This outline examines the U.S. tax consequences surrounding the use of equity based compensation by partnerships and limited liability companies1 (each, an "LLC").2 The grant of compensatory LLC equity interests and the vesting of restricted LLC equity interests raise some of the thorniest issues of Subchapter K, including the necessity of bookups, the occurrence and effect of capital shifts and other hypothetical transactions, and the ancillary tax consequences of a service provider becoming a member.3
These issues are discussed in detail in Section II of this outline and are also discussed briefly in subsequent sections with respect to different types of LLC interests. Sections III through VI discuss the federal income tax consequences to service providers, LLCs and other LLC members of granting restricted and unrestricted capital and profits interests, options to acquire LLC interests, and virtual options such as equity appreciation rights.
As the following sections make clear, there is no single "best" type of compensatory LLC interest for all parties. Certain types of interests are more favorable for service providers (e.g., interests for which taxation is deferred or for which a section 83(b)4 election may be made showing a zero value for the interest). Other types of interests may be more favorable for the other LLC members (e.g., fully vested interests that produce an immediate deduction for the LLC). Accordingly, the choice of what type of interest to issue will vary depending on the importance accorded each party's tax position in a given transaction.
The degree of certainty parties require with respect to the tax treatment of the compensatory interest will also be an important factor in choosing among interests, since each type of compensatory interest raises different tax questions. In particular, there are more questions than answers regarding the taxation of restricted profits interests and options. After spending altogether too many hours contemplating these issues, I am sure of only one thing-some element of the tax treatment of each type of LLC compensatory interest is, at best, gray.
II. GENERAL ISSUES REGARDING COMPENSATORY LLC INTERESTS
- The issuance and vesting of LLC compensatory interests raise a host of issues regarding bookups, capital shifts and attendant deemed asset transfers. As a threshold matter, it is well worth considering whether the cost of administering the mark to market regime described below, including bookups, capital shifts and deemed asset transfers, is justified. Granted, bookups (and to a lesser extent, capital shifts) are clearly fundamental to the workings of the section 704(b) safe harbor. Stepping outside those rules, however, it is less clear that any benefit obtained by requiring LLCs to mark to market non-liquid assets and members' interests each time a new compensatory interest is granted or vests (sometimes weekly, at the height of the dot.com boom) is worth the administrative cost of complying with the complex rules and policing those who fail to comply. While this paradigm may have served its original purpose well-policing the sale of tax benefits through real estate tax shelters-the author would submit that it doesn't work nearly as well for the dot.com LLCs and other operating company joint ventures of the new millennium.
A. Revaluations of LLC Assets
- The tax consequences and, more importantly, the quantum of interest transferred to a service provider, will often vary considerably depending on whether the assets are marked to market in connection with the issuance and vesting of compensatory interests. This result can be achieved either through a "bookup" of the LLC's assets or through the issuance of a separate class of LLC units representing an interest in profits/capital created after the date of issuance. As described below, the latter choice often has significant appeal. As discussed below, regulations now permit an LLC to take advantage of the section 704(b) rules to effect a bookup.5
- If an LLC's assets are not marked to market, the recipient of a profits interest would also effectively receive an allocable portion of the appreciation in value of the LLC's assets since the date of its last bookup. This transfer may come as quite a surprise to the other members of an LLC who agreed (or so they thought) only to forgo a portion of their interests in future LLC profits. Moreover, this inadvertent issuance of a part-capital, part-profits interest could subject a service provider to tax upon receipt of the capital portion of such an interest.6 To avoid these results, it is important for an LLC to revalue its assets, and to be able to support the fair market values of its assets, on the revaluation date. An artificially low asset value will produce the same issues (albeit of a smaller magnitude) as a failure to revalue assets.7
- The IRS recently confirmed that the issuance and vesting of a
bifurcated profits interest are each non-taxable events under
Revenue Procedures 93-27 and 2001-43.8 The ability of a
taxpayer to bifurcate a capital and profits interest and the
resulting treatment of the bifurcated interests had been unclear,
although IRS officials had informally suggested that such an
interest could be bifurcated to permit the unvested profits
interest to qualify for treatment under Revenue Ruling
- The ruling's sensible bifurcation of the part-capital, part-profits interest is particularly welcome since the partnership rules generally contemplate single LLC interests.10 However, due to its redacted nature, the ruling provides no guidance as to how such partial interests would be valued, either in the aggregate or as a relative matter. Possible bases for valuation would include fair market value or capital account balance, in the latter case with or without a discount to the anticipated distribution date.11
- Under the section 704 regulations, an LLC may revalue its assets in connection with the LLC's grant of a compensatory capital or profits interest. The compensatory interest can be granted to an existing partner, or to a new partner (acting either in a partner capacity or in anticipation of becoming a partner).12
- The IRS appeared to support revaluing LLC assets when compensatory interests are granted in a private ruling on the topic.13 Although the IRS did not rule specifically on the validity of the bookup, it is fair to assume the bookup affected the values of the profits interests issued for services that were the subject of the ruling.
