All posts in Business Entities

The Unbearable Lightness (of Being an LLC)

LLC Stock OptionsI had a client press me recently about converting from an LLC (taxed as a partnership) to a corporation.  The client had been considering raising money from angels and wanted to grant traditional corporate-style stock option to employees.

I suggested that if he wanted to raise money from third parties (whether angels or venture funds) and grant traditional stock options to employees and service providers, that it would probably make sense for him to convert to a C corporation.

“Most investors don’t want to invest in a pass through company. Either an LLC or an S corporation,” I told him. “They don’t want to receive a Form K-1.  Plus, stock option style equity grants in an LLC are not easy; they require book ups and complex capital account maintenance accounting.”

He and his co-founder changed their minds about raising angel money. The client didn’t think they needed or wanted to raise money from third parties, but still wanted to give employees traditional equity incentives. Their concern was, if they converted to a C corporation and decided to sell down the road, the future buyer might only want to buy the company’s assets and not the stock – thereby giving rise to the dreaded double tax.

“It is possible that if you convert your LLC to a C corporation that you could spend several years growing the business, and then have a buyer demand to buy the assets and not the stock,” I said. “If that happened and you went ahead and had the C corporation sell the assets, there would be a corporate level of tax owed that you would have avoided had you remained an LLC.”

“However,” I added, “there are still a number of good reasons to be a C corporation, and the likelihood of what you described happening is, in my experience, not common. You see, most ‘up’ deals are stock deals, or structured one layer of tax transactions, such as reverse triangular mergers.”

The client remained uncertain. I couldn’t tell the him that what they were afraid of was out of the realm of possibility, because frankly, it was a possibility. I have seen it happen on a few occasions in my career (granted, it’s been a long time).  On at least one occasion in the past, a C corporation received an acquisition offer on its assets.  The buyer wouldn’t budge on its demand to buy assets and not stock. In that case, due to the adverse tax consequences, the C corporation had to pass on the deal.

“Well, we want to remain an LLC then,” the client said.

“OK,” I said “but keep in mind that if in several years an acquiror company wants to acquire your company in an all stock transaction, you won’t be able to defer your gain on a stock deal until you sell the stock.”

“What do you mean?”

“Well, it is not uncommon for some acquirors, especially public company acquirors, to purchase other companies in all stock or mostly stock transactions.  Meaning, your stockholders will receive a portion of the deal (at least 40%) in stock, which might not be liquid.  In that case, they won’t be able to sell it for some time.  But if you are an LLC, such an acquisition could not qualify as a ‘reorg’ under the tax law, thus you would be taxed on the stock as if you received cash and turned around and bought the stock.”

“That sucks,” he said.

“I know,” I replied.

“What do I do?”

He wanted me to make the decision for him; to end his agonizing over the decision. I couldn’t do it.  It was his business; his decision.

“If I just stick as an LLC,” he said, “just how bad will it be again?”

“Well,” I said, “you will have to worry about book ups, and capital account maintenance, and a complex LLC agreement. But there are worse things that could happen to you than spending quality time with your tax lawyers and tax accountants. Just enjoy.”

“Plus,” I added, “if you remain an LLC you will not have to worry about a double level tax on sale of the LLC and you can always convert to a C corporation later.”

Conclusion

Choice of entity is not always easy.  Sometimes it is agonizing.

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Going, Going, Gone: Qualified Small Business Stock

QSBS

You may or may not be aware of this, but come December 31, 2013, one of the most exciting tax incentives for investing in startups is going to expire.  What am I talking about?  The 100% exclusion from tax for investing in qualified small business stock.  This benefit expires on December 31, 2013, and it is unclear whether Congress will renew it.  What I mean by this benefit expiring is, if you want to set yourself up to take advantage of this benefit down the road (you have to hold the stock for 5 years to avail yourself of the tax break), you have to acquire the qualified small business stock before the end of this year.

What does the 100% exclusion entitle you to?

Up to $10M in capital gains can be entirely excluded from tax, including the alternative minimum tax.  What you generally have to do to qualify for exclusion is:

  • Form or invest in a C corporation before the end of this year.
  • Have that C corporation start actively conducting a business this year.  (Under IRC Section 1202, stock is not treated as qualified small business stock unless, during substantially all of the taxpayer’s holding period for such stock, the corporation was engaged in an active trade or business.)  What this means is it is not good enough to simply incorporate this year; the new corporation has to do business this year as well.  Obtain your business licenses, open your bank accounts, and do business.
  • Have that business qualify as a “qualified small business.”  For example, software and Internet companies typically qualify.

