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

6. Inability to Sell Substantial Built-In Losses. With the passage of the American Jobs Creation Act of 2004, a purchaser of an interest in a partnership that has a "substantial built-in loss" (i.e., the partnership's adjusted inside basis in its assets exceeds the fair market value of those assets by more than $250,000) is to receive a special downward basis adjustment in the partnership's assets, regardless of whether the partnership has a Section 754 election in effect, to cause that purchaser's share of the partnership's inside basis to conform with the outside basis of the acquired partnership interest. I.R.C. õõ743(b) and (c) and 755.

Sound off on this buzz in the Comments Section.

7. Potential Increase in the Self-Employment Tax of the Fund's Management Team. The general partner of a PE/VC Fund usually is a limited liability company or other entity classified as a partnership for federal tax purposes so as to allow the capital gains character of the general partner's share of the Fund's income to flow through to the principals and other participating personnel of the Fund's sponsor. In addition to capital gains, the character of other income also will flow through the general partner to sponsor personnel. Thus, the general partner's share of an unincorporated portfolio company's operating income will flow through to its members and may cause them to have to pay additional self-employment tax (currently a 15.3% tax, comprised of a 12.4% social security (old age, survivors and disability insurance) tax under I.R.C. õõ3101(a) and 3111(a) that is subject to a cap under I.R.C. õ3121(a) on the first $106,800 of wages and net earnings for 2009 under Notice 2008-103, 2008-46 I.R.B. 1156) and a Medicare (hospital insurance) tax of 2.9% under I.R.C. õõ3101(b) and 3111(b) (which has no cap). Because of the cap on social security taxes, any additional self-employment taxes attributable to the earnings of an unincorporated portfolio company likely will be limited to the 2.9% Medicare tax. Also, any member who is, or is deemed to be, a "limited partner" under I.R.C. õ1402(a)(13) must pay self-employment taxes only on "guaranteed payments," not allocations of his or her distributive share of the partnership's income. Similarly, employment taxes are owed only on the wages paid to an S corporation's shareholder/employee for the services he or she renders to the corporation and not on that person's share of the S corporation's income.

8. Phantom Income. Generally speaking, a shareholder will recognize income as payments are received with respect to the shareholder's investment in the corporation. No such relative assurance may be given to partners in a partnership, particularly with respect to the recapture or other chargeback of prior deductions.

9. Complexity of the Governing Documents and Tax and Financial Accounting for Unincorporated Entities. The governing documents of LLCs and other unincorporated entities (particularly with regard to their incorporation of many tax accounting concepts, and those tax accounting rules in general), often are viewed as more complex than their corporate counterparts. For a discussion of the common mistakes that can be made when drafting partnership or operating agreements, see Warren P. Kean, Common Mistakes and Oversights When Drafting and Reviewing LLC Operating Agreements, 11 J. Passthrough Entities 23 (Jan./Feb. 2008). See also, Warren P. Kean, A Partner's Interest in the Partnership for Purposes of Section 704(b), in Tax Planning for Domestic & Foreign Partnerships, LLCs, Joint Ventures & Other Strategic Alliances (2008). A strong argument, however, may be made that LLC documents are no more complex and, perhaps, are less complex (or at least more coordinated and organized, usually with a single set of defined terms in the operating agreement) than the array of their corporate counterparts of certificates of incorporation and designation, bylaws, and such agreements as shareholders', securityholders', investors' rights, voting rights, indemnification, and rights of first refusal and co-sale agreements. Accordingly, perhaps a better description for this perceived disadvantage of LLCs is that some or many professionals, investors, and business people are less familiar with LLCs and their organizational documents than they are with corporations and their organizational documents. Although, this comfort gap has narrowed significantly over the last decade.

10. Delay in Providing Tax Information to Partners. Because each partner must include that partner's distributive share of the partnership's income or loss in computing the partner's tax liability, the delay in providing this information to partners is often a source of frustration and irritation for investors.

