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The Reasons Behind the Bias of PE and VC Firms Investing in Corps Rather than LLCs - Part1 of 2

Warren P. Kean, Partner, K&L Gates LLP


Original Title: Exploring the Reasons Behind the Bias of Private Equity and Venture Capital Firms Investing in Corporations Rather Than Limited Liability Companies - A Time to Reconsider

Part 1

A. Outside of the PE/VC Fund Portfolio Company Arena, LLCs Generally are the Choice of Entity - Why Have PE/VC Funds Been Reluctant to Invest in Them?

1. If C corporations are clearly the preferable entity choice for start-up and other businesses, then -

2. Why was it determined that the statutes and regulations listed below were needed?

  • The publicly-traded partnership rules under I.R.C. õ7704 to prevent the "de-incorporation" of America.
  • LLC statutes adopted in all 50 states and the District of Columbia (also LLP and LLLP amendments to general and limited partnership statutes).
  • The "check-the-box" regulations under Treas. Reg. õ301.7701.

3. Why was it necessary or beneficial to devise and employ the techniques listed below (and discussed later in this outline) to own interests in entities classified as partnerships?

  • Use of "blocker" corporations.
  • Use of the UPREIT/barnesandnoble.com structure.

4. Why over the past 15 years or so has there been an ever increasing number of limited liability companies ("LLCs") and other unincorporated entities organized; in many states in numbers greater than the number of new corporations? See 2007-2008 Int'l Ass'n of Com. Adm'rs, Ann. Jurisdictional Rep., available at http://www.iaca.org/node/80, reporting that for 2007 and 2008 over three times as many LLCs and partnerships were formed in Delaware than corporations, over two times as many LLCs and partnerships were formed in North Carolina as corporations, and California was one of the few states that in 2007 had more corporations formed (0.3 times more) than LLCs and partnerships. The data provided in this report demonstrates the nationwide trend towards LLCs and partnerships (principally LLCs) over corporations.

5. Why do law firms, accounting firms, and other professional service firms of all sizes (including international firms with billions of dollars of revenue) operate as LLCs or limited liability partnerships?

6. Why do hedge, private equity, and venture capital firms and their related investment funds operate as LLCs or limited partnerships, often utilizing many unincorporated entities in their organizational and operational structure? In 2008, the U.S. House of Representatives passed H.R. 6275, which, among other things, would add a new Section 710 to the Internal Revenue Code to tax certain partnership carried income and loss as ordinary income or loss.

7. Why the popularity of the seemingly endless number of books, periodicals, papers, and presentations on LLCs and other unincorporated entities and on "choice of entity" (of which, the list below is only a small sampling)?

Advising the Small Business: Choosing the Right Entity Type & Issues Arising in Representing Entities presentation sponsored by the ABA General Practice, Sole & Small Firm Division and the ABA Center for Continuing Legal Education (March 11, 2009) and the related book by Jean L. Betman, Advising the Small Business, Forms and Advice for the Legal Practitioner; Robert R. Keatinge and Anne E. Conaway, Keatinge and Conaway on Choice of Business Entity: Selecting Form and Structure for a Closely-Held Business, (West 2009 ed.); Laurence E. Crouch, Revival of the Choice of Entity Analysis: Use of Limited Liability Companies for Start-Up Business, in Tax Planning for Domestic & Foreign Partnerships, LLCs, Joint Ventures & Other Strategic Alliances, Practising Law Institute (2008); William P. Streng, Choice of Entity, BNA Tax Management Portfolio 700-3rd; Victor Fleischer, "The Rational Exuberance of Structuring Venture Capital Start-Ups," 57 Tax L. Rev. 137 (2004); Steven G. Frost and Sheldon I. Banoff, "Square Peg, Meet Black Hole; Uncertain Tax Consequences of Third Generation LLEs," 100 J. Tax'n 326 (June 2004); C. Wells Hall and Jordan P. Rose, "Considerations in Choice of Entity Revisited," 62 NYU Inst. on Fed. Tax'n 15-1 (2004); Daniel S. Goldberg, "Choice of Entity for a Venture Capital Start-Up; the Myth of Incorporation," 55 Tax Law 923 (Summer 2002); Steven A. Waters, Choice of Entity for Real Estate Deals CLE presentation sponsored by several state bar associations; Choice of Entity/Current Structures/Tax Planning for LLCs Holding Real Estate/Exit Strategies program presented at the Tenth Annual Real Estate Tax Forum (2008); Norton L. Steuben, Choice of Entity for Real Estate After Check-the-Box and the Entity Explosions, 37 R. Prop. Prob. & Trust J. (Spring 2002).

B. Advantages of LLCs and Partnerships

C. [1]

1. No Entity Level Income Tax or (in most states) Franchise Tax. Partnerships (and entities classified as partnerships for federal tax purposes, e.g. LLCs)[2] do not pay federal income taxes and generally do not pay state income or franchise taxes. See, e.g., I.R.C. õ701. But see Bruce P. Ely, Noted Trends in the State Taxation of Pass-Through Entities, in Tax Planning for Domestic & Foreign Partnerships, LLCs, Joint Ventures & Other Strategic Alliances, Practising Law Institute (2008) for a general description of how each state taxes partnerships and LLCs. See also taxes such as the California LLC franchise tax fee discussed in the "Shop Talk" column in the March 2009 issue of the Journal of Taxation; "Thumbs Down on California LLC Franchise Fee Again, Show Us the Money!" 110 J. Tax. 188 (2009) Quoting from this column:

A 2007 analysis was prepared by the California State Senate Republican Fiscal Office illustrates the phenomenal growth of LLCs and the amount of LLC taxes and fees paid to the state. In fiscal 1994, 7,000 LLC returns were received, generating total LLC taxes and fees to California of $800,000. In 2001, 98,000 returns were filed generating total revenues of $243.3 million. Within four years, the numbers had doubled - in 2005, 194,000 returns were received, transmitting LLC taxes of $156.9 million and LLC fees paid of $283.3 million, resulting in total revenues to California of $440.2 million. (The numbers probably are even larger for 2006 and onward.) [Emphasis added.]