For a more thorough discussion, check out my post on Section 1202.

What should you consider doing?

  • If you are pondering an investment in a C corporation that you could close either this year or next year, you may want to close it this year, so that you can potentially take advantage of this tax benefit down the road.
  • If you have an LLC that you have been considering converting to a C corporation, you might want to do it before year end.
  • If you formed a C corporation this year, and you were thinking you made a mistake and should have been doing business as an LLC, this information may provide you with an additional reason  to remain a C corporation.

Call your tax lawyer or tax accountant if you are on the fence about what to do.

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LLC Compensatory Equity Awards – Complex and Difficult

Complex and Difficult(2)By Joe Wallin and Dan Wright of Clark Nuber

Question

Is it more complex to make a compensatory equity grant from an LLC (taxed as a partnership) than from a corporation?

Answer

Yes

    Granting service providers an equity interest in an LLC is much more complex than granting an equity interest in a corporation.  Here are just a few of the reasons:
  • Once an employee receives equity in an LLC, the employee can no longer be considered an employee for federal income tax purposes.  Instead, for federal income tax purposes, they have to be treated as “partners.”  (They can still be employees for state law purposes.)  This means that instead of having income and employment taxes withheld from their paychecks and receiving a Form W-2, they will instead have to make quarterly tax deposits themselves as a self-employed person, pay self-employment taxes, and receive a Form K1 from the company.
    Employees who receive an equity grant in a corporation, in contrast, continue to retain employee status and receive a W-2 reporting their salary/withholding information.
    W-2 reporting (v. Schedule K1 reporting) is generally easier to understand.

Advantage: Corporations

  • Usually when a company wants to grant an equity award to a service provider, it doesn’t want the equity award recipient to owe tax upon the receipt of the award.  To do this in either an LLC or a corporation, it is necessary to value the equity to be awarded (and in the corporation context grant a stock option at FMV).  However, in an LLC, there is really no corollary to granting a FMV stock option.  Unless the recipient of the award pays FMV for the award, it is necessary to take the additional steps to ensure that the equity award qualifies as a “profits interest.”

Advantage: Corporations

  • A “profits interest” is defined in Rev. Proc. 93-27 and 2001-43 to mean an interest that entitles the holder to only a share of the future profits of a company.  When the LLC holds assets that have appreciated before the equity grant, in order to grant a profits interest to the recipient, adjustments need to be made on the books of the LLC to reflect the pre-equity grant appreciation in the capital accounts of the existing members.  This is often referred to as a “book-up”.  The federal tax accounting required to “book up” the capital accounts can be complex.  Frequent capital account “book-up” adjustments resulting from compensatory grants can make this difficult for the members to understand and expensive to track, especially if the value of the equity fluctuates significantly between equity grants.  Corporations do not have to track capital accounts.

Example:

    Suppose Moe, Larry and Curly own an LLC together.  They have been working on the LLC’s business for several years.  They believe the business is worth $1 Million.  Moe, Larry and Curly’s capital accounts, for tax purposes, aggregate to $100,000.  Their capital accounts don’t aggregate to $1M because the company has unrealized (unbooked) appreciation in its assets of $900,000.  The LLC wants to grant a 10% equity interest to Noob.  The fundamental question is – do Moe, Larry and Curly want to give Noob 10% of the current $1M value – a $100,000 equity award.  Or do they want to give Noob a 10% share of appreciation in the business from $1M and up?
    Usually Moe, Larry and Curly want to give the Noob just a share in future appreciation in the business above and beyond $1M. To do this in the LLC context, they have to book up their capital accounts to aggregate $1M. This is not necessary in the corporate context.

Advantage: Corporations

Recommendations

When favorable circumstances exist, electing to organize a business as an LLC can produce significant tax and legal advantages.   However, when it comes to administering equity grants, one should carefully consider the costs and benefits of the additional tax, legal and accounting complexities associated with granting LLC equity interests.   Administering a stock option and/or a restricted stock plan in a C corporation context is likely to be much simpler.

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