11. EfficiencyExpediency of Using Familiar or Customary Templates - Inertia? Using the approach, structure, and documents of prior deals allows for a more efficient and streamlined set of negotiations and closing for the Fund, its investors, and its professionals as they work to expedite the process for creating or replicating "the next ____." This very practical rationale for maintaining the status quo begs the question: What would be the choice of entity for portfolio companies if we were starting from scratch? Is the tide turning (or has it already turned) against PE/VC firms rejecting out of hand investing in companies other than corporations?

12. The Income Tax Rules for Corporations May be Less Than the Income Tax Rules for Individuals. The maximum federal income tax rate for C corporations for 2008 was 34% on taxable income of more than $75,000 but less than $10 million and (generally speaking) 35% on taxable income of more than $10 million. I.R.C. õ11(b). The maximum federal income tax rate on ordinary income for married individuals filing jointly for 2009 was, generally speaking, between 25% and 33% for taxable income above $65,100 and below $357,700 and 35% for taxable income above $357,700. I.R.C. õ1(f) and (i). Individuals are taxed at lower rates (generally 15%) on capital gains. Corporations are not. The federal tax brackets for individuals are adjusted for inflation. I.R.C. õ1(f). The federal tax brackets for corporations are not adjusted for inflation. Many states also tax corporations at lower income tax rates than for individuals. For example, the maximum North Carolina 2008 income tax rate for corporations was 6.9%, but its maximum income tax rate for individuals was 7.75%. Corporations, however, usually also are subject to a separate franchise tax that is not imposed on individuals.

13. Unavailability of the Benefits of "Qualified Small Business Stock"; I.R.C. õõ1202 and 1045. Noncorporate purchasers of "qualified business corporation stock" ("QSB" stock) may, upon satisfying a fairly long list of requirements, defer and exclude the recognition of capital gains from the sale of that stock. I.R.C. õõ1045 and 1202. The amount of the exclusion is 50% (60% for certain empowerment zone businesses) of 28% (because capital gains from the sale of QSB, before being reduced by 50%, are subject to a 28% tax rate instead of the 15% tax rate applicable to most other long-term capital gains). I.R.C. õõ1(h)(4)(ii) and (7). The difference between that rate (50% of 28% or 14%) and the regular rate for long-term capital gains of 15% is, therefore, only 1% (even less for low-income investors, and that 1% difference essentially can be eliminated by the application of the alternative minimum tax by the lower rate being treated as a "tax preference" under I.R.C. õ57(a)(7)). The exclusion rate, however, was increased from 50% to 75% (for an effective 7% federal income rate - i.e., an 8% rate reduction to the regular 15% capital gains rate) under Section 1241(a) of the American Recovery and Reinvestment Act of 2009, but only for QSB stock that is purchased before January 11, 2011. I.R.C. õ1202(3). Of course, if the 15% rate on long-term capital gains is increased as it is scheduled to do in 2011, the rate difference may be even greater. Of more importance for most investors, however, is the ability to rollover and otherwise defer the recognition of gain from the sale of QSB stock under I.R.C. õ1045.

The numerous requirements that have to be satisfied to get the benefit of QSB treatment include the following: (i)the stock must be purchased from the issuing corporation (i.e., stock purchased in a secondary transfer does not qualify for the õõ1045/1202 benefits; thus, a buyer will not pay the seller a premium for the QSB stock because of its QSB character; instead, as discussed above, the buyer likely will discount the purchase price for the built-in tax gain of the corporation's assets); (ii)the issuing corporation must be a C corporation (not an S corporation); (iii)the QSB must be held for more than 5 years (instead of the one-year requirement for long-term capital gain treatment; but for deferral treatment under I.R.C. õ1045, the stock need be held only for more than six months if the rollover occurs within 60 days of the sale of the QSB stock); (iv)the amount of gain from an investment that is subject to this special treatment is limited to $10 million; (v)the issuing corporation must be engaged in a "qualified," "active business" (which excludes many service business, such as those in the fields of health, engineering, architecture and other professional services, performing arts, consulting, athletics, financial services and brokerage services, businesses engaged in banking, insurance, financing, leasing, investing or similar business, any farming business, any oil and gas business, and any hotel, motel, restaurant, or similar business); (vi)the "aggregate gross assets" (generally the value) of the corporation at the time of the purchase of its stock by the investor must not exceed $50 million; and (vii)not more than 10% of the value of the corporation's assets may be in real estate. All of these types of restrictions and requirements for favorable QSB stock tax treatment and certain other ambiguities, complexities, and problems with the wording and the application of these provisions (particularly in the context of QSB stock held by entities taxed as partnerships), and the relatively small benefit of that treatment over regular tax treatment, have significantly dampen the interest of structuring investments in portfolio companies as purchases of QSB stock. For a discussion of some of the problems encountered by investment funds and other partnerships considering investing in QSB stock with the wording of I.R.C. õ1045 for rollover tax treatment, see Melanie W. Levy, Exclusion of Capital Gain on Sale of QSB Stock, 7 Bus. Entities 18 (July/Aug. 2005) and the Treas. Reg. õ1.1045-1, issued by Treas. Dec. 9353 on August 13, 2007.

