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Leveraging LLCs in Structuring M&A Transactions

Navigating Complex Capital Account and Tax Allocation Principles in Drafting Operating Agreements

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WEDNESDAY, OCTOBER 10, 2012

Presenting a live 90-minute webinar with interactive Q&A

• L. Andrew Immerman, Partner, Alston & Bird, Atlanta

Lee Lyman, Shareholder, Carlton Fields, Atlanta

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LLCs in Mergers and Acquisitions:

Navigating Capital Account and Allocation Provisions in Operating Agreements

Andy Immerman Chris Rosselli Lee Lyman October 10, 2012

5

• L. Andrew Immerman

Alston & Bird LLP andy.immerman@alston.com (404) 881-7532 Christopher M. Rosselli Delta Air Lines Law Dept. chris.rosselli@delta.com (404) 715-9704 Lee Lyman Carlton Fields llyman@carltonfields.com (404) 815-2677

6

LLCs in M&A

• LLCs are being utilized with increasing frequency as

vehicles for mergers and acquisitions.

• M&A counsel should understand the principles associated

with capital accounts and the implications of tax allocations when using LLCs to ensure that operating agreements properly reflect the economic bargain of the parties.

• Too often M&A practitioners skim through tax

"boilerplate" without understanding underlying principles

• r the impact of language changes to the transaction,

leading to costly mistakes.

7

Goals

• Understand principles underlying

allocations and distributions in LLC agreements (for LLCs taxed as partnerships).

• Understand vocabulary – Capital

Account, Allocation, Distribution, Gross Asset Value, Booking Up.

• Develop a sense of how these terms

are all connected.

• Understand issues that impact

economics.

8

Ground Rules

• We are not talking about wholly-
• wned subsidiaries

− LLCs that are wholly-owned subsidiaries may elect to be taxed as corporations OR they are "disregarded entities."

• LLCs taxed as partnerships

− Joint Ventures. − Minority Investments.

• Federal Income Tax.

− State and foreign income tax treatment may differ. − Other taxes may apply:

• Sales and use tax, FICA,

excise taxes

9

"Investment Company LLC"

• For purposes of illustration this

presentation refers to a simple deal reflected in the "Investment Company LLC Agreement."

• The parties are assumed to want

partnership tax treatment, but this is not a tax-motivated transaction.

• For simplicity, it is assumed that

Investment Company LLC has no debt.

• LLC debt, especially nonrecourse

debt, vastly complicates the issues.

• We will discuss LLC debt only

briefly.

10

Investment Company LLC Limited Liability Company Agreement August 5, 2012

LLCs Don’t Pay Income Tax; LLC Members Pay Income Tax

The LLC is not subject to income

• tax. Code § 701.

But the LLC does compute taxable income – generally, as if the LLC were an individual. Code § 703.

11

11

Why Partnership Tax Is So Complicated

12

The tension between:

• Income computed by

the partnership/LLC, and

• Tax paid by the

partners/members, creates endless pitfalls and

• pportunities.

Distributions vs. Allocations

• Members generally do not pay tax on cash
• r property distributed to them (with

exceptions).

• Members generally do pay tax on the share
• f LLC income allocated to them on the

books of the LLC (with exceptions).

• We will focus on these general rules, but the

exceptions are important.

13

One Reason These Rules Matter to You

• The way many LLC agreements work, if the

allocation provisions are drafted incorrectly, the distributions will not be what they are supposed to be.

• This means that the allocation provisions,

which you may think deal only with taxes, can affect the actual dollar amounts that the members are entitled to receive.

14

Possible Mischief

• If we didn’t have rules…
• Members could agree to allocate

all income to tax-exempt members (or to members that have large net

• perating losses), but to distribute

most of the cash to taxable members.

• If members could do this, the

government would lose vast amounts of revenue.

15

General Principle

• Tax rules and corresponding provisions in the LLC

agreement are designed to make sure that allocations

• f income and loss are consistent with the economic

bargain.

• Allocations must have "substantial economic effect," or

the equivalent (or else be in accordance with the "partner’s interest in the partnership," an extremely vague standard).

• Most LLC agreements attempt to achieve "substantial

economic effect" or the equivalent.

16

What Can the IRS Do?

• The IRS cannot invalidate provisions that call for

contributions or distributions; these provisions are matters of agreement among private parties.

• The IRS can invalidate allocations, and assess

interest and penalties, for lack of "substantial economic effect."

• "Economic effect," rather than "substantiality," is

the focus of most of the mysterious LLC language.

• So… How do you know if your allocations have

economic effect?

17

The "Secret" Formula!

CONTRIBUTIONS +/- ALLOCATIONS = DISTRIBUTIONS

18 18

Contributions +/- Allocations = Distributions

• Of course this formula is not a secret

but:

• It is not made explicit in LLC agreements.
• It is only occasionally made explicit in tax

discussions about LLCs.

• It is easy to miss if you focus on the details

instead of on the big picture.

19

However, this Agreement and most others are designed to satisfy the formula over the lifetime of the LLC.

