Equity Compensation in a Pass-through

World

Business Law Institute

May 2011

Presented by:

David D. Brauer

Lurie Besikof Lapidus & Company

Kevin W. Kaiser

Lindquist & Vennum

Equity Compensation in a Pass-through World

ANY TAX ADVICE CONTAINED IN THIS COMMUNICATION IS NOT INTENDED OR WRITTEN TO BE USED, AND CANNOT BE USED FOR THE PURPOSE OF (i) AVOIDING PENALTIES THAT MAY BE IMPOSED ON ANY TAXPAYER OR (ii) PROMOTING, MARKETING OR RECOMMENDING TO ANOTHER PARTY ANY MATTERS ADDRESSED HEREIN.

The information contained herein is general in nature and based on authorities that are subject to change. Applicability to specific situations is to be determined through consultation with your tax adviser.

Equity Compensation

Corporations have long used equity to compensate employees

During the 1990s and early 2000s, stock options became increasingly important method of compensating corporate executives and employees

Total compensation of executives of the largest public companies

In recent years, increasing proportions of total compensation have been represented by equity, including various forms of employee stock options and restricted shares

LLCs want in on the action…

Equity Compensation

Direct issuance of ownership interest

Equity

Common stock

Preferred stock

Partnership interest (general or limited)

LLC membership interest

Compensatory options

Options on equity interest

A type of call option, although in the employment context special rules apply

Equity Appreciation Rights

Cash compensation designed to mirror compensatory options

Terminology - Authority

LLC/Partnership rules (Subchapter K)

– Partner’s percentage interest

Capital interest

Profits interest

Contrast with interest in a corporation

– Partner capital account rules

This is where the analysis

between LLCs and corporations

part company

Equity Compensation

Corporate treatment, generally…

Equity interest (unrestricted)

Income to employee when issued

Deduction to corporation

Note – If restricted, recognition occurs when restrictions lapse

Unless elect otherwise

Stock options

Two types of compensatory options

- Incentive stock options (ISOs) – nontaxable/nondeductible

- Nonqualified options – taxable/deductible

Partnership Equity Compensation

The early cases…

Diamond v. Commissioner, 492 F.2d 286 (7th Cir. 1974)

Campbell v. Commissioner, 943 F.2d 815 (8th Cir. 1991)

Diamond v. Commissioner (1974)

K & D

DK

40% P & L

100% Capital60% P & L

1. K acquires option to

purchase building

2. K asks D to arrange

financing in exchange

for 60% profits

interest in P/S

3. P/S formed and

building acquired with

D arranged financing

4. No D cash outlay

5. D sells 60% profits

interest for $40K

(three weeks later)

6. Court rules D must

recognize receipt of

P/S interest

Sold

Campbell v. Commissioner (1991)

S & C

CS

85% P & L

100% Capital

15% P & L

1. C negotiates

employment contract

providing that C will

receive a % of

partnership profits in

exchange for services

2. C treats the receipt of

the profits interest as

nontaxable

3. IRS challenges

nontaxable treatment

4. Tax Court held

taxable

5. Appellate Court held

nontaxable because

P/S interest had no

ascertainable value

The 40 Year Saga of Taxing Partnership

Profits Interests for Services

• Diamond v. Commissioner (1971)

• Proposed Partnership Regulation (1971)

• Campbell v. Commissioner (1991)

• Revenue Procedure 93-27

• Revenue Procedure 2001-43

• Proposed Regulation on noncompensatory options (2003)

• Private Letter Ruling 200329001 (only PLR on p/s interest for services)

• Proposed Partnership Regulations (2005)

• Proposed Revenue Procedure 2005-43

What’s the problem? Why is this so hard?

What’s the problem? Why is this so hard?

• Valuation

– Capital Account Interest

– Profits-only Interest

• Partner Issues

– Amount of income

– Timing of income

– Character of income

• Partnership Issues

– Partnership deduction – When? How much?

– When is the service provider considered a partner?

– How are capital accounts maintained?

Current Guidance

Revenue Procedure 93-27

Generally, the receipt of a partnership profits interest for

services is tax free to the recipient

– “Profits interest” defined as an interest that would not

give the holder a share of the proceeds if the partnership

sold all of its assets for FMV and liquidated immediately

upon issuance of the profits interest.

– Exceptions

Predictable stream of cash flow (i.e., bonds, rents)

Partner disposes of partnership interest within two

years

Publicly traded partnership

Current Guidance

Revenue Procedure 93-27

Conflicts with Section 83 (remember the rules for corporate stock)

Rev. Proc. 93-27 measures taxability of the interest at the time of issuance

Section 83 measures the taxability of a transfer of property at the later of the time of the transfer or the vesting of the property

Example

If an unvested partnership profits interest were issued which was a profits interest under Rev. Proc. 93-27 on the date of transfer but a capital interest on the date of vesting, Rev. Proc. 93-27 and section 83 could be in direct conflict.