Choice of Entity Resources. For a more thorough comparison of corporations and partnerships, see any of the many choice of entity books, articles, and other materials on the subject, including those referenced in Part A of this outline. Two worthwhile articles that take contrary positions on whether partnerships or corporations are more efficient and effective vehicles for organizing a portfolio company of a PE/VC Funds are Victor Fleischer, The Rational Exuberance of Structuring Venture Capital Start-Ups, 57 Tax L. Rev. 137 (2004) and Daniel S. Goldberg, Choice of Entity for a Venture Capital Start-Up; the Myth of Incorporation, 55 Tax Law, 923 (Summer 2002).

E.Blocker Structures [5] The structures diagrammed in this part have been employed to reduce or eliminate UBTI and ECI for a PE/VC Fund's tax-exempt and foreign limited partners/investors.

Footnote [6]


Footnote [7] Footnote [8]

Footnote [9]

Certain tax and other issues to keep in mind:

1. I.R.C. õ269.

2. Agency principles.

3. Substantiality rules of Treas. Reg. õ1.704-1(b)(3).

4. Constructive or imputed partnership risk.

5. Tax rates of foreign investors' domicilary countries and amount of tax credit available for payment of U.S. and other taxes.

6. ERISA "Plan Assets" rules.[10]

F. Use of Convertible Notes and Warrants.

In 2003, the IRS issued proposed regulations on the taxation of noncompensatory partnership options and convertible securities. REG-103580-02, 68 Fed. Reg. 2930 (2003) reprinted in 2003-1 C.B. 543. The proposed regulations generally provide that the issuance and exercise of a noncompensatory option or convertible security does not cause the recognition of gain or loss by the issuing partnership, the option holder, or the other partners. The proposed regulations contain rules to account for any capital shifts that may result upon the exercise of such options or conversion rights (i.e., the extent to which upon the exercise of those rights, the holder becomes entitled to share in partnership capital in an amount that differs from the amount paid to the partnership in respect of the options or convertible securities). The amount of such a nonrecognition capital shift (i.e., in the case of an option holder, the amount by which the option holder's capital account exceeds the premium paid for the option and the option's exercise price for the partnership interest) is to be accounted for first by allocating unrealized ("book up" or "book down") income, gain, loss, or deduction in the partnership's assets to the exercising partner up to the amount of the capital shift and then, to the extent of any remaining amount of the capital shift, by reallocating partnership capital among the partners, as provided in Prop. Reg. õ1.704-l(b)(2)(iv)(s). The amount of the capital shift will then be taxed in accordance with the principles of I.R.C. õ704(c) (so called "reverse Section 704(c) allocations") and, to the extent necessary, "corrective allocations" under Prop. Reg. õ1.704-l(b)(2)(iv). See Treas. Reg. õõ1.704-l(b)(2)(iv)(f)(4) and 1.704-3(a)(6) and Prop. Reg. õõ1.704-l(b)(2)(iv)(s)(4) and 1.704-1(b)(4)(ix) and (x). For a discussion of these proposed regulations, see IRS Publishes Proposed Regs on Tax Treatment of Noncompensatory Partnership Options, 98 Tax Notes 502 (Jan. 27, 2003); New York State Bar Association Tax Section Report On The Proposed Regulations Relating To Partnership Options And Convertible Securities, Rep. No. 1048 (Jan. 23, 2004), available electronically in the Tax Notes Today file of the FEDTAX Library of LEXIS at 2004 TNT 16-80; and Matthew P. Larvick, Noncompensatory Partnership Options: The Proposed Regulations, in Tax Planning For Domestic & Foreign Partnerships, LLCs Joint Ventures & Other Strategic Alliances, Practising Law Institute (2008).