Contributions +/- Allocations = Distributions

1. Measured over the lifetime of the LLC. 2. Calculated using so-called "book value," as determined under unique tax rules (as discussed later, look for references in the LLC Agreement to the Regulations under Code § 704(b)). 3. These rules can be thought of as the IRS’s perception

• f the economic deal, but they need not correspond to

financial accounting or to tax basis (or to reality).

20

21

To check, see what would happen if

• - at any given time --

the LLC liquidated (sold all its assets and distributed the proceeds) at book value. If, no matter when the LLC liquidates, the formula holds true, then the LLC has gone a long way towards complying with the key tax rules.

Are the Allocations Valid?

Lifetime Perspective

• In partnership tax, focus on the

entire lifetime of the partnership.

• In particular, always ask:
• What would happen on a complete liquidation at

"book value" (i.e., what would happen if the LLC dissolved, wound up, sold its assets at "book value," and distributed the proceeds)?

• Many LLCs are intended to last

indefinitely, just like corporations, but partnership tax was not designed with indefinite life in mind.

22

How Does the LLC Know it is On Track?

The capital account is a snapshot that shows whether the allocations are

• n track for lifetime validity;

it generally shows the amount the member would receive if the LLC liquidated at book value.

23

Answer: Capital Accounts

How Does the LLC Know it is On Track?

At any given time: Contributions +/- Allocations – Distributions = Capital Account

24

Over the LLC’s lifetime: Contributions +/- Allocations = Distributions

Capital Accounts Keep Score

• The capital account keeps score for

each member of the LLC.

• It is intended to show what the LLC

member would be entitled to receive (or contribute) if the LLC liquidated at book value.

• Upon liquidation, after final

distributions have been made to each member, the score should be zero – the members are not entitled to any more distributions (and are not required to make any contributions).

25

Capital Account As Brokerage Account

• A capital account is

something like a brokerage account.

• It keeps track of how

much you put into the LLC, and how much you are entitled to take

• ut.

26

Capital Account As Brokerage Account

• When the LLC earns money, your share of

the earnings increases your capital account – the way earnings on your brokerage account increase your balance.

• When the LLC loses money, your share of

the losses reduces your capital account – the way losses on your brokerage account reduce your balance.

• When you take money out of the LLC, you

reduce your capital account – like withdrawing money from your brokerage account.

• When the LLC liquidates, it is like closing

your account – you should be left with a zero balance.

27

28

Avoid Common Misconceptions

• The Capital Account is not just

Contributions less Distributions.

• Allocations of profits and loss must be shown in

the Capital Account.

• Some LLC Agreements define a concept

such as "Unreturned Capital" consisting

• f:
• Capital Contributions, less
• Certain Distributions (those Distributions treated

as return of capital).

• Do not assume that Capital Account

corresponds to Unreturned Capital.

29

Avoid Common Misconceptions

• There is not necessarily any correlation

between Capital Account and tax basis.

• The Capital Account is generally supposed

to reflect book value rather than tax basis.

• The Capital Account does not include debt

because it is an equity interest.

• However, a member’s basis in the LLC

interest will include the member's share

• f the LLC's debt (almost, but not

exactly, as if the member incurred the debt himself).

Final Capital Accounts Equal Zero

30

There are different ways to draft an LLC Agreement, but different drafting approaches generally aim for the same result over the lifetime of the LLC: Contributions +/- Allocations – Distributions = Capital Account = 0

31

Final Capital Accounts Equal Zero

• It may be simpler to think of capital

accounts this way:

• Capital accounts represent the net

assets of the LLC (assets less liabilities).

• When the LLC liquidates, it pays off

its liabilities and distributes its net assets to the members.

• After the LLC has paid off all its

liabilities and distributed all its assets, it has no assets or liabilities.

• If the LLC has no assets or liabilities,

the capital accounts should be zero.

Allocations Can Be Negative

• Positive allocations are supposed to reflect

an increase in the amount that the member is entitled to receive, on liquidation if not before.

• Negative allocations -- allocations in the

nature of deductions or losses -- reflect a reduction in the amount a member is entitled to receive, and may even reflect amounts the member is required to contribute to the LLC.

• For simplicity -- and also because

businesses tend to be more interested in making money than in planning for losses -- this presentation focuses almost entirely on profits.

32

Capital Accounts Can Be Negative

• Distributions and loss

allocations could cause the capital account to be negative at a given point in time.

• To ensure that the capital

account equals zero on liquidation the LLC agreement may require:

• Additional capital contributions.
• Additional income allocations.

33

Capital Accounts Can Be Negative

• LLC members are usually not required to

make additional capital contributions to bring negative capital accounts up to zero, so additional income allocations are required instead.

• The most complicated and confusing tax

language in typical LLC agreements is designed to ensure that a member is allocated additional income to prevent a negative capital account after liquidation.

• In the Investment Company LLC

Agreement , these monstrous provisions are in Section 4.2.2 (the "Regulatory Allocations").

34

Tax Follows Book

35

With some exceptions, the Regulations say:

Tax income follows from "book" income.

Once you know the allocations on the "books" of the LLC, you generally (not always) know what taxable income each member of the LLC has.