- Notably, any bookup must take into account the consequences of any reverse section 704(c) allocations required thereafter, which may otherwise negate the effect of the bookup.
- Treasury Regulation section 1.704-1(b)(2)(iv)(f)(5) describes four circumstances under which an LLC is specifically permitted to revalue or "book up" its property, including its intangible assets such as goodwill: (i) a contribution of money or other property to the LLC as consideration for an LLC interest; (ii) a liquidation of the LLC or a distribution of money or other property by the LLC in consideration for an LLC interest; (iii) when granting a non-de minimis interest to an existing partner, or to a new partner (acting either as a partner or in anticipation of becoming a partner); or (iv) under generally accepted industry accounting practices, provided that substantially all of the partnership's property (excluding money) consists of stock, securities, commodities, options, or similar instruments that are readily tradable on an established securities market.
- A supplemental rule (the "q" rule) also provides that if the specific bookup rules fail to provide guidance as to how particular adjustments to LLC capital should be made, such adjustments must be made to equalize members' capital accounts with the LLC's capital in a manner consistent with the members' economic arrangement (such adjustments must also be based on Federal tax accounting principles to the extent practicable).14
- Even before regulations were issued, two theories justified a bookup when granting compensatory LLC interests. First, if the LLC is treated as issuing an interest in exchange for a deemed cash or property contribution from the service provider, as discussed in Section II.C. below, that deemed contribution may constitute a specifically permitted bookup event.15 Second, even if such a bookup does not constitute one of the four specifically enumerated events in the regulations, the supplemental "q" rule that permits bookups in circumstances where guidance is lacking should support a bookup.16
- Before regulations were issued, the LLC's tax counsel could
have also effected a "phantom bookup" by issuing separate
classes of LLC interests limited to future profits or capital
and/or special allocations of income to a service provider solely
with respect to taxable periods after issuance or vesting of
Such allocations should have satisfied the section 704(b) requirements because they would have been in accordance with the members' interests in the LLC, even though they may have lacked the vaunted substantial economic effect. Presumably, given the final 704 regulations, LLCs that maintain capital accounts no longer need to rely on such valuations (although those that nevertheless choose to effect phantom bookups may be well advised to make such special allocations out of gross income in order to more closely track the parties' business deal).