2. Flow-Through of Income and Losses/Deductions. Taxation of partnership earnings and operations generally occurs at the owner level, with income and losses/deductions, and the character of that income and losses/deductions, passing through the entity to the owners. See, e.g., I.R.C. õõ702 and 703.

(a) This treatment may allow losses/deductions to be utilized sooner than if, as in the case of C corporations, they had to be carried forward to future profitable years [subject to capital account (I.R.C. õ704(b)), basis (I.R.C. õ704(d)), at risk (I.R.C. õ465), and passive loss (I.R.C. õ469) considerations and limitations]. In this regard, it is important to note that unlike a loss on an investment in a C corporation that has gone bad that [except for the case for corporations filing consolidated returns] may only be recognized when the purchased shares of stock are sold or otherwise disposed of in a taxable transaction [and then, except for õ1244 stock, only as capital losses], the losses of flow-through entities generally are recognized as ordinary or õ1231 deductions as the invested funds are spent by the portfolio company [or recovered over applicable depreciation or amortization periods or at the time (generally as õ1231 losses) that assets of the portfolio company are sold] or, at the latest, when the investment is disposed). In most cases, this will be a better answer than that for a shareholder of a C corporation, even an individual owner of Section 1244 stock [who is able to deduct the loss recognized on that stock as an ordinary loss instead of as a capital loss if certain requirements are satisfied [such as the 50% active income requirement and the small business corporation requirement limiting capital contributions to $1,000,000] and subject to certain limitations [such as not being able to treat more than $50,000 ($100,000 for married couples filing joint returns) of such losses as ordinary losses in any taxable year)]. There are no such limitations and restrictions on a direct or indirect partner recognizing suspended (such as by the application of the passive loss rules) ordinary losses when an investment is disposed.

(b) This treatment may allow losses/deductions to be utilized when they might otherwise be lost or delayed because of the application of the loss disallowance rules of I.R.C. õõ382 and 384. But see the somewhat comparable rules preventing the "trafficking of losses" of partnerships having "substantial built-in losses" of I.R.C. õõ743(b)(2) and 743(d) discussed in Parts B.9 and C.7 below.

(c) Because the character of partnership losses flow through to its owners, investors are able to report their share of the partnership's ordinary and õ1231 losses instead of being limited to recognizing only capital losses when their investments are disposed of, as is the case with stock issued by a C corporation. Capital losses are far less attractive than ordinary losses because they generally may only be used only to shelter capital gains.[3] Thus, except for the annual $3,000 ($1,500 in the case of married individuals filing separate returns) exception under I.R.C. õ1211(b), capital losses may only be used by individuals to offset income that generally would otherwise be taxed at a 15% federal income tax rate instead of the maximum ordinary federal income tax rate of 35%.

3. Flexible Exit. Perhaps most importantly in the PE/VC Fund ("Fund") context, given the limited time horizon of its investments and most of the gain on sale of a portfolio company usually being attributable to goodwill, going concern, and similar intangible assets, the buyer is able to purchase assets (or, if the parties prefer, equity interests that under Rev. Rul. 99-6, 1999-1 C.B. 432 or, generally speaking, I.R.C. õõ743(b), 754, and 755, allow for the adjusted tax bases of the entity's assets to be stepped up to their fair market values, i.e. for the amount paid for them by, the buyer) usually with little or no additional tax to the seller or its owners, except with respect to preserving the ordinary income character of inventory, recapture items and other "unrealized receivables" such as under the collapsible partnership rules of I.R.C. õ751(a). This ability of the buyer to purchase (or otherwise push down the purchase price for the target company into the tax bases of) the target company's assets generally enables the buyer to recover (i.e., deduct) the price paid for the company over an average of (roughly speaking) 15 years (meaning for each $15 million of purchase price, an average of $1 million per year of sanctioned tax shelter is created, resulting in an annual average net cash flow benefit of $400,000 to $450,000 of annual federal and state income tax savings). See I.R.C. õ197(a).

4. Outsized Returns Have Become Harder to Come By. Generally, with the growth in number of financial buyers and the increased sophistication of the owners of prospective portfolio companies, opportunities for realizing above-market returns have become increasingly challenging to develop; thus, financial buyers increasingly need to squeeze out returns from non-traditional sources. These economic pressures also may cause the Fund's managers to become more targeted not only in the type of industries or geographic areas in which the Fund invests but also defining their "space" to include the type of investor that they would like to attract.

5. More Tax-Efficient Equity Incentive. Profits interest awards in entities taxed as partnerships generally are more flexible and favorable than their corporate counterparts of restricted stock and qualified and nonqualified stock options. That is because, unlike incentive stock options, the entity does not give up its deductions (or the equivalent of allocating income or gain to management and, therefore, away from the investors) for members of management to have their equity incentive awards taxed at capital gains rates. Also, many hurdles must be overcome for the appreciation in value of ISOs to be taxed at favorable capital gain rates, including, for example, when the option must be exercised and the stock acquired by the exercise of those options may be sold, the recipient not being a 10% shareholder, and the $100,000 annual limitation. I.R.C. õ422. Even if those and other hurdles are overcome, the spread between the exercise price and the fair market value of the stock on the date of exercise is subject to the alternative minimum tax. I.R.C.õõ422 and 56(b)(3). In the case of nonqualified options that do not have a "readily ascertainable fair market value" on the date of grant, the spread between the exercise price and the value of the underlying stock generally is taxed as ordinary, compensation income when the option is exercised or sold. Treas. Reg. õ1.83-7.