• An LLC may have to keep three
• r more kinds of books:
• Tax.
• Financial reporting (GAAP, IFRS
• r other).
• "704(b)" (defined by Regulations

under Section 704(b) of the Code).

• Typical LLC agreements require

the LLC to keep 704(b) books.

36

How Many Books Do You Need?

• Most of the allocation provisions in typical

LLC agreements are technically 704(b) book allocations; they are not tax allocations.

• 704(b) books start from taxable income, but

make significant adjustments.

• 704(b) books represent, in effect, the IRS's

version of the real economics of the deal.

37

704(b) Books vs. Tax Books

• The theory is that the real economics should

determine the tax consequences.

• For example, if you will be entitled to a

distribution of profits, you – not another member -- should be taxable when those profits are earned.

• In many situations, you cannot figure out the

tax consequences without first thinking about the 704(b) books.

38

704(b) Books vs. Tax Books

Remember

• Capital Accounts are maintained on the

books of the Company.

• Capital Accounts are bookkeeping entries;

they do not represent cash.

• Capital Accounts under the tax Regulations

are kept under a special set of "book"

• principles. They do not necessarily reflect tax

basis or GAAP or anything else.

39

What We Know So Far:

• 1. Members generally pay tax on LLC income allocated to

them.

• 2. Allocations must have economic effect.
• 3. Allocations generally are valid if upon liquidation at

book value, Contributions +/- Allocations = Distributions.

• 4. Capital Accounts represent what each member would

receive at liquidation if the LLC is honoring the formula.

• 5. Capital Accounts are increased by contributions and

allocations of income; they are decreased by distributions and allocations of loss.

40

Connecting the Pieces

• The 704(b) Regulations neatly tie together

the principal tax and economic provisions

• f the LLC agreement:

1. Contributions. 2. Allocations. 3. Distributions. 4. Capital Accounts.

• The economic deal and the tax terms are

interrelated.

• There are other tax-related provisions but

these four concepts are fundamental and are the ones we focus on.

41

In a sense, the Capital Accounts summarize the other three

• concepts. Capital Accounts are essential for typical LLC

agreements and partnership tax.

Connecting the Pieces

• In the Investment Company LLC

Agreement, the most crucial tax-related sections are:

• Section 4.1 (Distributions).
• Section 4.2 (Allocations).
• Section 1.4.2(e) (Liquidating Distributions).
• Section 2.3 (Capital Contributions).
• However, the Agreement relies heavily on

Exhibit A ("Definitions").

• Some of the most important and surprising

provisions are tucked away in the definitions rather than in the text.

• Do not neglect the definitions, especially not the

definitions of "Capital Account" and terms relating to the Capital Account.

42

The Life Cycle Of The LLC Begins

Investor contributes cash and all the issued and outstanding stock of Corp 1.

43

CASH CORP 1 Fair Market Value: $1,000 $1,000 Basis: $1,000 $0

LLC uses the cash to buy Corp 2. Asset Manager proposes to increase the value of Corp 1 and Corp 2 by providing services, and receiving a share of the proceeds from any increase in value.

The LLC is Born

44

Investor contributes cash and Corp 1 stock. Investor and Asset Manager form an LLC in Year 1.

The LLC is Born

45

Contribution is Tax-Free

• Investor recognizes no gain on

contributing Corp 1.

• Investor has in effect "sold" Corp 1 for

$1,000 in LLC interests, but he defers tax

• n his gain.
• However, the LLC holds Corp 1 with the

same zero basis that Corp 1 had for the Investor.

• The Investor has built-in gain on Corp 1,

which will later come back to haunt him.

The LLC is Born

46

• The book value of the LLC’s assets – generally, the fair

market value of the contributed assets, as agreed by the parties – is equal to $2,000 (including $1,000 cash). $2,000 will be credited to Investor’s Capital Account.

• However, the tax basis of the LLC in its assets (called

"inside basis") is only $1,000, because the LLC inherits Investor’s basis in the property.

• The excess of book value over basis at the time of

contribution is built-in gain, equal to the amount of gain Investor would have recognized on a cash sale.

Capital Contributions

47

Capital Contributions include cash and the Gross Asset Value of property

• contributed. However, the amount of

liabilities that the property is subject to is debited from the Capital Account.

"Capital Contributions" means, with respect to any Member, the amount of money and the initial Gross Asset Value

• f any property (other than money)

contributed to the Company with respect to the Membership Interest held by such Member.

Documenting the Contributions

• Exhibit B shows:
• $2,000 value of capital contribution by

Investor.

• $0 capital contribution by Asset Manager.
• Some advisors recommend that Asset Manager put in at least

some capital.

• In any case, services are not capital.
• Sometimes the LLC Agreement or a separate

"Contribution Agreement" will contain representations and warranties as in a sale.

48

2.3.1 Member's Capital Contribution. Each Member's initial Capital Contribution is set forth on Exhibit B.

Gross Asset Value

49

The value of property reflected in Capital Accounts is often defined, as in the Investment Company Agreement, as "Gross Asset Value." Investment Company LLC has no debt so gross and net value are equal.