- The IRS recently confirmed that the issuance and vesting of a bifurcated profits interest are each non-taxable events under Revenue Procedures 93-27 and 2001-43.8 The ability of a taxpayer to bifurcate a capital and profits interest and the resulting treatment of the bifurcated interests had been unclear, although IRS officials had informally suggested that such an interest could be bifurcated to permit the unvested profits interest to qualify for treatment under Revenue Ruling 2001-43.9
B. Capital Shifts
- The IRS has a long history of successfully asserting that a shift in capital among partners produces a taxable event both for the member receiving capital18 and, if an "appreciated" capital interest is transferred, for the transferring members.19
- Capital shifts can take many forms, but a capital shift generally occurs when a member with a capital interest agrees to forgo part or all of its right to proceeds on liquidation of the LLC. Accordingly, a shift of unrealized appreciation in the LLC's assets is thought to produce a taxable capital shift.20
- Consistent with this definition, a capital shift could theoretically occur when an unrestricted interest is issued, when a restricted interest vests, and when a preferred interest is converted into a common interest.21 The amount of the capital shift is typically thought to equal the service provider's undivided interest in the LLC's assets. As Shelley Banoff astutely points out, however, the value of the assets deemed transferred in the capital shift will generally exceed the value of the service provider's LLC interest once liquidity and minority discounts are applied to his or her interest. As a result, the LLC's books won't balance, and I shudder to think of the section 704(b) machinations necessary to force that result.
- In connection with the issuance or vesting of a compensatory interest, it may also be argued that the services performed for the LLC have increased the value of the LLC's assets (and so its aggregate capital), theoretically permitting the LLC to avoid a capital shift whenever the increase in capital equals or exceeds the value of the compensatory interest. Not surprisingly, the IRS has yet to adopt this view.
C. Hypothetical LLC Transfers When Compensatory Interests Are Issued
- The quantum of interest received and the resulting tax consequences to the service provider and the LLC's other members each generally depend on whether some type of consideration, e.g., cash or an undivided interest in the LLC's assets, is deemed to be received by a service provider and then used to acquire the LLC interest.22
- One of two hypothetical transactions may be deemed to occur. Each transaction can be theoretically supported, and in the absence of controlling authority, an LLC will presumably choose to adopt the more favorable approach based on its particular facts and circumstances. The IRS may of course counter with another, less taxpayer favorable recast.
- Deemed Asset Transfer
- Under this theory, the LLC is deemed to transfer an undivided interest in each of its assets, or the LLC's members are deemed to transfer LLC interests, to the service provider, which the service provider is treated as immediately re-contributing to the LLC in exchange for an LLC interest.
- If an LLC holds appreciated assets, including, notably, goodwill, and the members hold appreciated LLC interests, the LLC or its members may be treated as recognizing gain upon the deemed asset/LLC interest transfer. The IRS may assert this theory based on the general principle that gain is generally imposed when appreciated property is transferred as compensation for services.23 Note that the LLC or its members may also recognize loss with respect to deemed transfers of its depreciated assets subject to section 267. LLC gain or loss may be allocable only to the old members under section 706(d) principles, in a manner consistent with section 704(c), since the gain or loss would be recognized immediately before the service provider receives his or her LLC interest.
- Because only a small portion of the LLC's assets would
generally be deemed transferred in any hypothetical transaction,
any interest "purchased" with the assets would still
constitute a part-capital interest unless the LLC's assets are
booked up. It is not clear whether a bookup avoids a capital shift
entirely under these circumstances, since the capital account
received by the service provider will exceed any amount paid for
the interest and may exceed any amount deemed paid for the
interest. In any event, a bookup immediately before the issuance of
the interest would minimize the value of the interest received, and
the amount of any capital shift.
- Deemed Cash Transfer
- Alternatively, the LLC could be deemed to transfer cash (rather than an interest in the LLC's assets) to the service provider in exchange for his or her services. If so, the service provider would be deemed to immediately re-contribute the cash to the LLC in exchange for his or her LLC interest.
- Under this analysis, the other LLC members would not recognize gain in connection with a deemed transfer of appreciated LLC assets. This analysis can be supported by analogy to the section 1032 rules that sanction deemed cash transfers for corporations. Given the identical purpose of section 721 (and its virtually identical language), a different result should not properly obtain for LLCs.