Restricted stock presents the recipient with the dilemma of having to recognize the value of that stock as compensation income either on the date of grant (by filing a Section 83(b) election) or on the date on which it becomes vested (i.e., no longer subject to a substantial risk of forfeiture). I.R.C. õ83. Another consideration is the manner in which the deferred compensation rules of I.R.C. õ409A and the Treasury Regulations promulgated thereunder (particularly Treas. Reg. õ1.409A-1(b) and the rules applicable to stock options, stock appreciation rights and other equity-based compensation arrangements under Treas. Reg. õ1.409A-1(b)(5)) may apply to different compensation arrangements that a portfolio company may want to adopt. In that regard, it is important to note that, currently, the IRS generally exempts partnership profits interests from the application of Section 409A. See Linda Z. Swartz, Section 83(b), Section 409A and Subchapter K, in Tax Planning for Domestic & Foreign Partnerships, LLCs, Joint Ventures & Other Strategic Alliances (2008).

6. Ability to Make Tax-Free Distributions. Generally, a corporation may not distribute built-in gain property to its owners without triggering one (if it is an S corporation) or two (if it is a C corporation) levels of tax. I.R.C. õ311(b)(1). In addition, C corporation shareholders generally must pay tax on the cash dividends and other distributions (e.g., recapitalization proceeds) paid to them. See I.R.C. õõ301, 302. S corporations with accumulated earnings and profits must pay tax on the cash dividends and other distributions (e.g., recapitalization proceeds) paid to them to the extent that those distributions exceed the S corporation's accumulated adjustments account balance until the corporation's accumulated Subchapter C earnings and profits have been exhausted, then again (as is the case for S corporations that never had any accumulated Subchapter C earnings and profits) as capital gains, to the extent that the distributions made to them exceed the adjusted basis in their stock (which basis, unlike the rule for partners in a partnership, is not increased by a shareholder's share of the corporation's liabilities). Compare I.R.C. õõ1367(a) and 1367(b)(2) to I.R.C. õ752(a).

On the other hand, an entity that is classified as a partnership for federal tax purposes usually may distribute built-in gain property to its owners without triggering income or gain to the partnership or its members [except as otherwise provided by (i) I.R.C. õ751(b) with respect to the deemed exchange by a partner of that partner's interest in certain "hot" assets of substantially appreciated inventory and unrealized receivables (including depreciation recapture) and that partner's interest in the partnership's other assets or (ii) the I.R.C. õ707(a)(2)(B) disguised sale of assets and partnership interests rules], and may distribute money to its owners without them having to recognize gain except to the extent that the amount of the money (including marketable securities under I.R.C. õ731(c) and reduction in a partner's share of the partnership's liabilities under I.R.C. õ751(b)) paid to a member exceeds the adjusted basis of that member's partnership or membership interest (which is increased by the member's share of the company's liabilities). I.R.C. õõ731 and 752(a).

7. Ability to Convert to or Merge with Other Entities Tax Free. Depending on whether a corporation is a C corporation or an S corporation, one or two levels of tax must be recognized when the corporation liquidates or converts or merges into or with a domestic entity that is not classified as a corporation for federal tax purposes. See Part VII.A of Warren P. Kean, M&A Transactions Involving Partnerships and LLCs, Including Conversions, Mergers and Divisions, in Tax Planning for Domestic & Foreign Partnerships, LLCs, Joint Ventures & Other Strategic Alliances, Practising Law Institute (2008). On the other hand, usually little or no tax gain need be recognized when an entity that is classified as a partnership for federal tax purposes merges into another entity that is classified as a partnership for federal tax purposes or converts into or merges with a corporation and the 80% "control" test of I.R.C. õõ351(a) and 368(c) is satisfied. Id., Parts IV and VII.B.

8. Ability to Divide (Spin-Offs, etc.). A corporation's ability to divide tax-free is significantly limited by the many formidable requirements of I.R.C. õ355, which do not apply to partnerships. Id., Parts II.D and V.

9. Ability to Avoid Special Adverse Tax Provisions that Apply to Corporations. Some provisions of the Internal Revenue Code treat corporations more harshly than partnerships (which, in the case of partnerships, that treatment generally flows through to the partnership's corporate members but not its individual members). For example, Section 163 imposes restrictions on the ability of a corporation to deduct certain interest expenses. See, e.g., applicable high yield discount obligations issued by corporations (I.R.C. õõ163(e)(5) and 163(i)), disqualified interest paid or accrued by a C corporation (I.R.C. õ163(j) re: earnings stripping), interest on disqualified debt instruments issued by corporations (I.R.C. õ163(l)). See also, the imputation of dividend payments on certain corporate stock and convertible debt instruments under I.R.C. õ305 and the limitation on a corporation's ability to deduct net operating loss carryovers after there has been an ownership change under I.R.C. õ382. However, after the American Jobs Creation Act of 2004, partners now have their own limitation from being able to sell built-in partnership losses, for I.R.C. õõ743(b)(2) and 743(d) now require the inside basis of a partnership's assets to be stepped down to fair market value (regardless of whether a Section 754 election is in effect) with respect to the purchaser or other transferee of a partnership interest if the combined adjusted bases of the partnership's assets exceed the combined fair market value of those assets by more than $250,000.

10. Flexibility. Perhaps the biggest advantage of partnerships over corporations is the flexibility afforded partnerships under both tax law and the unincorporated entity statutes of most states. See, e.g., the stated public policy of Delaware "to give the maximum effect to the principles of freedom of contract and to the enforceability of limited liability company agreements." 6 Del. Code Ann. õ18-1101(b) (for Delaware LLCs) and comparable language in 6 Del. Code Ann. õ17-1101(c) (for Delaware limited partnerships). See also Warren P. Kean, M&A Transactions Involving Partnerships and LLCs, Including Conversions, Mergers and Divisions, in Tax Planning for Domestic & Foreign Partnerships, LLCs, Joint Ventures & Other Strategic Alliances, Practising Law Institute (2008) for a discussion of the flexibility that owners have to move assets in and out of a partnership; to determine and alter the manner in which the partnership's income and losses (including items of gross income, gain, deduction, and loss) are to be shared by the partners, and to determine the extent to which they may share and include the partnership's liabilities in the amount of the basis in their partnership interests, thereby allowing the deferral of the recognition of income that they otherwise would be required to recognize upon receiving cash distributions from the partnership that exceed the amount of cash and the basis of other property that they have invested in the partnership; and to otherwise structure transactions involving the partnership in tax-advantageous ways.