In the case of convertible securities, the preamble to the proposed regulations state that the proposed regulations do not change the general tax rules that treat a conversion right embedded in convertible debt or convertible equity as part of the underlying instrument (and not a separate instrument). See also Prop. Regs. õõ1.1272-1(e), 1.1273-2(j), and 1.1275-4(a)(4).

G. General Discussion of Warrants.

Part of an Investment Unit. When a warrant is received in conjunction with a debt instrument, the amount paid for that investment unit must be allocated between the warrant and the debt instrument based on their relative fair market values. I.R.C. õ1273(c)(2). The allocation usually will generate imputed interest on the debt instrument under the original issue discount rules of I.R.C. õ1272.

Holder's Income and Loss Recognition. That part of the purchase price of an investment unit that is allocated to the warrant is capitalized and is included in the adjusted tax basis of the property purchased by the exercise of the warrant. Rev. Rul. 78-182, 1978-1 C.B. 265. The holder will recognize a capital gain or loss (assuming the property that the holder had the right to purchase with the option would have been a capital asset in the hands of the holder) upon the sale or other taxable disposition of the warrant, depending on whether the sales price is more or less than the holder's adjusted tax basis in the warrant (generally what the holder paid for the warrant). Id. If the holder does not sell or exercise the warrant (i.e., allows it to lapse), the tax treatment to the holder will be the same as if the holder had sold it for nothing on the expiration date of the warrant. Rev. Rul. 78-182, 1978-1 C.B. 265 and I.R.C. õ1234(a)(2) and Treas. Reg. õ1.1234-l(b).

No gain or loss is recognized upon the exercise of the warrant, except in the case of a warrant to acquire shares of stock of a corporation, the holder may have to recognize gain to the extent that cash is received in lieu of fractional shares. Rev. Rul. 72-71, 1972-1 C.B. 99. The partnership counterpart to such treatment is the possible application of the disguised sale rules under I.R.C. õ707(a)(2)(B).

Warrants (and other Stock Rights) Treated as Stock under I.R.C. õ305 (d) --Adjusting or Failing to Adjust the Exercise Price. Warrants and other rights to acquire stock of a corporation are treated as "stock" and their holders as "shareholders" under I.R.C. õ305. I.R.C. õ305(d). There is no comparable rule for partnerships.

No Tacking of the Warrant's Holding Period. The holding period of the stock or partnership interest or other property purchased by the exercise of a warrant begins on the day that the warrant is exercised, not when the warrant was acquired. I.R.C. õ1223(5); Treas. Reg. õ1.1223-1(f), and Weir v. Commissioner, 10 T.C. 996 (1948), aff'd per curiam, 173 F.2d 222 (3rd Cir. 1949) (holding that the holding period for the stock acquired by the exercise of a warrant begins on the day after the date that the warrant is exercised). If instead of exercising a warrant, the warrant is exchanged (or treated as being exchanged) for stock (other than nonqualified preferred stock) in a corporate recapitalization or other corporate reorganization (other than a divisive "D" reorganization) under I.R.C. õ368, then because the warrant is to be treated as a "security" under I.R.C. õ354, the warrant's holding period should be included (tacked on) to the holding period of the stock acquired. See Treas. Dec. 8752, reprinted in 1998-1 C.B. 611 (adding subsection (c) to Treas. Reg. õ1.354-1, treating options and other rights to acquire stock as securities with no principal amount); I.R.C. õ354(a)(2) (shares of nonqualified preferred stock are not treated as stock or securities when they are exchanged for shares of stock other than nonqualified preferred stock); I.R.C. õ1223(1) (tacking of holding periods for substituted basis property received in an exchange). Thus, the cashless exercise of a warrant to purchase shares of stock of a corporation may allow the tacking of the warrant holding period to the holding period of the acquired stock. See Martin D. Ginsburg and Jack S. Levin, Mergers, Acquisitions, And Buyouts, ô604.1.2 (Aspen, 2008 ed.) (particularly the discussion of Example 7 and footnote 19 thereof) ("Ginsburg & Levin"). There is no comparable theory for treating an "exchange" of a warrant for a partnership interest in connection with a recapitalization or other reorganization of the partnership as other than the exercise of the warrant (i.e., it is questionable whether a cashless exercise of an option to acquire a partnership interest will be treated as an "exchange" of property for that partnership interest instead of as the "exercise" of the option).

