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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Can An S Corporation Issue Qualified Small Business Stock?

Q&AI am the founder of a company.  If I formed my startup as an S corporation, can I convert it to a C corporation before the end of this year and still get 1202 status for my founder stock?

Answer:

Section 1202 stock is entitled to a special tax break if held for five years. If acquired between 9/27/10 and 12/31/13 – the break is 100% (subject to a generous cap).*

No.  “Qualified small business stock” means stock in a C corporation, if “at the date of issuance, such corporation is a ‘qualified small business.’”  A “qualified small business” means a C corporation.

What this means is that if you initially formed your company as an S corporation and you terminate your S election before the end of this year, your founder shares will not qualify for the 1202 stock benefit (because you will have not received them when the company was a C corporation).

If you convert to a C corporation, subsequent investors may obtain the 1202 benefit, however.  The reason for this?  Because IRC Section 1202 (c)(1) says: “as of the date of issuance, such corporation is a qualified small business.”  But shares received while the company was an S corporation cannot qualify.

The answer is different if you are currently an LLC and you incorporate.  If you incorporate an LLC, your founder shares can qualify for the Section 1202 benefit.

* For more information on Section 1202 generally, please see this blog post:  startuplawblog.com/section-1202-qualified-small-business-stock 

Posted in Business Entities, Business/Corporate Law, Taxes | Tagged , , , , , , , | 11 Comments

Does An SPC Have to Give Money To Charity?

Does An SPC Have to Give Money To CharityI had a prospective client call me the other day. She was thinking that in order to be a Social Purpose Corporation the corporation would have to pay a certain amount of money to charity each year.

There is no such requirement.

There a number of things SPCs have to do, but giving money to nonprofits or charities isn’t one of them.

What Must SPCs Do

  • They have to have Articles of Incorporation that conform to the SPC statute (RCW 23B.25).
  • They must be organized for a general social purpose (See RCW 23B.25.020). An SPC could also elect to have an additional special social purpose (See RCW 23B.25.030), which could be, for example, to donate a certain amount of money to charity.
  • They must have “SPC” or “Social Purpose Corporation” in their name.
  • Before issuing shares, they must give a copy of their Articles of Incorporation to the recipient of the shares.
  • They must put a special legend on their stock certificates (See RCW 23B.25.070).
  • They must issue to shareholders, by making publicly available on the company’s web site, a social purpose report (See RCW 23B.25.150).

So, unless my prospective client voluntarily elects in its Articles of Incorporation to require the company to make charitable contributions, the closest thing to giving money to charity each year is the requirement to issue the social purpose report.

The Social Purpose Report

This report has to include a narrative discussion concerning the social purpose or purposes of the corporation, including the corporation’s efforts intended to promote its social purpose or purposes.

So, an SPC could give a certain amount of money to nonprofits or charities each year, and report in its social purpose report that it made these gifts in an effort to promote its social purposes, but it wouldn’t have to do this. It could, if it wanted, spend the money directly in furtherance of its purpose.

For example, suppose the SPC adopted the general social purposes in the statute. Those are:

to promote positive short-term or long-term effects of, or minimize adverse short-term or long-term effects of, the corporation’s activities upon any or all of (1) the corporation’s employees, suppliers, or customers; (2) the local, state, national, or world community; or (3) the environment.

To advance its social purpose, for example, each year the corporation could devote some percentage of its profits directly to environmental clean up. Or it could commit to contribute that percentage of its profits to a charity or charities that engage in such efforts. In either case, it could undertake these actions rather than reinvesting the profits in expanding the business or improving profitability or paying dividends to shareholders—all in order to promote the positive short-term or long-term effects of, or minimize adverse short-term or long-term effects of, the corporation’s activities on the environment.

Direct spending on environmental cleanup, or making charitable contributions to do so, rather than or in addition to shareholder distributions would be a completely legitimate corporate action on the part of the SPC, and a shareholder would have no ground to complain–even if the Board of Directors of the SPC decided to forego shareholder dividends in their entirety and spend all of the corporation’s distributable cash in furtherance of such pursuits, as long as the Board reasonably believed such an action would promote the social purposes of the corporation.

Why would a director have little to worry about in this situation? Because the SPC statute (RCW 23B.24.050) provides, in part, as follows:

(2) Unless the articles of incorporation provide otherwise, in discharging his or her duties as a director, the director of a social purpose corporation may consider and give weight to one or more of the social purposes of the corporation as the director deems relevant.

(3) Any action taken as a director of a social purpose corporation, or any failure to take any action, that the director reasonably believes is intended to promote one or more of the social purposes of the corporation shall be deemed to be in the best interests of the corporation.

(4) A director of a social purpose corporation is not liable for any action taken as a director, or any failure to take any action, if the director performed the duties of the director’s office in compliance with this section.