11. Flexibility and Proposed Legislation to Tax Certain Carried Interests as Compensation Income and a General Change in the Regulatory Environment. In 2008, the U.S. House of Representatives passed H.R. 6275 (and, on December 9, 2009, passed H.R. 4213) to, among other things, tax a partner's income attributable to an "investment services partnership interest" as compensation income. The clear target of this proposal is the carried interests of investment fund managers. The proposal, however, defines an "investment services partnership interest" as one issued to a partner in exchange for that partner providing certain services with respect to "specified assets," which are defined as certain securities under I.R.C. õ475(c)(2), real estate, commodities (as defined in I.R.C. õ475(c)(2)), or options or derivative contracts with respect to such securities, real estate or commodities. In the case of PE/VC Funds, the "specified assets" that most likely will be applicable [although, given the potentially broad application of this proposed legislation, one could inadvertently step into being deemed to provide management, financing, etc. services with respect to one or more of the other "specified assets"] are "securities" under I.R.C. õ475(c)(2), which include, among other securities, capital stock issued by a corporation (regardless of whether it is publicly traded) and partnership interests in a "widely held or publicly traded partnership." Thus, the last draft of the proposed legislation suggests that it might be possible to push down a Fund manager's promoted interest to the portfolio company level, which would be more easily accomplished if those portfolio companies were partnerships or LLCs classified as partnerships for federal tax purposes. (See generally the placement of a partnership (a blocker subsidiary or "B Sub" in the diagrams in Part D below) beneath blocker corporations to allow the PE/VC firm to receive its carry on a pre-tax basis with respect to the Fund's investments in unincorporated portfolio companies for a structure, with appropriate modifications, that might be utilized for this purpose). Bottom line, no one knows what tax or other legislation and regulations might be enacted that could affect the type of entity structure that is favored or required by a Fund for its portfolio companies. That uncertainty may cause PE/VC firms and their advisors to consider selecting the entity type that offers the greatest flexibility and ease for converting into some other type of entity should the financial, market, tax, or legal environment change in favor of operating under a different entity shell or format.

12. Improve IRR. LLC operating agreements typically provide for tax distributions. Those distributions are treated the same as any other distributions for purposes of computing the investors' preferred return and internal rate of return, off of which the fund sponsor's (the general partner) carried interest is determined and its performance is measured. Thus, the sponsor benefits (sometimes significantly when compared to an identical firm that invests only in corporations) by having the firm's portfolio companies distribute amounts to its owners (which the investment fund then distributes its share to its investors) that would otherwise be paid to the government in the form of taxes.

D. Disadvantages of Partnerships and Other Reasons Why a PE/VC Fund May Decline to Invest in Entities Taxed as Partnerships.

The two biggest reasons why PE/VC Funds do not invest in entities taxed as partnerships is because their Fund documents either preclude or substantially limit them from engaging in activities that may generate (i)"unrelated business taxable income" (UBTI) or (ii)income effectively connected with the conduct of a trade or business within the United States ("ECI"). Fund advisors believe that such restrictions are necessary to attract investment in the Funds they manage by pension plans, endowments, and other tax-exempt investors and by foreign investors. Some Funds are able to attract the investment of large amounts of capital by these types of investors. Many Funds, however, are less successful. In the latter case, is it sensible for a Fund and its other investors to allow one investor, or a minor group of investors, to dictate terms that disadvantage the majority, in many cases the overwhelming majority, of the other investors?

1. UBTI. For purposes of discussion, UBTI comes in two forms: (i)income from an "unrelated trade or business" and (ii)"unrelated debt-finance income." Unrelated trade or business income is income from a trade or business that is "not substantially related (aside from the need of such organization for income or funds or the use it makes of the profits derived) to the exercise or performance by" that organization of its tax-exempt purpose. I.R.C. õ513. This type of income does not include passive income such as dividends, interest, certain royalties and rental income and, more importantly for PE/VC Funds, gains from the sale of non-dealer on-inventory property (except to the extent of I.R.C. õ1245 or 1250 depreciation recapture) when the investment is not made, or deemed to be made, with borrowed funds (the rules applicable to unrelated debt-finance income are discussed below). I.R.C. õõ512(b) and 514(b)(1)(B) and Treas. Reg. õõ1245-6(b) and 1.1250-1(c)(2). In the case of partnerships, the aggregate theory of partnerships is applied in that the activities of the partnership are treated as if they are undertaken by its members for determining whether they have UBTI. I.R.C. õ512(c).

An otherwise tax-exempt entity must pay corporate income taxes at the graduated rates of I.R.C. õ11 on the net UBTI recognized for a particular year. I.R.C. õ511. Thus, a tax-exempt entity is subject to the same tax rates on UBTI as any non-tax-exempt, corporate investor. Moreover, a direct (or indirect, through tiers of partnerships) tax-exempt partner is allocated its share of the partnership's business deductions and losses as well as its income. Also, net operating losses from unrelated business activities may be applied to offset UBTI recognized in other taxable years under the principles of I.R.C. õ172, as modified by I.R.C. õ512(b)(6). Accordingly, a tax-exempt investor may benefit from being allocated that investor's share of portfolio company losses to offset UBTI that it recognizes from other sources. That may be an important consideration with respect to many prospective portfolio companies that are expected not to be able to generate taxable income for many years or, perhaps, at any time prior to its sale or other disposition.