The period of time that a taxpayer is treated as holding a capital asset is important for individuals because for an individual taxpayer to be taxed at the 15% current maximum capital gains rate (instead of at ordinary income tax rates, for which the maximum rate currently is 35% -- there is no rate differential on capital gains for corporations), that individual must be deemed to have held the capital asset for more than one year prior to its sale or exchange (so-called long-term capital gains). See I.R.C. õõl(h) and l(i). For that reason, holders of warrants usually negotiate to sell their warrants instead of exercising the warrants to sell the underlying stock or other property. See also Prop. Reg. õõ1.721-2(e)(1) and 1.761-3(b)(2): "A contract that otherwise constitutes an option shall not fail to be treated as such for purposes of this section merely because it may or must be settled in cash or property other than a partnership interest."

No Gain or Loss to the Issuer. A corporation does not recognize gain or loss when it receives money or other property in exchange for shares of its capital stock or when warrants paid to acquire its stock lapse. I.R.C. õ1032(a). A partnership is subject to similar treatment under I.R.C. õ721(a) and the proposed noncompensatory option rules discussed in Part E above.

"Penny Warrants." If under the particular circumstances, the purchaser of a warrant in substance acquires the benefits and burdens of ownership of the underlying property, the option will be ignored for federal income tax purposes, and the holder will be treated as purchasing the underlying property. Thus, if a person pays $70 for a warrant giving the holder the right at any time, upon paying an exercise price of $30, to purchase stock that on the date that the warrant is purchased has a fair market value of $100, that person will be treated as owning the stock, not a warrant to purchase that stock. See Rev. Rul. 82-150, 1982-2 C.B. 110 and a similar example in Example 3 of Prop. Reg. 1.761-3(d) (in which an investor pays $14x to purchase an option to acquire a partnership interest that has a value of $15x on the date that the option is issued). See also Priv. Ltr. Rul. 9747021 (Nov. 21,1997) (in which the IRS had no difficulty in ruling that warrants having a "nominal exercise price" of a penny per share were to be treated as stock). But see Rev. Rul. 85-87, 1985-1 C.B. 268 (the purchase of an "in-the-money option" to require the issuer to buy stock that on the date that the option was acquired had a fair market value that was "substantially less" than the put price was treated for purposes of the I.R.C. õ1091 wash sale rules as a contract to purchase the stock subject to the put because at the time the put option was sold there was "no substantial likelihood that the put would not be exercised"). Tax practitioners frequently cite Ginsburg & Levin for the following rule of thumb concerning the possible recharacterization of warrants or other options: "Although there is little helpful precedent, it appears that where the option price is less than 10% of the option stock's FV at grant, the likelihood that the option grant is treated as a transfer of the underlying stock is high; if the option price is between 10% and 25% of FV, treatment of the option grant (option versus underlying stock) is unclear and likely turns on additional relevant facts; and if the option price is 50% or more of FV, the option grant is unlikely to be treated as a transfer of the underlying stock." Ginsburg & Levin at 1502.1.2.2 (n. 52). It is important to note, however, that this rule of thumb is made by Messrs. Ginsburg and Levin in the context of nonqualified compensatory stock options, not investment warrants that are either purchased by the holder or, because they are part of an investment unit, are deemed to have been purchased by the holder; and therefore, the holder has a risk of loss (i.e., it is a "risk investment" for which the holder has some burden of ownership) that was a critical part of the IRS's analysis in Rev. Rul. 82-150.

