (the “BBA”), and (ii) the “partnership representative” under Code section 6223(a) after it was amended.
  2. Tax Examinations and Audits. At the expense of the Company, the Tax Representative shall represent the Company in connection with all examinations of the Company’s affairs by the Internal Revenue Service and state taxing authorities (each, a “Taxing Authority”), including resulting administrative and judicial proceedings, and is authorized to engage accountants, attorneys, and other professionals in connection with such matters. No Member will act independently with respect to tax audits or tax litigation of the Company, unless previously authorized to do so in writing by the Tax Representative, which authorization may be withheld by the Tax Representative in his, her, or its sole and absolute discretion. The Tax Representative shall have sole discretion to determine whether the Company (either on its own behalf or on behalf of the Members) will contest or continue to contest any tax deficiencies assessed or proposed to be assessed by any Taxing Authority, recognizing that the decisions of the Tax Representative may be binding upon all of the Members.
  3. Tax Elections and Deficiencies. Except as otherwise provided in this Agreement, the Tax Representative, in his, her, or its sole discretion, shall have the right to make on behalf of the Company any and all elections under the Internal Revenue Code or provisions of State tax law. Without limiting the previous sentence, the Tax Representative, in his, her, or its sole discretion, shall have the right to make any and all elections and to take any actions that are available to be made or taken by the “partnership representative” or the Company under the BBA, including but not limited to an election under Code section 6226 as amended by the BBA, and the Members shall take such actions requested by the Tax Representative. To the extent that the Tax Representative does not make an election under Code section 6221(b) or Code section 6226 (each as amended by the BBA), the Company shall use commercially reasonable efforts to (i) make any modifications available under Code section 6225(c)(3), (4), and (5), as amended by the BBA, and (ii) if requested by a Member, provide to such Member information allowing such Member to file an amended federal income tax return, as described in Code section 6225(c)(2) as amended by the BBA, to the extent such amended return and payment of any related federal income taxes would reduce any taxes payable by the Company.
  4. Deficiencies. Any deficiency for taxes imposed on any Member (including penalties, additions to tax or interest imposed with respect to such taxes and any taxes imposed pursuant to Code section 6226 as amended by the BBA) will be paid by such Member and if required to be paid (and actually paid) by the Company, may  be recovered by the Company from such Member (i) by withholding from such Member any distributions otherwise due to such Member, or (ii) on demand. Similarly, if, by reason of changes in the interests of the Members in the Company, the Company, or any Member (or former Member) is required to pay any taxes (including penalties, additions to tax or interest imposed with respect to such taxes) that should properly be the obligation of another Member (or former Member), then the Member (or former Member) properly responsible for such taxes shall promptly reimburse the Company or Member who satisfied the audit obligation.
  5. Tax Returns. At the expense of the Company, the Tax Representative shall use commercially reasonable efforts to cause the preparation and timely filing (including extensions) of all tax returns required to be filed by the Company pursuant to the Code as well as all other required tax returns in each jurisdiction in which the Company is required to file returns. As soon as reasonably possible after the end of each taxable year of the Company, the Tax Representative will cause to be delivered to each person who was a Member at any time during such taxable year, IRS Schedule K-1 to Form 1065 and such other information with respect to the Company as may be necessary for the preparation of such person’s federal, state, and local income tax returns for such taxable year.
  6. Consistent Treatment of Tax Items. No Member shall treat any Company Tax Item inconsistently on such Member’s Federal, State, foreign or other income tax return with the treatment of such Company Tax Item on the Company’s tax return. For these purposes, the term “Company Tax Item” means any item of the Company of income, loss, deduction, credit, or otherwise reported (or not reported) on the Company’s tax returns.

Questions? Let us know.

Steve Poulathas is member of Flaster Greenberg’s Taxation, Business and Corporate, Trusts and Estates and Employee Benefits Practice Groups. He counsels and represents individuals, family-owned businesses and public companies in the tax, business and finance, and estate practices. He can be reached at 856.382.2255 or steve.poulathas@flastergreenberg.com.

Mark Roderick is one of the leading Crowdfunding lawyers in the United States. He represents platforms, portals, issuers, and others throughout the industry. For more information on Crowdfunding, including news, updates and links to important information pertaining to the JOBS Act and how Crowdfunding may affect your business, follow Mark’s blog. 

Will Someone Please Offer Investment Advice For Crowdfunding?

On By crowdfundattnyIn Crowdfunding, Investing4 Comments

business handshake

Very few retail investors have the skill to pick a great deal from a mediocre deal. I know I don’t, and I’ve been representing real estate developers and entrepreneurs my whole career.

Taking a cue from the public stock market, one way to address the retail market is to create the equivalent of a mutual fund for Crowdfunding investments. You would create a limited liability company to act as the fund, raise money from investors using Crowdfunding, and the manager would select investments from Crowdfunding portals.

Great idea conceptually, but it doesn’t work legally:

  • The LLC would, by definition, be an “investment company” under the Investment Company Act of 1940. As such, you would be prohibited from using Title III or Title IV to raise money for the fund.
  • You could use Title II to raise money for the fund, but as an investment company the fund would be subject to extremely onerous and costly regulation, e., the same regulation that applies to mutual funds. To avoid the regulation, you would have to limit the fund to either (1) no more than 100 accredited investors, or (2) only investors with at least $5 million of investments. In either case, you defeat the purpose.

But there is another way! A licensed investment adviser could offer investment advice with respect to investments in Crowdfunding projects and, for that matter, make the investments on behalf of his or her retail customers, charging an annual fee based on the amount invested. The adviser would allow each retail investor to effectively create his or her own “mutual fund” of projects based on individual preferences.

Not only would the investment adviser make money, the availability of unbiased advice would draw retail investors into the space – a win for the industry.

To quote Pink Floyd, is there anybody out there?

Questions? 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.