- Unfortunately, no controlling authority in the partnership area compels a deemed cash payment. In the absence of an analog to the section 1032 regulations (which explicitly treat a corporation's issuance of its stock for services as a transfer of cash to its employee that is re-contributed in exchange for stock), the IRS may not feel compelled to extend this beneficial (and proper) treatment generally to LLCs.24
- As in the case of a deemed asset transfer, a capital shift may
occur regardless of whether assets are booked up, if the capital
account received by the service provider exceeds the amount paid
(or deemed paid) for the interest. However, a bookup immediately
before the issuance of the interest would minimize the amount of
any capital shift.
- Actual Loan and Cash Purchase of LLC Interest
- To avoid the possibility that the IRS may deem a transfer of assets or cash to have occurred, an LLC may wish to actually borrow and loan to the service provider funds sufficient to purchase the LLC interest.
- These transactions may limit the negative consequences to the other members of the LLC, but they are nonetheless vulnerable to be recast by the IRS. For example, the IRS may seek to disregard the circular flow of cash between the LLC and the service provider, and instead either treat one of the deemed transactions described above as having occurred, or treat the service provider as having not actually acquired the LLC interest at all (e.g., as having acquired only an option to acquire the interest).
- Alternatively, the service provider could be treated as receiving ordinary income in the amount of the cash received and then purchasing the LLC interest. In that case, although the IRS could raise the same capital shift issues discussed above with respect to deemed transfers, a strong argument can be made that no capital shift occurred because the interest was paid for with new borrowed capital.
* I am deeply indebted to my colleague Jean M. Bertrand for her collaboration with me on this outline in 2000 and to Sheldon I. Banoff, Hoon Lee and Alexander F. Anderson for their thoughtful contributions in subsequent years. I'm also very grateful to Jessica W. Seaton, in particular for her organizational suggestions, and to Simon Friedman, for inspiring my interest in this topic with his excellent Partnership Securities article (1 Florida Tax Review 521 (1993)) and for his patience years ago in teaching me enough partnership tax lore to allow me to make sense of the law.
1 Throughout this article LLC is used to refer to both partnerships and LLCs, and member is used to refer to both partners in a partnership and members in an LLC.
2 This article does not discuss the 2005 proposed regulations regarding partnership (and LLC) compensatory interests or the interaction of section 409A and subchapter K. For a discussion of these issues, see Swartz, L. Z., Section 83(b), Section 409A, Section 457A and Subchapter K, published in the PLI LLC and Corporate Tax Conference materials.
3 Another very important consideration in choosing among types of compensatory LLC interests, which is beyond the scope of this outline, is the accounting treatment accorded each type of interest.
4 All references to sections are to sections of the Internal Revenue Code of 1986, as amended, or to Treasury Regulations promulgated thereunder.
5 Treas. Reg. § 1.704-1(b)(2)(iv)(f)(5)(iii); Section 704(b) and Capital Account Revaluations, REG-139796-02, 68 F.R. 39498 (July 2, 2003).
6 See Priv. Ltr. Rul. 2003-29-001 (July 21, 2003).
7 As discussed in the text that follows, the valuation of a profits interest granted to a service provider raises several difficult, and perhaps insoluble, issues. For example, the value the parties place on such an interest may differ from the value of the corresponding portion of the LLC's assets. Since Treasury Regulation section 1.704-1(b)(2)(iv)(f) requires that capital accounts be revalued on the basis of the LLC's assets, a bookup will not eliminate any inside-outside value differences. Moreover, it is not clear how, if at all, the value of a service provider's future services affects the value of the LLC's assets. Perhaps only a service provider's interest, and not other members' interests, should have additional value ascribed to it, although the resulting disparity in the values of similar or identical interests may create other equally difficult issues.
8 Priv. Ltr. Rul. 2003-29-001 (July 21, 2003).
In order to satisfy the requirements of Revenue Procedures 93-27 and 2001-43, the partnership represented that (i) it was not a publicly traded partnership, (ii) it was not anticipated that the units would be disposed of within two years, (iii) the partnership would treat the unit holders as partners for all federal income tax purposes, and (iv) the units would not be related to a substantially certain and predictable stream of income from partnership assets, such as income from high-quality debt securities or a high-quality net lease.