Prop. Reg. õ1.761-3(a) recognizes that the principles discussed in the preceding paragraph and related concepts apply for determining whether a contract right to acquire a partnership interest is, in fact, an option or substantively the partnership interest itself: "A noncompensatory option... is treated as a partnership interest if the option (and any rights associated with it) provides the holder with rights that are substantially similar to the rights afforded to a partner." Prop. Reg. õ1.761-3(a), however, goes on to provide: "This paragraph applies only if, as of the date that the noncompensatory option is issued, transferred, or modified, there is a strong likelihood that the failure to treat the holder of the noncompensatory option as a partner would result in a substantial reduction in the present value of the partners' and the holder's aggregate tax liabilities." For an example of how those rules are intended to apply, see Example 3 of Prop. Reg. õ1.761-3(d). For a description of rights that are considered to be "substantially similar" to the rights of a partner and the factors to consider in determining whether it is "reasonably certain" that a warrant will be exercised, see Prop. Reg. õ1.761-3(c). The preamble to the proposed regulations also makes it clear that the IRS will not challenge the option character of a partnership warrant or a convertible note if that warrant or convertible note is being employed in a way that does not reduce the amount of the overall taxes paid to the federal treasury:

Treasury and the IRS recognize that treating a noncompensatory option holder as a partner may, in some circumstances, frustrate the intent of the parties without substantially altering their aggregate tax liabilities.

For these reasons, the proposed regulations generally respect noncompensatory options as such and do not characterize them as partnership equity. However, the proposed regulations contain a rule that characterizes the holder of a noncompensatory option as a partner if the option holder's rights are substantially similar to the rights afforded to a partner. This rule applies only if, as of the date that the noncompensatory option is issued, transferred, or modified, there is a strong likelihood that the failure to treat the option holder as a partner would result in a substantial reduction in the present value of the partners' and option holder's aggregate tax liabilities. [Preamble to REG-103580-02, 68 Fed. Reg. 2930-01, 2932 reprinted in 2003-1 C.B. 543 (emphasis added).]

H. Techniques/Structures That May Be Employed to Manage the Complexity of Federal and State Tax Reporting and Payment.

1. Special Allocations. Under the substantial economic effect and related rules of Treas. Reg. õ1.704-1(b)(2), -(b)(4) and -2, entities taxed as partnerships are given broad latitude in determining how their income and loss (including individual items of income, gain, loss, and deduction) are allocated among its members. Accordingly, to minimize both the administrative costs and complexity of members preparing tax returns for, and paying the taxes to, many states, the partnership agreement might provide that, to the extent possible, income earned by a partnership in a particular state is to be allocated to members who are residents of that state. For example, instead of allocating to each partner a pro rata share of income earned by the partnership in all states, the partnership could first allocate the partnership's income earned in Florida, Texas, and other states that either have no income taxes or relatively low income taxes to the partners who reside in those states to the extent of their distributive shares of the partnership's overall income. That way the favorable tax treatment afforded by those states is not lost (or, at least, the extent of that loss may be minimized) by allocating income earned in those states to members who live in states with moderate to high income tax rates. Partners living in states with high income tax rates will have to pay those high rates regardless of where the income is earned subject to tax credits for taxes paid to those jurisdictions where the income is earned.

2. Use of Noncompensating Options and Convertible Securities. See discussion in Parts E and F above.

3. Use of Transitory Allocations to a Principal or Provisional Member or Corporate Blockers. Under this strategy, income or loss is allocated to one member (which may be a provisional member; i.e., a member whose sole purpose is to manage the allocations made to other members) only to be reversed (including offsetting the consequences of those allocations) later without running afoul of the substantiality rules of Treas. Reg. õ1.704-1(b)(2)(iii). Alternatively, corporate blockers may be used in the manner contemplated under Part D.