Because of the large amount of debt that PE/VC Funds historically have incurred at the portfolio-company level to finance their investments in those portfolio companies, a more troubling aspect of UBTI for those Funds is the imposition of corporate income taxes on so-called "unrelated debt-financed income" under I.R.C. õ514. Under I.R.C. õõ512(b)(4) and 514, income and related deductions that I.R.C. õ512((b) otherwise would exclude from UBTI (such as interest, dividends, rents, royalties, and gains from the sale of investment property or property used in a trade or business) are brought back into the computation of UBTI to the extent that they are attributable to debt-financed property (which generally is determined by the amount that the property's average acquisition indebtedness for a particular taxable year bears to the average adjusted basis of that property for the year). I.R.C. õ514(a) and 514(b)(1)(B). Under I.R.C. õõ702(b) and 512(c)(1), the character of income and deductions (including unrelated debt-financed income character) of a partnership are passed through to its members. See, e.g., Example 4 of Treas. Reg. õ1.514(c)-1(a)(2). Moreover, the IRS apparently takes the position (some might say over-reaches to tack the position) that a tax-exempt partner will recognize the same amount of unrelated debt-financed income regardless of whether the disposition of the portfolio company is structured as an asset sale or the sale of membership or partnership interests. See Tech. Adv. Mem. 9651001 (June 27, 1996) and similar analysis in Rev. Rul. 91-32, 1991-1 C.B. 107 with respect to a foreign partner's recognition of ECI upon the disposition of his partnership interest.

The IRS's analysis in Tech. Adv. Mem. 9651001, however, arguably is not supported by current law. Except for the limited extent provided in I.R.C. õ751(a) for recharacterizing that part of the gain or loss from the sale of a partnership interest that is attributable to the partnership's unrealized receivables and inventory as ordinary income or loss instead of as a capital gain or loss and the look-through rules under FIRPTA (particularly, I.R.C. õ897(g)) and for õ1250 gain and collectibles gain on the sale but not liquidation/redemption of a partnership interest under Treas. Reg. õõ1.1(h)-1(a) and -1(b)(3)(ii), the federal income tax law consistently treats the sale of a partnership interest as not being a sale of that partner's indirect interest in the partnership's assets. See, e.g., I.R.C. õ741 and the regulations promulgated thereunder; Rev. Rul. 68-79, 1968-1 C.B. 310 (the holding period of a partnership's assets is not impacted by the holding period of any partner's partnership interest); Rev. Rul. 99-6, 1991-1 C.B. 432 (the sale of all of the outstanding partnership interests to a single purchaser is treated as the sale of partnership interests under I.R.C. õ741 by the selling partners and a purchase of assets by the buyer); Prop. Reg. õ1.721-1(b)(2) (rejecting the recommendation of some commentators that the partnership should recognize a portion of the built-in gain or loss of its assets on the transfer of an interest in the partnership in payment for services provided to the partnership on the theory advanced by those commentators that the partnership interest represents a fractional interest in each of the partnership's assets); and Brown Group, Inc. v. Commissioner, 77 F.3d 217 (8th Cir. 1996), rev'g, 104 TC 105 (1995) (a controlled foreign corporation's distributive share of a foreign partnership's income did not become Subpart F income under the pre-1987 version of I.R.C. õ954(d)(3) simply because it would have been Subpart F income if earned by the CFC; the IRS subsequently amended its regulations by promulgating Treas. Dec. TD 9008, issuing Treas. Reg. õõ1.702-1(a)(8)(ii), 1.952-1(g), 1.954-1(g), 1.954-2(a)(5), 1.954-3(a)(6), 1.954-4(b)(2)(iii) and 1.954-2(a)(3)). See also the preamble to REG-105346-03, 70 Fed. Reg. 29675 (2005) reprinted in 2005-1 C.B. 1244. See also William M. Shaheen, Selling a Partnership Interest May Create UBTI Problems, 10 J. Tax'n Exempt Org. (Jan./Feb. 1999). But see I.R.C. õ752(d) and Treas. Reg. õ1.752-1(h) (neither of which is mentioned in either Rev. Rul. 91-32 or Tech. Adv. Mem. 9651001), which provide that the amount realized on the sale of a partnership interest includes the selling partner's share of the partnership's liabilities - a corollary to the adjusted tax basis of a partnership interest being increased, as if the partner had contributed additional money to the partnership, under I.R.C. õ752(a) (which is cited as authority for the Service's ruling in Tech. Adv. Mem. 9651001) by the partner's share of the partnership's liabilities. However, Subchapter K does not have a general look-through rule for partnership liabilities as it has for items of partnership income, deductions and losses under I.R.C. õ702, and the Service's position in Rev. Rul. 91-32 and Tech. Adv. Mem. 9651001, if valid, would make I.R.C. õ108(d)(6) (applying certain exceptions to partnership discharge of indebtedness income at the partner level instead of at the partnership level) superfluous. Lastly, the Service's issuance of Rev. Rul. 2008-39, 2008-31 I.R.B. 252 (an upper-tier partnership is not considered to be engaged in the trade or business of a partnership in which it is a partner for purposes of determining whether its management fees are deductible as ordinary and necessary business expenses or as õ212 investment expenses) suggests that the results in Rev. Rul. 91-32 and Tech. Adv. Mem. 9651001 may be avoided by injecting another partnership in the structure to hold the Fund's membership interest in the operating company; that way when the Fund sells its partnership interest in the holding partnership and Section 741 is ignored, then the Fund should be considered as selling its interests in the holding partnership's assets (i.e., its partnership interest in the operating company, which is a capital asset under I.R.C. õ1221) not its indirect interests in the assets of the operating partnership.

