Limited Liability Companies in Private Equity
The limited liability company, or LLC, is by far the legal entity most favored by private equity. LLCs enjoy the distinct tax advantage of passing through tax attributes, such as income, loss and gain, to owners. At the same time LLCs are infinitely flexible, offering the ability to create a private world of terms and conditions governing the relations of the members. Only the limits of human imagination restrict the scope of provisions that the LLC agreement can contain. Limited partnerships, which LLCs have largely replaced, have the same flexibility, but they also have a number of annoying structural and capital requirements in order to pass tax scrutiny.
The owners of an LLC are allowed a wide degree of latitude in fashioning this agreement to meet their needs. In particular, the agreement may contain provisions establishing multiple classes of membership interests, limiting the transfer of interests in the company, requiring that members elect certain parties to the board of managers of the company and requiring greater than majority approval for designated material transactions. These provisions are useful to keep control of the organization within the hands of the founding partners, while allowing key members of management to have equity positions in the company.
An LLC structure allows flexibility in allocating distributions of income and loss among the partners. This enables flexible arrangements between the suppliers of capital and managers in a tax-neutral setting. In an LLC, interests in profits can be allocated and reallocated more or less as the parties agree, without regard to the respective contributions of capital. In this regard, they are more flexible that corporations, which generally require that profits be allocated and distributed pro rata according to share ownership.
The owners of an LLC must pay tax on income whether or not cash is distributed by the company to pay taxes. This can be a hotly contested issue in private equity, as the lenders typically block any cash distributions to equity when there is a covenant default. Although the instances of a company having taxable income and experiencing loan covenant defaults are fairly rare, it can and does happen. If distributions are blocked, the owners would have to dip into their own pockets to pay the tax liabilities—not a pretty picture.
Private equity deals with a simple capital structure can in theory be done through a corporation that elects to be treated as a sub-chapter “S” corporation under the Internal Revenue Code. All tax items of a sub-chapter S corporation are passed through to the owners, as in a LLC. Shareholders must report these items on their personal income tax returns and pay taxes on those items. Any income or gain of the corporation so attributed to the shareholders increases the tax or cost basis of the stock. As a result of this increase in cost or tax basis, a lower capital gain is realized when the shares are sold or liquidated.
Sub-chapter S corporations have a number of limitations that make them relatively useless for private equity. They can only have one economic class of stock, which rules out the complex capital structures often found in venture capital or private equity deals. And they can only have natural persons or certain trusts as shareholders, precluding the involvement of institutional investors, such as lenders who frequently secure warrants.
With the recent adoption of state laws enabling the formation of LLCs, many problems associated with limited partnerships and sub-chapter S corporations were solved. An LLC has all the advantages of a limited partnership while providing a flexible vehicle for business operations.
An LLC is formed by filing a one-page certificate with the appropriate state office. The owners then sign a private agreement setting out the provisions governing management, transferability of interests, voting rights, allocation of profits and losses, distributions, issuing new interests and other matters. It is an ideal vehicle for private equity, as the internal ownership structure and control of the entity remains private, as the LLC agreement is not required to be filed with any government agency. That said, the agreements do become visible if the company goes through the process of becoming a publicly traded company.