Current Guidance

Revenue Procedure 93-27

Conflicts with Section 83 (remember the rules for corporate stock)

Rev. Proc. 93-27 measures taxability of the interest at the time of issuance

Section 83 measures the taxability of a transfer of property at the later of the time of the transfer or the vesting of the property

Current Guidance

Revenue Procedure 93-27

Conflicts with Section 83 (remember the rules for corporate stock)

Example

If an unvested partnership profits interest were issued which was a profits interest under Rev. Proc. 93-27 on the date of transfer but a capital interest on the date of vesting, Rev. Proc. 93-27 and section 83 could be in direct conflict.

Current Guidance

Revenue Procedure 2001-43

Rev. Proc. 2001-43 issued to resolve this conflict between section 83 and Rev. Proc. 93-27

The time for testing whether the interest qualifies as a profits interest is, under certain circumstances, when the interest is granted (Note – section 83(b) election not required, see PLR 200329001)

The service provider must be treated as a partner from the time of grant

Neither the partnership nor the other partners could deduct any amount in respect to the vesting of the interest, and

The interest otherwise must qualify as a profits interest under Rev. Proc. 93-27

Valuation

What is the correct method for valuing a capital interest for services?

Under current law:

Relinquishment of capital

Value added

Cost of services

Discounted value

Valuation of Capital interest

Example: X and Y each contribute $10,000 to a newly formed LLC, in

exchange for 50% capital interest in LLC. Shortly thereafter, Z is issued

a 33 1/3% vested capital partner interest solely in exchange for

services being rendered to the partnership at that time. X’s and Y’s

capital interests are each reduced to 33 1/3% to reflect this change.

Query – What is the proper amount for Z to include in compensation

income (and LLC to deduct for Z’s services)?

Valuation of Capital interest

X & Y & Z

XY

Z

Service

Partner$10K

$10K

Carried Interest

Definition of "Carried Interest"

The Carried Interest is a share of fund net profits allocated to the

General Partner that is disproportionate to the General Partner’s capital

commitment to the fund.

The total compensation received by an investment advisor to a private

investment fund ordinarily will comprise a management fee and the

performance fee. A traditional arrangement will award the advisor a

management fee of 2% of net assets under management, and a 20%

performance fee, or "Carried Interest".

Carried Interest

Fund Capitalization

Capital Committed by Investors: 99%

Capital Committed by General Partner: 1%

Carried Interest

Typical Allocation of Fund Net Profits

• Proportionate Allocation:

80% to all Partners (including the General Partner) in

proportion to their respective capital commitments

• Carried Interest Allocation:

20% to the General Partner

Simple Fund Structure

Limited Partnership

(U.S.)

Prime Broker

U.S. Taxable Investors

(limited partners)

Investment

Advisor

Administrator

General

Partner

1%99%

20% Carried

Interest

2% Mgmt

Fee

Carried Interest

Carried Interest under scrutiny by Congress:

The previous Congress proposed legislation designed to treat the

Carried Interest income as ordinary income received as compensation.

Why the proposed change? What's the problem?

Carried Interest

Carried Interest under scrutiny by Congress:

• Congress views the Carried Interest arrangement as abusive

Compensation income can be characterized as capital

Compensation income can deferred

Carried Interest

Carried Interest under scrutiny by Congress:

• Legislative changes have been proposed since 2007

• Targeted primarily at partners performing investment management

services

• Easy to discuss, hard to design a law that addresses the issue

Carried Interest

Carried Interest under scrutiny by Congress:

• Recent proposed legislation was introduced in September 2010

In addition to other changes, the proposal directed ordinary

income treatment at any person (including corporation or

partnership) that holds an investment services partnership

interest ("ISPI"). The proposal included:

o ISPI related income must be treated as ordinary

o Dispositions of ISPIs treated as ordinary and must be taxable

o Property distributions treated as ordinary

o Deferring losses allocated to ISPI holders

o Subjecting ISPI income to self-employment taxes

Carried Interest

Carried Interest under scrutiny by Congress:

Questions and concerns about "Carried Interest" changes.

• How will Carried Interest rules be applied to real estate

partnerships?

Does the ISPI definition extend to real estate?

• Corporate joint ventures?

• Normal return on invested capital?

• Mergers and Acquisitions (M&A) transactions?

Plans To Mirror Equity

Phantom Stock or Phantom Equity

Financial Rights

No Voting Authority

Section 409A Scared Many Away

Plans To Mirror Equity

Section 409A Merely Adds Hurdles

Documentation Is The Key

No Acceleration But Lots Of Creativity

Q&A

Contact Information

Kevin W. Kaiser

Lindquist & Vennum PLLP

Phone: (612) 371-2467

E-mail: kkaiser@lindquist.com

David D. Brauer

Lurie Besikof Lapidus & Company LLP

Phone: (612) 381-8838

E-mail: dBrauer@lblco.com