One way tax-exempts mitigate or eliminate unrelated debt-finance income that might be attributable to their interest in an entity classified as a partnership is to take advantage of the flexible rules under the Section 752 regulations and cause the partnership agreement to allocate as much of a partnership's liabilities to the taxable partners as possible. See Example 4 of Treas. Reg. õ1.514(c)-1(a)(2) and Tech. Adv. Mem. 9651001 (June 27, 1996). See also, Rev. Rul. 76-95, 1976-1 C.B. 172.

2. ECI. Foreign persons (individuals and corporations) are taxed on income that is considered to be effectively connected with the conduct of a trade or business within the United States (including õ1231 gains and certain gains from the sale of capital assets). I.R.C. õõ864(c), 872(a)(2) and 882(a)(1) and Treas. Reg. õ1.864-4(c). If, however, a foreign person is a resident of a country that has a tax treaty with the United States, then that tax convention likely requires that the ECI (including gain from the disposition of personal property) be attributable to a "permanent establishment" (i.e., "a fixed place of business through which the business of an enterprise is wholly or partly carried on") in the U.S. for it to be subject to the U.S. net income tax. Articles 5, 7, and 13 of the United States Model Income Tax Convention of November 15, 2006 (the "Model Treaty").

In addition to a foreign person having to pay U.S. income taxes on ECI, if the foreign person is a corporation, that income likely also will be subject to a second, "branch profits tax" to the extent (i.e., the "deemed equivalent amount") that it is deemed to be paid to, or otherwise repatriated by, that corporation other than in connection with that foreign corporation completely terminating all of its trade or business activities in the U.S. (which, presumably, would include all of the foreign corporation's direct and indirect interests in unincorporated portfolio companies) and, thereby, ceasing to directly or indirectly have any "U.S. assets." I.R.C. õ884 and Treas. Reg. õ1.884-2T. In the absence of an applicable tax treaty, the U.S. branch profits tax is imposed at a flat 30% rate, which could cause the effective tax rate on the foreign corporation's U.S. ECI to exceed 50%.

A foreign person is deemed to be engaged in the business conducted directly or indirectly (through one or more tiers of partnerships) by each of the partnerships in which the foreign person is a partner for purposes of determining that person's ECI and, if that foreign person is a foreign corporation, branch tax liability. I.R.C. õõ702(b) and 875(1). To ensure that the tax on a foreign person's distributive share of a partnership's ECI is paid, I.R.C. õ1446 requires the partnership to withhold and remit to the U.S. Treasury the foreign partner's income tax on the foreign partner's distributive share of that income calculated at the highest applicable marginal federal income tax rate. Moreover, as mentioned in the above discussion on UBTI, the IRS takes the dubious position that a foreign person is to be treated as effectively owning an undivided interest in the assets of a partnership in which that person is a member to determine the amount of the gain from the sale of that partner's interest in the partnership that is to be taxed as ECI (i.e., based on the ratio of ECI that the foreign partner would recognize had the partnership instead sold all of its assets, discharged its liabilities, and distributed the remaining proceeds to its members in liquidation of their interests in the partnership). Rev. Rul. 91-32, 1991- C.B. 107. See also I.R.C. õ897(g) for similar rules regarding that part of the amount realized from the sale of a partnership interest that is to be treated as being attributable to the partnership's U.S. real property interests.

3. Foreign Investors' Obligation to File U.S. Tax Returns. A foreign person is deemed to engage in the trade or business conducted in the U.S. by any partnership in which that foreign person is directly (or indirectly through tiers of partnerships) a partner. I.R.C. õ875(1). Every foreign person that engages in a trade or business (whether directly or indirectly through one or more partnerships) becomes a U.S. taxpayer and like other U.S. taxpayers must file U.S. federal income tax returns regardless of whether that person has any ECI or other income for a particular taxable year. Treas. Reg. õõ1.6012-1(b)(1)(i) and 1.6012-1(g)(1)(i). As for other U.S. taxpayers, a foreign person that engages in a U.S. trade or business that fails to timely file U.S. income tax returns is subject to penalties and, in addition, if that foreign person is an individual, he or she is subject to having deductions and credits (other than credits for taxes paid) disallowed. I.R.C. õõ874(a) and 882(c)(2); Treas. Reg. õ1.874-1(a).

4. State and Local Taxes. If a PE/VC Fund invests in an unincorporated portfolio company that conducts business in many states (presumably any business activities of that company in foreign countries will be conducted through foreign corporations), its investors either will need to be included as part of composite returns filed by the partnership or separately incur the expense and challenge of having to file their own income tax returns in those states. Some states, however, do not give the partners this option; instead, they require the partnership to withhold and pay state income taxes on each non-resident partner's share of the partnership's income attributable to that state. See, e.g., N.C.G.S. õ105-154(d) (requiring the partnership to withhold and remit North Carolina income taxes of nonresident individuals' shares of the partnership's North Carolina income (a nonresident corporation may forego being included in the North Carolina composite return by executing an affirmation that it will file North Carolina income tax returns and pay the North Carolina taxes owed on its share of the partnership's North Carolina income)). For a general discussion of the state tax issues that may arise when a business is conducted by an LLC or other unincorporated entity, see Bruce P. Ely, Noted Trends in the State Taxation of Pass-Through Entities, in Tax Planning for Domestic & Foreign Partnerships, LLCs, Joint Ventures & Other Strategic Alliances, Practising Law Institute (2008), with attached charts summarizing the manner in which each of the 50 states tax LLCs and other entities classified as partnerships for federal tax purposes.

5. General Inability of an LLC or Partnership to Make a Public Offering of its Equity Securities or Merging Into a Publicly-Traded or Privately-Held Corporation.