(a) Corporate carryback and carryover periods

(i) NOLs. Corporations may carry net operating losses back 2 years and forward 20 years. I.R.C. õ172(b)(1)(A). Section 1211 of the newly enacted American Recovery and Reinvestment Act of 2009 (the so-called stimulus bill) provides that certain "eligible small businesses" may elect to carryback certain 2008 net operating losses back either 3, 4, or 5 years.

(ii)Capital Losses. Corporations may carry net capital losses back 3 years and forward 5 years. I.R.C. õ1212(a)(1).

(b)Individual carryback and carryover periods

(i) NOLs. Individuals may carry net operating losses back 2 years and forward 20 years. I.R.C. õ172(b)(1)(A). Section 1211 of the newly enacted American Recovery and Reinvestment Act of 2009 (the so-called stimulus bill) provides that certain "eligible small businesses" may elect to carryback certain 2008 net operating losses back either 3, 4, or 5 years.

(ii)Capital Losses. Individuals may deduct $3,000 of net capital losses against their ordinary income for the year and carry the remainder forward indefinitely. I.R.C. õõ1212(b) and 1211(b).

4. Ability to Cause the Purchase (but not the "Sale") of Equity Interests to be Treated for Federal Income Tax Purposes as (or Substantially Equivalent to) the Purchase of the Target's Assets. Rev. Rul. 99-6, 1999-1 C.B. 432 and I.R.C. õõ754 and 743(b). But see, Rev. Rul.. 91-32, discussed above in Parts C.1 and C.2.


Arguably, the biggest advantage of LLCs and partnerships over corporations is the flexibility and generally more favorable treatment afforded LLCs and partnerships both under federal and state tax law and state entity law. Thus, if it ultimately is determined that the entity and its owners will be better off if the entity were organized as a corporation instead of as an unincorporated entity, such a conversion usually may be accomplished relatively easily. The converse, however, generally will not be the case. The costs [particularly a corporation's built-in tax gain and having to pay one (for S corporations that have not been C corporations during the built-in gain period of I.R.C. õ1374, generally ten years) or two (for C corporations or S corporations that were C corporations during the built-in gain period of I.R.C õ1374) levels of income tax] for converting a corporation into an entity treated as a partnership for federal tax purposes (other than, at least for federal income tax purposes, a subsidiary of a common parent of a group of corporations filing consolidated federal income tax returns) frequently will make such a conversion economically unfeasible.

It is the flexibility accorded unincorporated entities that allows one to solve and otherwise overcome many, if not all, of the perceived deficiencies and disadvantages of these entities as compared to corporations in the PE/VC context. That being the case, the question becomes: Is that flexibility and the other advantages of organizing and operating a business as an LLC or partnership worth breaking from the use of past archetypes and biases of PE/VC firms for investing in corporations over LLCs and partnerships? When LLCs were new and unfamiliar to many clients, business people, and professionals, the answer given by many was no. Now, as LLCs have become popular and widely accepted with a reasonably developed and understood body of case, regulatory, and statutory law, and with LLCs increasingly being recognized as the "entity of choice" for private-held businesses, ventures, and other enterprises, it perhaps is time for PE/VC firms to reconsider investing in, and otherwise organizing their portfolio companies as, LLCs.

Warren P. Kean, Partner,

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.

K&L Gates LLP

K&L Gates LLP comprises over 1,800 lawyers who practice in 36 offices located on three continents: Anchorage, Austin, Beijing, Berlin, Boston, Charlotte, Chicago, Dallas, Dubai, Fort Worth, Frankfurt, Harrisburg, Hong Kong, London, Los Angeles, Moscow, Miami, Newark, New York, Orange County, Palo Alto, Paris, Pittsburgh, Portland, Raleigh, Research Triangle Park, San Diego, San Francisco, Seattle, Shanghai, Singapore, Spokane/Coeur d'Alene, Taipei, Tokyo, Warsaw and Washington. K&L Gates represents leading global corporations, growth and middle-market companies, capital markets participants and entrepreneurs in every major industry group as well as public sector entities, educational institutions, philanthropic organizations and individuals. Our practice is robustly a full market practice at once regional, national and international in scope, and it is cutting edge, complex, and dynamic. In 2009, our revenues exceeded $1 billion.