Conclusion

SPCs are extremely flexible business entities that provide significant protection to directors in making business judgments. They also allow a company to bind itself in advance to a level of required commitment by adopting third party standards against which its success in satisfying its the social purposes is measured. At the same time, however, they allow a company, if it wishes, to be more flexible and fluid in its approach and not commit itself in advance to measure its effectiveness in satisfying its social purposes against any such performance standards. In either case, the SPC statute provides a venue, through the social purpose report mechanism, for each of the constituencies of the corporation and the public at large to evaluate, comment and provide feedback to the corporation on how the corporation is doing in advancing its social purposes.

Posted in Business Entities, Social Purpose Corporations | Tagged , , , , , , | 2 Comments

Discounted Stock Options and Tax Code Section 409A: A Cautionary Tale

Caution tax code aheadGuest Post By Scott Usher of Bader Martin, P.S.

In the startup ecosphere, stock options are commonplace. They’re one way young companies can compensate for sweat equity and lower-than-market salaries or consulting fees, and generally provide recipients with a performance or retention incentive in the form of a stake in the company’s future.

The tax rules for most options are relatively straightforward. But when options are intentionally or unintentionally offered at a discount—meaning with an exercise price less than fair market value on the date the options are granted—it’s another story. And one that companies should consider carefully to avoid adverse tax consequences.

The Impact of Internal Revenue Code Section 409A

According to the IRS, discounted stock options fall under Section 409A of the federal tax code governing nonqualified deferred compensation plans—i.e., those nonqualified plans that provide for a deferral of compensation. Stock options with an exercise price that is equal to or above fair market value when granted are exempt from 409A.

409A was enacted in 2004 to ensure that recipients of discounted options and other forms of deferred compensation comply with strict guidelines regarding the timing of their deferrals. Otherwise, they must recognize the income when they have a legally binding right to receive it, even if they don’t actually receive it until sometime in the future. The fine print includes an exception for short-term deferrals where the compensation is actually received within two and a half months of the end of the year in which there is no longer a substantial risk of forfeiture. Such short-term deferrals are not subject to 409A.

For stock options that are subject to 409A, option recipients have limited flexibility in when they can exercise their options without violating the rules. The rules allow recipients to exercise options based on a limited number of triggering events, including retirement or other separation of service, a change in control of the business, disability, death, an unforeseen emergency or at a previously specified date or year.

For those who run afoul of 409A’s rules, the penalties are onerous. In general, the entire amount of compensation that has been deferred for the current and all previous tax years becomes taxable. That compensation is also subject to a 20 percent penalty, plus interest.

Many of the uncertainties in applying 409A have stemmed from the fact that the law doesn’t specifically define deferral of compensation. The IRS’s rules and pronouncements have consistently interpreted the phrase to include discounted stock options. However, those rules were not tested in the courts—until this year, when the U.S. Court of Federal Claims granted a partial summary judgment in Sutardja v United States. This ruling addresses various legal arguments with regard to the application of 409A, leaving the factual issue of whether the options were actually discounted to be determined at trial.

Consequences of the Sutardja Ruling

Sutardja is particularly significant because it is the first court ruling on the application of 409A to discounted stock options. As a result of Sutardja, we now have judicial affirmation of the following IRS positions:

  • Discounted stock options are subject to Section 409A treatment as nonqualified deferred compensation
  • The date an option is granted determines when compensation is considered to be earned.
  • The date an option vests, not the date it is exercised, determines when the recipient has a legally binding right to the compensation. The date it vests also establishes the time at which the option is no longer considered to have a substantial risk of forfeiture.
  • The relevant period for applying the short-term deferral exclusion is not based on the date the options are actually exercised, but rather based on the period of time the options can be exercised under the terms of the plan.

The Cautionary Part of the Tale

409A occupies some 80 pages of the federal tax regulations, which gives an indication of just how complicated it can be to either avoid it altogether or comply with its requirements. A few strategies can help.

To Discount or Not to Discount: Fair Market Value

409A hinges on whether or not a stock option is discounted. If an option’s exercise price is equal to the fair market value at the date the option is granted, the option is not discounted and 409A does not apply.If your company does not intend to discount the exercise price of its stock options, properly valuing them is central to avoiding the negative tax consequences of 409A. In the Sutardja case, the company intended to grant its stock options at fair market value. A combination of lack of oversight and poor execution led the company to grant those options at less than fair market value, which may cost the recipients of those options many millions of dollars.Establishing fair market value can be problematical for startups and other privately held companies. Perhaps the safest way—and generally the most expensive way—to determine fair market value is to hire a qualified independent appraiser to perform the valuation. The appraisal must be performed within 12 months of the option transaction to satisfy the first of three valuation safe harbor rules under 409A. Under the second safe harbor rule, startup companies can use someone other than an independent appraiser to perform the valuation, as long as the person has the requisite knowledge and experience and the valuation satisfies other criteria under 409A. The third safe harbor involves the use of a formula to determine the valuation, as prescribed under Section 83 of the federal tax code.Separate from the safe harbor approaches, companies are allowed to use a reasonable application of a reasonable valuation method based on specific factors identified in 409A. Unlike properly implemented safe harbor approaches, this valuation method is subject to challenge by the IRS, so it’s critical to develop and save detailed documentation of the method used in determining the valuation.