IPOs. Another reason given for PE/VC Funds prefer investing in corporations instead of LLCs or other entities taxed as partnerships is to put those companies into position at the outset for being able to make an initial public offering or to merge, on a tax-free basis, into a publicly-traded or privately-held corporate "acquirer." While one may always hope and work towards having a portfolio company "go public," that aspiration usually is not realized. If it is, then it is relatively easy to convert the LLC or other unincorporated entity into a corporation prior to, or in connection with, the IPO. See Rev. Rul. 84-111, 1984-2 C.B. 88. See also the 2008 amendments to SEC Rule 144, which among other things generally reduced the holding period for the resale of restricted stock issued by a publicly-traded (i.e., a "reporting") company and held by non-affiliated shareholders from one year to six months (volume limitations and other requirements in addition to the current information requirements generally must be satisfied for an affiliated shareholder to sell restricted shares after holding them for six months); thus, making the inability to tack the converted securities holding period less relevant.

In addition, several companies have employed a variant of the UPREIT or umbrella REIT structure to go public (generally referred to as the barnesandnoble.com structure after one of the first non-REIT companies made an initial public offering using this structure). See Registration Statement of barnesandnoble.com, Inc. filed on Form S-1 on May 24, 1999, File No. 333-64211; see also Form 10-K filed May 1, 2000. In notes 123 and 126 and the related discussion, Eric B. Sloan, Steven E. Klig, and Judd A. Sher, Through the Looking Glass: Seeing Corporate Problems as Partnership Opportunities, in Tax Planning for Domestic & Foreign Partnerships, LLCs, Joint Ventures & Other Strategic Alliances, Practising Law Institute (2008), identify the following companies as using some version of the UPREIT/barnesandnoble.com structure: "Prospectus for Evercore Partners (August 11, 2006); prospectus for Lazard Ltd. (May 2, 2005); prospectus for Texas Genco Inc. (June 3, 2005) (later withdrawn due to sale of the company); prospectus for Calamos Asset Management, Inc. (Oct. 26, 2004); prospectus for Accenture Ltd. (July 18, 2001); prospectus for Charter Communications, Inc. (Nov. 8, 1999); prospectus for barnesandnoble.com Inc. (May 25, 1999) (on May 27, 2004, the structure was unwound when barnesandnoble.com inc. merged with and into a wholly owned subsidiary of Barnes & Noble, Inc)." See also Mark J. Silverman, Lisa M. Zarlenga, Eric B. Sloan, and Lewis Steinberg, Thinking Outside the Box and Inside the Circle (or Triangle): Use of LLCs in Consolidated Return Context, In Corporate Acquisitions, and Otherwise, Tax Strategies for Corporate Acquisitions, Dispositions, Spin-Offs, Joint Ventures, Financings, Reorganizations & Restructurings, Practising Law Institute (2008) in which the following additional companies are identified as using a variation of this structure: "Highbridge..., National Cinemedia, Fortress and Blackstone."

The basic structure is presented in the following diagram:

barnesandnoble.com Variant of the UPREIT Structure*

Graphic1

Tax-Free Mergers. The Internal Revenue Code allows for certain corporate mergers and other "reorganizations" described in I.R.C. õ368 to occur tax-free (i.e., with the corporations or the shareholders participating in the reorganization not recognizing gain or loss except for having to recognize gain to the extent that cash or other "boot" is received in the transaction). See Part II.C.2 of Warren P. Kean, M&A Transactions Involving Partnerships and LLCs, Including Conversions, Mergers and Divisions, in Tax Planning for Domestic & Foreign Partnerships, LLCs, Joint Ventures & Other Strategic Alliances, Practising Law Institute (2008). This exception to gain or loss recognition only applies if the entities involved in the reorganization are corporations. Thus, unless I.R.C. õ351 applies, the merger or other combination of a partnership into a corporation in exchange for stock of the surviving corporation (as contrasted from a merger of a partnership with another partnership) is taxable to the partnership and its members. Id. at Part VII.B. In addition, the merger of a corporation into a partnership is taxable to the corporation and its shareholders on the same basis had the corporation instead liquidated. Id. at Part VII.A.

If the PE/VC Fund intends to sell any shares it receives shortly after the close of a merger, then having gain triggered by the merger or combination may not be that significant, particularly if the acquirer is willing to pay additional consideration for the step-up in the tax basis of the target's assets. If continued deferral is important, then [with appropriate care so as to not run afoul of the step-transaction doctrine (which under Treas. Reg. õ301.7701-3(g)(2)(i) applies to elective conversions under the check-the-box rules)] before the merger or other combination and under circumstances that establish that doing so has independent, non-tax, significance and purpose, either the portfolio company can convert into a corporation or the Fund can transfer its membership interest in the portfolio company to a corporation formed to hold the membership interest and then merge that corporation into the acquirer or an acquisition subsidiary of the acquirer. Compare West Coast Mktg. Corp. v. Commissioner, 46 T.C. 32 (1966) (transfer of an undivided interest in land to a newly-formed corporation when "the sale of the land was imminent" for the sole purpose of being able to receive the agreed-upon consideration for that land (i.e., shares of stock of the acquiring corporation) in a tax-free B reorganization (demonstrated, at least in part, by the acquiring corporation liquidating the new corporation less than two months after the share exchange) was disregarded under the step transaction doctrine; instead, the taxpayer was treated as having transferred the undivided interest in the land to the acquiring corporation in exchange for shares of that corporation's stock) with Vest v. Commissioner, 57 T.C. 128 (1971) (because there were valid, non-tax, business reasons for the transfer of assets to a new corporation one month before that corporation signed (and otherwise committed to) a share exchange agreement and plan of reorganization with the acquiring corporation (and before that transaction was otherwise "imminent") and two months before the transaction was consummated, the share exchange was held to be a valid B reorganization even though the acquiring corporation liquidated the target corporation shortly after the share exchange) and Weikel v. Commissioner, T.C. Memo 1986-58 (holding that the transfer of assets to a newly-formed corporation during the course of negotiations for the purchase and sale or license of those assets to Johnson & Johnson had "economic substance" that was "independent" of the share exchange that was agreed to two months after the incorporation of the targeted business and which was closed two months after that because (i) at the time of the target's incorporation, it was uncertain that an agreement would be reached with J&J, (ii) the assets were of a business (as contrasted from the passive, investment asset that were at issue in West Coast Mktg. Corp.), (iii) the business had become profitable and those profits would be taxed more favorably if the business were incorporated, (iv) J&J (for its own business reasons) wanted the business incorporated so that it could acquire stock instead of assets of the business, and (iv) J&J continued to operate that business in the target corporation for almost three years after it acquired the company).