"Gross Asset Value" means, with respect to any asset, the asset's adjusted basis for federal income tax purposes, except as follows:

Gross Asset Value

50

Focus on who gets to make the decision about what the Gross Asset Value of an asset is, especially after the initial

• contribution. Initial Gross Asset Value is

usually a mutual decision between the Company and the contributor.

(a) The initial Gross Asset Value of any asset contributed by a Member to the Company shall be the fair market value of such asset, as determined by the contributing Member and the Company;

The Business Deal

51

• The business deal is that Investor gets back the

first $2,000 of cash flow.

• Investor puts in $1,000 cash, and property that

the parties agree has a value of $1,000.

• Asset Manager benefits only to the extent that

the value of the LLC increases to more than $2,000. For simplicity, we assume that Investor has no preferred return on his capital.

Documenting the Distributions

• Section 4.1.1(a) says that Investor first

receives a cumulative distribution equal to his initial Capital

• Contribution. He receives the first

$2,000 of distributions.

• Section 4.1.1(b) says that after

Investor receives this first $2,000 of distributions, distributions are made 20% to Asset Manager and 80% to Investor.

52

Documenting the Distributions

53

(a) First, 100% to Investor until the cumulative distributions under this Section 4.1.1(a) equal Investor's initial Capital Contribution. (b) Second, twenty percent (20%) to Asset Manager and eighty percent (80%) to Investor.

What Gets Distributed?

• Answer: "Net Cash Flow"
• Net Cash Flow is defined by reference

to defined terms such as "Disbursements," "Reserves," and "Gross Receipts."

• Notwithstanding all these definitions,

the upshot in this Agreement is that Net Cash Flow generally means whatever amount the Managers decide is available for distribution.

• Members may want tighter controls.
• ver distributions.

54

Net Cash Flow

• Different LLC agreements use

different terms for what gets distributed, including:

• "Net Profits."
• "Net Income."
• "Distributable Income."
• The exact term doesn't matter, but a

phrase like "Net Cash Flow" is less misleading than some others:

• Profits and income do not get distributed.
• Cash (and sometimes property) gets

distributed.

55

56

Don’t Confuse Distributions with Allocations

Distributions are actual cash or property.

Allocations are adjustments on the books of the LLC.

"Payments" to Members

• Partnership tax practitioners often distinguish

"distributions" from "payments."

• "Payments" do not enter directly into the formula.
• "Payments" are treated entirely or partially as if

paid to third parties.

• "Payments" are sometimes set forth outside the

LLC agreement, including:

• "Guaranteed payments" for capital or services.
• Payment of sales price for property sold to the LLC.

57

"Payments" to Members

However, this Agreement provides in vague terms for certain "payments."

58

3.1.9 Compensation. Compensation of the Managers will be fixed from time to time by an affirmative vote of a Majority in Interest. 2.4.1 Loans to the Company. The Members may lend money to the Company as approved by the Managers.

What is Asset Manager’s Interest?

59

Answer: Asset Manager has a $0 interest in capital and a 20% interest in profits. In almost every LLC there are "capital interests" and "profits interests." It is often misleading to express

• wnership as either a single

percentage or as a number of "units."

Capital: $0.00 Profits: 20%

What is Asset Manager’s Interest?

60

"Capital Interest":

Any interest that would give the holder a share of the proceeds if the partnership's assets were sold at fair market value and the proceeds distributed in liquidation of the partnership. "Profits Interest": Any partnership interest other than a capital interest.

• Rev. Proc. 93-27, 1993-2 C.B. 343.

Capital: $0.00 Profits: 20%

Does Asset Manager Have a Capital Account?

61

Answer: Yes and no. The Asset Manager starts with a zero Capital Account. However, the Asset Manager’s Capital Account will build up

• ver time as income is allocated to the Asset

Manager (and will be reduced again as the Asset Manager receives distributions).

Initial Capital Account Investor $2,000 Asset Manager $0

Is Asset Manager Taxable on Receiving the Profits Interest?

Answer: Generally no. With a few exceptions, if a person receives a profits interest for the provision of services to or for the benefit of a partnership in a partner capacity or in anticipation of being a partner, the IRS will not treat the receipt of the profits interest as a taxable event for the partner or the partnership.

62

63

IRS may try to impose tax if:

• 1. The profits interest relates to a

"substantially certain and predictable stream of income" (like income from high-quality debt securities or a high- quality net lease).

• 2. Within two years of receipt, the partner

disposes of the profits interest.

• 3. The profits interest is a "publicly

traded" limited partnership interest.

Possible Exceptions

Capital: $0.00 Profits: 20%

64

How to Draft Profits Interests

• Elaborate terms defining and

governing the Asset Manager's "profits interest" are not essential , although may be desirable.

• A distribution scheme in

which the Investor receives all his contributed capital, and profits are split 80/20, without more, represents a profits interest for Asset Manager.

65

How to Draft Profits Interests

• Especially if the LLC has a formal

equity compensation plan, it may want additional documents such as a "Profits Interest Plan," and individual "Profits Interest Awards" for each recipient.

• The LLC may also want a service

contract with the service provider.

• However, the distribution

provisions of the LLC agreement are essential; always check the LLC agreement.