9 See, e.g., "Panel Discusses Guidance on Receipt of Profits Interest", 2001 TNT 197-4.
10 See Treas. Reg. § 1.704-1(b)(2)(iv)(b) (second-to-last sentence provides that each partner has only a single capital account even if multiple interests are held); Rev. Rul. 84-53, 1984-1 C.B. 159 (a partner has only one basis even if multiple interests are held); Chase v. Commissioner, 92 T.C. 874 (1989) (redemption of limited partner interest not complete redemption because general partner interest retained); Hensel Phelps Construction Co. v. Commissioner, 703 F.2d 485 (10th Cir. 1983) (no bifurcation of limited and general partnership interests); compare G.C.M. 37193 (July 13, 1977) (separate capital and profits interests); United States v. Stafford, 727 F.2d 1043 (11th Cir. 1984) (same); United States v. Frazell; 335 F.2d 487 (5th Cir. 1964) (same).
11 A number of general questions also remain unanswered. For example, the ruling does not address the ability of the service provider to make a valid section 83(b) election, the treatment of a service provider whose services are rendered to a party other than the LLC (such as a member), or the treatment of a service provider holding an unvested profits interest that lapses, is forfeited or is transferred.
12 Treas. Reg. § 1.704-1(b)(2)(iv)(f)(5)(iii).
13 Priv. Ltr. Rul. 2003-29-001 (July 21, 2003).
14 Treas. Reg. § 1.704-1(b)(2)(iv)(q).
15 Treas. Reg. § 1.704-1(b)(2)(iv)(f)(5)(i).
16 Treas. Reg. § 1.704-1(b)(2)(iv)(q).
17 A similar allocation method is also used after a contribution of built-in gain property without a corresponding bookup. Treas. Reg. § 1.704-1(b)(5), Ex. 14(iv).
18 Treas. Reg. § 1.721-1(b)(1) (fair market value of capital shifted to service partner is ordinary income to recipient).
19 See, e.g., Lehman v. Commissioner, 19 T.C. 659 (1953); Farris v. Commissioner, 22 T.C. 104 (1954), rev'd and remanded, 55-1 USTC ¶ 9411, 222 F.2d 320 (10th Cir. 1955); U.S. v. Frazell, 335 F.2d 487 (5th Cir. 1964); National Oil Company v. Commissioner, 52 T.C.M. 1223 (1986) (determination of whether capital shift has occurred is based on tax accounting principles).
20 See McDougal v. Commissioner, 62 T.C. 720 (1974), acq. 1975-2 C.B. 2; Edgar v. Commissioner, 56 T.C. 717, 747 (1971); Johnston v. Commissioner, T.C. Memo. 1995-140; see also S. Rep. No. 86- 1616, at 117-19 (1960) (1960 proposed legislation that was never enacted would have confirmed this position).
21 See 1996 FSA LEXIS 246 (June 25, 1996) (profits interest may subsequently be transformed into a capital interest by virtue of a taxable capital shift).
22 An additional consequence of issuing new LLC interests that this outline does not analyze in detail is the effect of re-allocating liabilities under section 752 when a new member is admitted. The minimum gain chargeback rules would generally govern reallocations of nonrecourse debt, but reallocations of recourse or guaranteed debt may produce taxable deemed distributions and should be carefully analyzed.
23 See Treas. Reg. § 1.83-6(b) ("Except as provided in section 1032, at the time of a transfer of property in connection with the performance of services the transferor recognizes gain to the extent that the transferor receives an amount that exceeds the transferor's basis in the property."); see also, e.g., General Shoe Corp. v. U.S., 60-2 USTC ¶ 9678, 282 F.2d 9 (6th Cir. 1960); Riley v. Commissioner, 64-1 USTC ¶ 9254, 328 F.2d 428 (5th Cir. 1964).
24 See Treas. Reg. §§ 1.1032-1(a), 1.721-1.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
Specific Questions relating to this article should be addressed directly to the author.