Alternatively, and perhaps more likely to survive a collapsible transaction attack, the Fund (and perhaps other members, as long as the LLC continues to have at least two economic members after the transaction) could transfer its membership interest in the LLC to a corporation and have all of the stock of that corporation acquired by the acquiring corporation in either a B Reorganization or a Reverse Triangular merger that qualifies for tax-deferral treatment under I.R.C. õ368(a)(2)(E) with the affirmative covenant that the acquirer maintain the target structure (of a corporation holding a membership interest in the LLC that retains its classification as a partnership for federal tax purposes) for a sufficient period of time to establish the business and economic relevance (and non-transitory nature) of the pre-merger transaction(s). See Weikel v. Commissioner, TC Memo 1986-58, discussed in the preceding paragraph and compare that case to Intermountain Lumber Co. v. Commissioner, 65 T.C. 1025 (1976) (the sale of 50% of the total number of shares of stock received in exchange for the contribution of assets to a newly-formed corporation pursuant to an integrated agreement with the buyer caused the selling shareholder to be deemed to own only the retained shares "immediately after the exchange" and, therefore, the exchange did not satisfy the "control" requirement for tax-free treatment under I.R.C. õ351[4]) and Rev. Rul. 70-140, 1970-1 CB 73 (the transfer of assets to the transferor's previously-established and operating, wholly-owned, target corporation in connection with (i.e., as part of a "prearranged integrated plan") the transfer of all of the stock of that target corporation to the acquiring corporation in exchange for stock in the acquiring corporation was ruled, in substance, to have been transferred by the taxpayer to the acquiring corporation, which the taxpayer did not control immediately after the deemed exchange and, therefore, was taxable (however, the continued viability of this ruling after Esmark, Inc. v. Commissioner, 90 T.C. 171 (1988), aff'd 886 F.2d 1318 (7th Cir. 1989) is debatable, particularly in the situation where the target corporation is maintained and not liquidated after the share exchange)).

See also the discussion of the foregoing issues in Part II.A.2 and 3, particularly Part II.A.3.c, of Laurence E. Crouch, Revival of the Choice of Entity Analysis: Use of Limited Liability Companies for Start-Up Business, in Tax Planning for Domestic & Foreign Partnerships, LLCs, Joint Ventures & Other Strategic Alliances (2008).


Warren P. Kean, Partner, warren.kean@klgates.com

Mr. Kean focuses his practice on matters relating to limited liability companies, partnerships, and other unincorporated entities and the taxation of those entities. His practice emphasizes venture capital and private equity financings, strategic alliances and joint ventures, and organizing and advising private equity funds and their investors and management.

In addition, Mr. Kean is involved with mergers and acquisitions; organizing and advising real estate ventures, advising emerging and other closely-held businesses; and corporate finance. His clients rely on his abilities as both a business and a tax lawyer to be two advisors in one.

Mr. Kean frequently lectures on his areas of practice. He is chair of the North Carolina Bar Association's Joint Task Force responsible for making legislative revisions to the North Carolina Limited Liability Company Act. He is past chair of the Model Operating Agreement Drafting Subcommittee of the Partnerships and the Unincorporated Business Organizations Committee and the past chair of the Tax Committee of the American Bar Association's Business Law Section.

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[1] For a more comprehensive discussion of the federal income tax treatment of partnerships and entities classified as partnerships for federal tax purposes engaged in mergers and acquisitions, see Warren P. Kean, M&A Transactions Involving Partnerships and LLCs, Including Conversions, Mergers and Divisions, Tax Planning for Domestic & Foreign Partnerships, LLCs, Joint Ventures & Other Strategic Alliances, Practising Law Institute (2008).

[2] This outline refers to LLCs, partnerships, and other domestic unincorporated entities interchangeably because under Treas. Reg. õõ301.7701-2 and 301.7701-3 each is an eligible business entity, which with two or more members will be deemed to be a partnership for federal tax purposes unless it files a Form 8832 to be classified as a corporation.

[3] Individuals, however, may apply in each taxable year up to $3,000 ($1,500 in the case of married individuals filing a separate return) of their excess capital losses (the amount by which their capital losses exceed their capital gains for the year) to offset ordinary income. I.R.C. õõ1211(a) and (b).

* For a more in depth discussion of this structure, see Robert A. Rizzi, Dot Com Exit Structures; barnesandnoble Reorganization Issues, 27 J. Corp. Tax'n (Oct. 2000).

[4] The Court reasoned:

A determination of 'ownership,' as that term is used in section 368(c) and for purposes of control under section 351, depends upon the obligation and freedom of action of the transferee with respect to the stock when he acquired it from the corporation. Such traditional ownership attributes as legal title, voting rights, and possession of stock certificates are not conclusive. If the transferee, as part of the transaction by which the shares were acquired, has irrevocably foregone or relinquished at that time the legal right to determine whether to keep the shares, ownership in such shares is lacking for purposes of section 351. By contrast, if there are no restrictions upon freedom of action at the time he acquired the shares, it is immaterial how soon thereafter the transferee elects to dispose of his stock or whether such disposition is in accord with a preconceived plan not amounting to a binding obligation.

After considering the entire record, we have concluded that Shook and Wilson intended to consummate a sale of the S&W stock, that they never doubted that the sale would be completed, that the sale was an integral part of the incorporation transaction, and that they considered themselves to be co-owners of S&W upon execution of the stock purchase agreement in 1967." Id. at 1031-32 (citations omitted).

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