So… How Does an LLC Allocate Income and Loss?

66

• Remember: allocations must be consistent with the

economic deal as the Regulations construe it.

• Over the LLC’s lifetime: Contributions +/-

Allocations = Distributions.

• At any given point in time: Contributions +/-

Allocations – Distributions = Capital Account

What is Allocated?

67

Answer: "Profits" (and "Losses" and other "items"). You can use other terms, but be clear that allocations are accounting entries and not actual money or property. "Net Cash Flow" gets distributed, not allocated.

"Profits" and "Losses"

68

The definition of "Profits" and "Losses" starts from taxable income and then makes adjustments.

"Profits" or "Losses" means, for each Allocation Year, an amount equal to the Company's taxable income or loss for such Allocation Year, determined in accordance with Section 703(a) of the Code (for this purpose, all items of income, gain, loss or deduction required to be stated separately pursuant to Section 703(a)(1) of the Code shall be included in taxable income or loss), with the following adjustments:

"Profits" and "Losses"

69

The adjustments bring taxable income and loss into line with "book" income and

• loss. However, these are the "704(b)"

books – the books kept under the 704(b) Regulations – and not tax books or financial accounting books.

(a) Any income of the Company that is exempt from federal income tax and not otherwise taken into account in computing Profits or Losses pursuant to this definition shall be added to such taxable income

• r loss;…

"Profits" and "Losses"

70

• Adjustments are needed to get to Profits from

taxable income because Profits is a book concept, supposedly reflecting the economic

• deal. For example,
• Tax-exempt income must be allocated because it

increases the amount that the LLC has available to distribute and so affects the economics.

• "Book value," and not basis, determines the total

amount that may be depreciated (but depreciation schedules are still calculated under tax rules and not, for example, under GAAP).

71

Draft Distributions First

Drafting Tip:

• When drafting an LLC Agreement

for a business deal:

• Focus first on the distributions,
• Then see how the allocations

will come out, and whether the distributions should be adjusted in light of the allocations.

• In most deals, the distributions are

the primary concern.

72

Allocating Profits and Losses

• Section 4.2 of the Investment Company

LLC Agreement illustrates two alternative styles of drafting allocations:

• "Layered" (also known as "layer

cake" or "waterfall").

• "Targeted" (also known as "forced").

Layered Allocations

73

• Layered allocations fit within one of the

"safe harbors" in the Regulations.

• They require liquidation in accordance

with capital accounts.

• If the capital accounts are not what the

parties intended then the liquidating distributions will not be what the parties

• intended. For example, an unknown

drafting error in the allocations may unintentionally increase some capital accounts at the expense of other, leading some members to receive more than intended

Layered Allocations: First Tier

74

• The first "tier" of Profit allocations
• ffsets ("charges back" or "reverses")

any prior Losses.

• Although this tier comes first, it is

generally not the first in importance.

• This presentation focuses on Profits.
• If there are no Losses this first tier of

Profit allocations is irrelevant.

Layered Allocations: First Tier

75

• Crude explanation of this charge back of prior

Losses:

• Asset Manager starts with a zero Capital Account
• Losses reduce Capital Accounts; initial Losses can’t be

allocated to Asset Manager or else she would have a negative Capital Account.

• Initial Loss allocations to Investor means that his Capital

Account is less than $2,000; he is entitled to less than $2,000 on liquidation at book value.

• If there are no later Profits, the Company really has

lost some of Investor’s $2,000, and he can’t receive his full $2,000.

• However, if there are later Profits offsetting the

initial Loss, the initial Loss was temporary; the Company now can give Investor back his $2,000, and his Capital Account should reflect $2,000 or more.

Layered Allocations: First Tier

76

(i) First, Profits shall be allocated one hundred percent (100%) to Investor in an amount equal to the excess, if any, of the cumulative Losses allocated to Investor pursuant to Section 4.2.1(b)(ii) for all prior Allocation Years over the cumulative Profits allocated pursuant to this Section 4.2.1(a)(I) for all prior Allocation Years. The Company allocates Profits first to Investor to charge back prior Losses, bringing his Capital Account back up to $2,000, the minimum amount he should receive over the lifetime of the Company.

Layered Allocations: Second Tier

77

Assuming there are no prior Losses remaining to be charged back, Profits are simply allocated 80/20. The second tier of allocations is actually the general rule.

(ii) Second, after giving effect to the allocations made pursuant to Section 4.2.1(a)(I), Profits shall be allocated twenty percent (20%) to Asset Manager and eighty percent (80%) to Investor.

Targeted Allocations

78

Many LLC agreements nowadays omit specific allocation rules, in favor of "targeted" allocations. The targeted capital account provision says: Allocate so that Capital Accounts (with certain adjustments relating to nonrecourse debt) equal the amounts the members would receive in a liquidating distribution.

Targeted Allocations

79

Instead of following detailed allocation instructions specified in the LLC agreement, the LLC’s accountants must figure out each year how to make allocations based on what the LLC would distribute if the LLC liquidated at book value at the end of the year. This is sometimes called the "forced" allocation approach because allocations are forced to correspond to a hypothetical liquidating distribution for each Member.