Properly Establishing the Grant Date

In the Sutardja case, the company’s compensation committee approved the option grant and established the options’ fair market value at on same date. But the committee did not formally ratify that grant until nearly a month later, when the fair market value was higher.The court determined that the date of ratification was the grant date, so the options were actually granted at a discounted price. By the time the company and recipient attempted to fix the error, it was too late as the options had been exercised.Because of the impact that the grant date—and other elements of the process— can have on determining fair market value and general compliance with 409A rules, companies must develop and follow well-thought-out procedures governing the issuance of stock options.

Remedial Actions

It’s always better to prevent compliance problems than to try and correct them later. But for those companies that find themselves out of compliance with 409A, the IRS has published guidance (in Notices 2008-113, 2010-6 and 2010-80) on certain allowed corrective actions.

Ultimately, whether the problem can be corrected—and, if so, how much relief is available—is as complex as the rest of 409A. It depends on a number of factors, including the nature of problem and the timing of the correction.

For stock options that were erroneously granted at less than fair market value, it may be possible to amend the option agreement to eliminate the discount. Generally, the exercise price can be increased to the fair market value (as of the grant date) in the year the options were granted. For option recipients who are not considered company insiders, that period is extended to include the following year. Under proposed regulations, it may also be possible to amend the option agreement prior to the year the options vest. Regardless, no corrective action is permitted for options that have been exercised.

409A is a particularly complex area of the federal tax code and, as Sutardja clearly demonstrates, the cost of noncompliance can be onerous. If you’re considering stock options or other alternative forms of compensation, get great advice.

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Incorporating an LLC

LLC TO INCBy Joe Wallin and Scott Usher of Bader Martin, P.S.

It is not uncommon for founders to start their companies as LLCs and then want to or need to incorporate or convert to a corporation later. Incorporating an LLC does not have to be a difficult or expensive process. It may be, because of exceptional or unusual facts, but frequently it can be quite straightforward.

There are essentially three different ways (well, four, but more on that later) to convert an LLC to a corporation:

  1. You can form a new corporation, and you can merge the existing LLC (via a state law statutory merger) with and into the new corporation. If you use this method, the separate legal existence of the LLC will terminate on the merger and by operation of law the new corporation will succeed to all of the rights and obligations of the LLC.
  2. You can form a new corporation, and then have the LLC contribute its assets to the new corporation in exchange for the stock in the new corporation, and then you can liquidate the LLC.
  3. You can form a new corporation and then have the LLC’s owners assign their LLC interests to the new corporation. Immediately afterward, the LLC will be a wholly-owned subsidiary of the new corporation. You can then either continue to operate the business through the subsidiary LLC or you can liquidate the LLC into the parent corporation. Continuing to operate the business through the subsidiary LLC can work well if the LLC has a bunch of contracts that you don’t want to re-title in the name of the new corporation, or if you don’t want to re-do bank accounts, business licenses, etc. If you follow this route, the transaction looks like this:

graph2

Another method to convert an LLC to a corporation for federal income tax purposes is to “check the box” and file form 8832 to treat the LLC as a corporation, but this is not an ideal alternative. While this will change the tax treatment of the LLC, its legal structure is unchanged, causing any number of complications due to the dual status of the entity.

Tax Issues

The biggest issue on the incorporation of an LLC is typically tax. You don’t want to trigger a tax on the incorporation of an LLC. The most common way you can do this is if the LLC has debt in excess of the basis of its assets.

One not uncommon reason to incorporate an LLC is to be eligible for a tax-free stock-for-stock exchange. If this is your motivation, you will need to avoid incorporating immediately before the exchange, as the IRS has ruled that such a series of transactions can be collapsed, resulting in a taxable LLC interest for stock transaction.

There may also be different state tax consequences among these methods. A number of states (like California) treat LLCs as separate taxpaying entities. Leaving the LLC intact may add another layer of tax filings and/or additional state tax, while merging it may require additional steps to eliminate the need for future filings.

Conclusion

You should always work closely with your counsel and tax advisors on LLC incorporation. It doesn’t have to be a painful process, but you will want to make sure it is done right.

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