[5] For a discussion of these and other structures and arrangements to deal with UBTI/ECI recognition concerns, see Part VII.D, Andrew W. Needham and Anita Beth Adams, 735 BNA Tax Management Portfolio, Private Equity Funds, and Robert D. Blashek and Scot M. McLean, Investments in "Pass-Through" Portfolio Companies by Private Equity Partnerships: Tax Strategies and Structuring, Tax Planning for Domestic & Foreign Partnerships, LLCs, Joint Ventures & Other Strategic Alliances, Practising Law Institute (2008).

[6] If the portfolio company is a partnership, then there will be flow-through tax treatment under I.R.C. õõ702, 512(c), and 875(1) through the Fund and other tiers of partnerships in the ownership structure between the ultimate owners and the portfolio company.

[7] A Fund might invest in the unincorporated portfolio company both directly (with the non-tax-exempt and non-foreign investors' capital contributions) and indirectly through a blocker corporation (with the tax-exempt and foreign investors' capital contributions).

[8] A new blocker corporation is established for each unincorporated portfolio company to avoid being subject to branch profits tax (if the blocker corporation is a foreign corporation) by allowing the foreign corporation to completely terminate its trade or business activities as contemplated by Treas. Reg. õ1.884-2T(a)(2) and to cause the distributions that it makes to its shareholders to be treated as liquidating distributions instead of as dividends subject to withholding taxes under I.R.C. õõ1441 and 1442 if the blocker corporation is a domestic corporation. Alternatively, if the branch profits tax and FDAP withholding taxes are not concerns, each tax-exempt and foreign investor that wants to avoid UBTI or ECI may establish its own blocker corporation or all participating tax-exempt and foreign investors may elect to invest in the Fund through one blocker corporation.

[9] The benefit of a foreign blocker organized in a tax haven is that the FDAP income of the corporation will not be subject to U.S. tax, and it may make payments to its owners/shareholders without having to pay withholding taxes.

[10] The trustee, or deemed trustee, of the assets of an ERISA pension plan (so-called "plan assets") must invest and otherwise manage those assets in accordance with the fiduciary standards (including the prohibited transaction rules (and subject to the 15% (and possibly up to 100%) excise tax on prohibited transactions under I.R.C. õ4975)) of Part 4 of Title I of the Employee Retirement Income Security Act of 1934, as amended ("ERISA"). Money invested by an ERISA pension plan in a PE/VC Fund (or other non-publicly traded equity security or security that is not issued by a regulated investment company registered under the Investment Company Act of 1940) is considered to be a plan asset for which the Fund (i.e., its general partner or manager) must comply with those ERISA fiduciary standards unless an exception applies. The two exceptions that PE/VC Funds typically try to fit under are: (i) the "venture capital operating company" exception (generally referred to as the VCOC exception under Labor regulations õ2510.3-101(d)(1) (i.e., 29 C.F.R. õ2510.3-101(d)(1)) and (ii) preventing ERISA pension plans (or other "benefit plan investors") from having a significant participation in the Fund (i.e., holding 25% or more of the value of any class of equity interest in the Fund (or any other non-publicly traded investment entity, ERISA õ3(42)).

Under the Labor regulations, a VCOC is an entity (such as a PE/VC Fund) with at least 50% of its assets (determined by the cost of those assets and without regard to certain short-term investments) being invested in "venture capital investments" (or certain "derivative investments"). A venture capital investment is defined as an investment in an operating company (other than a VCOC) in which the Fund (or other applicable entity) has contractual rights "to substantially participate in, or substantially influence the conduct of," that operating company's management. In addition, to be a VCOC, the Fund (or other applicable entity) must not only have such management rights in the operating company to which it invests but it, in fact, must exercise those rights in the ordinary course of its business "with respect to one or more of the operating companies in which it invests." An "operating company" for this purpose is defined as "an entity that is primarily engaged, directly or through a majority owned subsidiary or subsidiaries, in the production or sale of a product or service other than the investment of capital." Labor Regulations õ2510.3-101(a)-(d).

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