Targeted vs. Layered

80

• Both methods are intended to get to the same place.
• However, if something goes wrong, the different methods seek

to save different aspects:

• Targeted allocations: economic terms (distributions) are

thought to be safe.

• Layered allocations: tax treatment is thought to be safe.
• Of course the distribution provisions still need to be carefully

thought through when using targeted allocations.

• Targeted allocations are especially handy when there is an

elaborate multi-tier distribution waterfall.

• However, targeted allocations are not used in some situations

(for example, certain investments by tax-exempts in real estate LLCs, where the dreaded "fractions rule" is relevant).

Why Does the Allocation Language Go On So Long?

81

• Answer: The possibility of negative capital accounts.
• Most LLC agreements include a series of complicated

exceptions to the primary allocation provisions.

• These are sometimes called the "regulatory" (or "special"
• r "curative") allocations.
• These allocations are directed at actual or potential negative

capital accounts.

• A positive capital account should imply an ultimate right to

receive distributions.

• Does a negative capital account therefore imply an ultimate
• bligation to make contributions?

Why Does the Allocation Language Go On So Long?

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• But remember: The IRS has no authority to require capital

contributions.

• The most the IRS can do is to force allocations to be made in

such a way that:

• A negative capital account will not arise except to the extent that the

member has (or is deemed to have) an obligation to contribute capital; or

• If such a negative capital account arises anyway, then to the extent

possible, income will be allocated to the member to increase the capital account.

• Many agreements use the term "Adjusted Capital Account" to refer to the

result of adding required contributions on to the capital account.

Adjusted Capital Account Deficit

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• The "Adjusted Capital Account Deficit" starts with the Capital

Account.

• It adds back amounts that the Member:
• Is obligated to restore (none under our facts), or
• Is deemed obligated to restore (this would only arise if there

are distributions or deductions attributable to nonrecourse debt).

• It subtracts certain deductions and distributions that are

expected to be made later. "Adjusted Capital Account Deficit" means, with respect to any Member, the deficit balance, if any, in such Member's Capital Account as of the end of the relevant Allocation Year, after giving effect to the following adjustments: . . .

Nonrecourse Debt

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• Perhaps the most common situations in which the

Regulatory Allocations come into play are those in which members take deductions or distributions attributable to (funded by or sourced to) nonrecourse debt.

• Roughly speaking, a deduction or distribution is

attributable to nonrecourse debt to the extent it reduces a capital account below zero.

• Deductions or distributions are not necessarily

attributable to nonrecourse debt, even if the LLC has nonrecourse debt.

Nonrecourse Debt

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• "Minimum Gain" can be thought of as the amount of

negative capital account that is attributable to nonrecourse debt – the amount that the lender, and not the member, stands to lose.

• The member has no obligation to make a Capital

Contribution to eliminate the negative Capital Account; the debt is nonrecourse.

• However, the IRS can require the LLC to eventually

allocate income to the member in order to eliminate the negative Capital Account.

• Roughly, the "Minimum Gain Chargeback" is income that

is allocated to eliminate a negative Capital Account attributable to nonrecourse debt .

What Have We Learned So Far?

• Capital Accounts begin with a contribution of cash or property.
• If contributed property is appreciated (i.e., its value is higher than

its tax basis), there will be built-in gain, which will be allocated to the member over time in accordance with Code § 704(c).

• Allocations of income and loss are made in accordance with Code §

704(b) to ensure allocations have economic effect.

• Safe harbors exist for "Layered Allocations," but the modern trend

is to instead use "Targeted Allocations."

• The "Regulatory Allocations" address special situations that involve
• r could involve negative capital accounts.

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Sale of Corp 2

• Assume that Corp 2 is sold in Year two for $2,000, resulting

in $2,000 in proceeds, $1,000 in book income, and $1,000 in tax income.

• The business deal is that the first $2,000 in cash is returned to

Investor.

• However, the $1,000 book income represents profits, and is

allocated $800 to Investor and $200 to Asset Manager.

• There has been $1,000 of profits (the value of the LLC

increased by $1,000 over the initial value of $2,000), and the business deal is that, over the lifetime of the LLC, Asset Manager is entitled to 20% of all profits.

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Asset Manager Has "Phantom Income"

Asset Manager has "phantom income" in year two – she has $200 of taxable income, but no distribution to pay it with. Phantom income here is a consequence

• f the economic deal.

It is not the result of faulty legal draftsmanship or inept accounting.

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Minimum Tax Distribution

A common solution to the phantom income problem is a minimum tax distribution: Require the LLC to first distribute enough to the parties so that they can pay tax on the income allocated. This solution means that Investor is not getting all of the first $2,000 of cash, but he is getting most of it.

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Minimum Tax Distribution

4.1.2 Minimum Tax Distribution. Except as otherwise provided in Section 1.4.2, notwithstanding Section 4.1.1 the Company shall make distributions out of Net Cash Flow to the Members at such times and in such amounts as are reasonably estimated by the Managers to be at least sufficient to enable each Member to make timely payments of federal, state and local income taxes , including estimated taxes, attributable to such Member's Membership Interest.

