Tag: LLCs

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, Investing1 Comment

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, TaxLeave a 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.

C Corp Vs. LLC: What’s The Right Choice?

On By crowdfundattnyIn C corporations, Crowdfunding, Entrepreneurs, Investor, LLCs, UncategorizedLeave a comment

Ryan Feit, the CEO of SeedInvest, just published a great piece in Inc. Magazine about the pressure some entrepreneurs feel from venture funds to convert from a limited liability company to a C corporation. Ryan points out that the tax cost associated with a C corporation often makes the LLC the better choice.

It’s a question I’m asked all the time. And like Ryan, I normally come out on the side of the LLC for Crowdfunding companies, at least so far.

To flesh out the issue, I’ve written an overview, Choosing The Right Legal Entity MSR describing the main characteristics I’m thinking about when I recommend LLC or C corporation. If you want to understand why corporate lawyers seem so isolated at social gatherings, take a look.

Choosing the Right Legal Entity Flyer

Questions? Let me know.

When Can My Investors Sue Me?

On By crowdfundattnyIn Business Judgement Rule, Crowdfunding, D&O Insurance, Investing, Investor, JOBS Act, LLCsLeave a comment

You’ve raised money from investors, through Crowdfunding or otherwise. You did everything right through the money-raising process, such as disclosing all the right information. What are your obligations to the investors/shareholders as you now operate the company? Or, to ask the question in a more negative but practical way, when can they sue you successfully?

The exact answer depends primarily on (1) the state you chose to incorporate, (2) whether you are a corporation or a limited liability company, and (3) whether you included provisions in your governing instruments (Certificate of Incorporation, Operating Agreement) to protect yourself. State laws are not uniform and there can be enormous differences between LLCs and corporations.

Nevertheless, we will assume that you are in a “normal” state and that your lawyer prepared “normal” documents. That allows us to generalize by saying you can be sued successfully under these two circumstances:

  • You make business decisions that are unusually bad and careless.
  • You take actions that unfairly benefit yourself to the disadvantage of your company.

Under the laws of “normal” states, if you try your best, pay attention, review relevant information beforehand, and have the best interests of the company at heart, it is fairly hard to make a business decision so poor that you can be sued successfully by investors. The hands-off approach taken by statutes and courts in this area – referred to as the “business judgment rule” – recognizes that management must often make decisions without complete information, that decisions are easy to challenge with the benefit of hindsight, and that if investors were allowed to sue for every poor decision, judges could never take vacations.

It is much easier to be sued successfully where you take actions that unfairly benefit yourself to the disadvantage of your company. Examples:

  • You lease office space to your company for higher-than-market rent.
  • You borrow money from your company when you shouldn’t, or on unfair terms.
  • Your company is in the business of developing digital imaging software, but when you are approached by an inventor with a new technique, you form a new company with the inventor and don’t offer the opportunity to your old company.

Investors are an odd group inasmuch as when they lose their money they tend to be unhappy. This means that even before raising money you should:

  1. Make sure your governing instruments include the right language;
  2. Get good legal advice; and
  3. Get a quote for Director and Officer (“D&O”) insurance.

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.