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Minimum Tax Distribution

Section 4.1.2 only requires the tax

distribution to be a reasonable estimate

• f the amount needed to pay taxes. The

estimate may be less than is actually needed. Section 4.1.2 only requires the tax distribution to be made out of "Net Cash Flow." For example, the Company does not need to borrow money to make a tax distribution. No matter what the LLC agreement says, there is always some risk that a Member will have phantom income.

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Minimum Tax Distribution

Distributions under this Section 4.1.2 shall be made twenty percent (20%) to Asset Manager and eighty percent (80%) to

• Investor. Any amount distributed pursuant

to this Section 4.1.2 will be deemed to be an advance distribution of amounts otherwise distributable to the Members pursuant to Section 4.1.1(b) and will reduce the amounts that would subsequently

• therwise be distributable to the Members

pursuant to Section 4.1.1(b) in the order they would otherwise have been distributable.

Minimum Tax Distribution

• A tax distribution is normally treated as an advance on

amounts that otherwise would be distributed in the future.

• Tax distributions affect the timing of distributions but in

general are not intended to alter the total distributions that the member is entitled to receive over the lifetime of the LLC.

• Tax distributions have no special status under tax law; they

are treated for tax purposes the same as any other distributions.

• Tax law does not require tax distributions.
• The LLC can make distributions for any reason or no reason;

some distributions happen to be designed so that the members have enough cash to pay their taxes.

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Minimum Tax Distribution

• There are many ways to draft tax distribution provisions; no

approach is ideal.

• Tax distributions are usually based on assumed tax rates,

specified conventions and/or estimates; actual tax liability is harder to determine than you might think.

• Carefully consider tax distributions, especially if you are in

the position of the Asset Manager (i.e., the service provider).

• Assuming that the LLC wants to give the members some relief

from the problem of phantom income, there are techniques

• ther than tax distributions, such as loans or special

allocations.

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Sale of Corp 1

• Assume that Corp 1 is sold in Year three for $2,000,

yielding:

• $2,000 in cash proceeds.
• $1,000 in book income.
• $2,000 in tax income.
• Investor got the first $2,000 of proceeds in Year two

(assume no Minimum Tax Distribution in Year two), so Year three cash of $2,000 is split 80/20:

• $1,600 to Investor.
• $400 to Asset Manager.

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Liquidating Distributions

• For tax purposes, and under the

Agreement, the distribution of Year 3 proceeds is a liquidation of the LLC; the LLC has no more assets.

• Liquidating distributions are drafted in

different ways.

• Two common approaches are:
• In accordance with positive Capital

Accounts (typical with "Layered Allocations").

• In accordance with specific distribution

instructions in the LLC agreement (typical with "Targeted Allocations").

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Liquidating Distributions

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1.4.2 Liquidation of Property and Application of Proceeds. Upon the dissolution of the Company, the Managers (or, if none, a liquidator appointed by the Personal Representatives of the deceased Members) will wind up the Company's affairs in accordance with the Delaware Act, and will take any and all actions contemplated by the Delaware Act that are necessary or appropriate, including, without limitation: …

Liquidation provisions generally begin by requiring the Managers to take the steps required by law.

Liquidating Distributions

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(e) distributing the proceeds of liquidation and any undisposed Property to the Members in accordance with [their positive Capital Account balances] [Section 4.1.1]. For the members, the crucial provision on liquidation relates to the distribution of amounts remaining after creditors have been paid or reasonable provision has been made for their

• payment. This residual will be distributed

either in accordance with Capital Accounts, or in accordance with a distribution scheme spelled

• ut in the LLC agreement.

Liquidating Distributions

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In our example, liquidating in accordance with Capital Accounts or in accordance with Section 4.1.1 has the exact same results, as intended. Although the drafting trend in recent years is to require liquidation in accordance with a specified distribution schedule, if things work out right, the results will be the same under either approach.

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Over the Lifetime of the LLC, the Formula Works Just Right

INVESTOR

Year Contributions Allocations Distributions One: $2,000 Two: $800 $2,000 Three: $800 $1,600 Life of LLC: $2,000

+

$1,600 = $3,600

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Over the Lifetime of the LLC, the Formula Works Just Right

ASSET MANAGER

Year Contributions Allocations Distributions One: Two: $200 Three: $200 $400 Life of LLC: + $400 = $400

Aren’t We Forgetting Something About Corp 1?

• The book income of $1,000 (and $1,000 of the tax

income) on the sale of Corp 1 was allocated the same way as it was for Corp 2: $800 to Investor and $200 to Asset Manager.

• However, there is $2,000 of tax income, which is

$1,000 more than the book income.

• Corp 1 stock had a zero basis when contributed.
• Corp 1 stock had a $1,000 book value when contributed.
• How do we reconcile the $2,000 tax income with the

existence of only $1,000 book income?

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The Formula Revisited

103

• The formula applies to the $1,000 of book income, and

to tax income to the extent that the tax income equals the book income (i.e., to $1,000 of tax income).

• The $1,000 of built-in gain when Investor contributed

the property is not book income.

• However, the $1,000 of built-in gain was deferred when

Investor contributed Corp 1

• Investor got $1,000 of Capital Account credit on

property with a zero basis.

• Now that the property is sold, it is time for him to

pay the tax.

Book/Tax Reconciliation

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Investor wound up getting total cash distributions of $3,600 from the Company. Investor's initial tax basis in the property contributed to the Company was $1,000. Thus he should have $2,600 of taxable income, and not $1,600. Allocating the extra $1,000 entirely to Investor seems quite fair.

Book/Tax Reconciliation

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• Investor got the economic benefit of that $1,000 of

value and there is no reason Asset Manager should pay tax on it.

• In some cases, the

contributing member’s gain is triggered long before the property is sold.

• Code § 704(c) and

related Code provisions – seek professional help!

Book/Tax Reconciliation (Section 4.2.6)

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4.2.6 Tax Allocations. Tax Allocations. In accordance with Section 704(c) of the Code and the Treasury Regulations thereunder and with Treasury Regulations Section 1.704- 1(b)(2)(iv)(f)(4) and 1.704-1(b)(4)(i), income, gain, loss and deduction with respect to any property contributed to the capital of the Company or property revalued on the Company's books and in the Capital Accounts shall, solely for tax purposes, be allocated among the Members so as to take account, under the [SPECIFY METHOD] as defined by Treasury Regulations Section 1.704-3, of any variation between the adjusted basis of such property to the Company for federal income tax purposes and its Gross Asset Value.

Capital Account: Further Explanation

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• The remainder of this

presentation:

• Goes over the definition of

Capital Account in somewhat more detail.

• Explains how the concept of

"booking up" affects the Capital Accounts.

Capital Account

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Credit Capital Account With Contributions and Profit Allocations

(a) To each Member's Capital Account there shall be credited such Member's Capital Contributions, such Member's distributive share of Profits and any items in the nature of income or gain that are allocated pursuant to Section 4.2 hereof, and the amount of any Company liabilities assumed by such Member or that are secured by any Property distributed to such Member;

Capital Account

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Debit Capital Account for Distributions and Loss Allocations

(b) To each Member's Capital Account there shall be debited the amount of cash and the Gross Asset Value of any Property distributed to such Member pursuant to any provision of this Agreement, such Member's distributive share of Losses and any items in the nature of expenses or losses are allocated pursuant to Section 4.2 hereof, and the amount of any liabilities of such Member assumed by the Company or that are secured by any property contributed by such Member to the Company;

Capital Account

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If the Member assumes liabilities of the Company, the Member is treated as making a capital contribution; If the Company assumes liabilities of the Member, the Member is treated as receiving a distribution.

(d) In determining the amount of any liability for purposes of clauses (a) and (b) of this definition, there shall be taken into account Section 752(c) of the Code and any other applicable provisions of the Code and Treasury Regulations.

Capital Account

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• Capital Accounts are affected by liabilities that

the Member assumes or that the LLC assumes.

• Capital Accounts are not affected by the

Member's "share" of the Company's liabilities, even though the Member's "share" of liabilities is included in the Member's basis.

• If the Member's tax basis is higher than the

Member's Capital Account, the reason is often that the tax basis – but not Capital Account – includes a share of the Company's liabilities.

Capital Account

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Transferee succeeds to Capital Account of transferor.

(c) Subject to the other provisions of this Agreement, in the event all or any portion of a Membership Interest is Transferred in a Permitted Transfer, the transferee shall succeed to the Capital Account of the transferor to the extent it relates to the Transferred interest . . .

Booking Up

• Booking up Capital Accounts means reflecting new fair

market values for the LLC’s assets, and adjusting Capital Accounts accordingly.

• Technically the procedure is a "restatement," since it

can lead to booking down as well as booking up.

• It can be thought of as "marking to market."
• In the Investment Company LLC Agreement, the

concept of booking up is part of the definition of Gross Asset Value.

• Booking up is often essential to prevent distortion of

the economic deal.

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Booking Up

• Gross Asset Value is typically "booked up" when an

additional interest is issued to a new or existing Member (other than de minimis interests), when property is distributed, or upon liquidation. See Clause (b) of the definition of "Gross Asset Value."

• Although the provision on booking up looks like

neutral tax definitional boilerplate, the appearance may be deceiving.

• Decisions about booking up can have major effects on

the economics of the deal.

• Focus on how booking up decisions are made;

decision-making procedures vary widely.

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Booking Up

• Example: Suppose that Investment

Company LLC at some point needs extra cash and New Investor agrees to contribute $2,000.

• If the net assets of the LLC at the

time have increased in value to $4,000 (rather than the $2,000

• riginal book value), New Investor’s

contribution will represent $2,000

• ut of the total $6,000 value.
• New Investor should be credited with
• wning only 1/3 of the capital – not

½.

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Booking Up

• The $2,000 increase in value that

accrued before the new investment should be credited to the Capital Accounts of Investor and Asset Manager, as if the assets had been sold.

• This increase in Capital Accounts is

not taxable to Investor and Asset Manager, but creates built-in gain that can eventually come back to haunt them – almost as if Investor and Asset Manager had contributed appreciated property to a new partnership with New Investor.

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