Private Equity Law Review : New York Private Equity Lawyer & Attorney : Geoffrey Parnass : Corporate & Business Law

A recent article in the Wall Street Journal points to a ruling of the Tax Court that lets an active investor in a limited liability company (LLC) offset his losses in the LLC against income from other sources, including compensation and investment income. The Tax Court ruled that a set of “temporary” guidelines, in place since 1988, which let an active investor in a limited partnership (LP) offset losses against other income, should also apply to an LLC investor.

The ruling is good news for “active” investors, although it will have little impact in the larger world of private equity, where most investors are passive. That’s because the criteria for being deemed an “active” participant in a business are quite stringent. The investor must have “regular, continuous and substantial involvement” in the business. In the case of limited partners in an LP, under the temporary regulations, active participation can be established only if one of the following criteria is met:   

(1) The individual participates in the activity for more than 500 hours during such year;

(2) The individual materially participated in the activity for any five taxable years (whether or not consecutive) during the ten taxable years that immediately precede the taxable year; or

(3) The activity is a personal service activity, and the individual materially participated in the activity for any three taxable years (whether or not consecutive) preceding the taxable year.

Oddly, given the huge popularity of LLCs over the past decade, the IRS has never expanded these guidelines to make them applicable to LLCs in the same way as LPs. The recent ruling of the Tax Court fixed that. Now, because the Tax Court ruling has national impact, an LLC member who meets one of the criteria cited above can offset his allocable share of the losses in the LLC against any other income.  Before, those losses would be trapped in the LLC, possibly never to be utilized.

The fact that the IRS never got out in front of this issue is remarkable. Instead, the taxpayers here (Nebraska farmers) had to litigate with the agency for years and the Tax Court had to write a lengthy opinion to fill the gap.

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A recent opinion issued by the Delaware Court of Chancery serves as a cautionary tale to entrepreneurs, venture capitalists, and others entering into LLC operating agreements in connection with start-up companies. A minority investor with a substantial stake in a company sought to dissolve the company on the grounds it had abandoned its original business plan. However, because the purposes of the LLC were worded quite broadly in the operating agreement, the court ruled against the dissolution, much to the frustration of the minority investor. Thanks go to Francis Pileggi for bringing the case of In re: Arrow Investment Advisors, LLC to my attention and providing, as usual, an excellent summary and analysis of the court’s opinion on his blog. 

 Along with two others, Noah Hamman co-founded Arrow Investment with the intention of offering advisory services to investment funds. Hamman, who held a 30% membership interest in the company, had been its CEO until he was removed by his two fellow founders as a result of disagreements over management decisions. Like many other financial services firms, Arrow’s prospects began to sink with the market’s. In response, Arrow’s management committee decided to explore other investment opportunities and sent out a notice to the company’s members requesting capital contributions to fund their new programs. Hamman disagreed with this approach and brought a petition before the Court of Chancery seeking dissolution of the LLC under §18-208 of the Delaware LLC Act, alleging that Arrow had departed from the business strategy set out in its original business plan.  

 The court noted that Arrow’s LLC operating agreement, and not its business plan, was the controlling document for determining the company’s purpose. Arrow’s operating agreement clearly stated it was formed “for the purpose of acting as an investment adviser to certain investment funds and for such other lawful business as the Management Committee chooses to pursue.” Given the broad formation clause of the operating agreement, the court ruled that Arrow’s management had not violated the purpose for which the company had been formed simply by choosing to pursue new business strategies. In the words of Vice Chancellor Strine:

Dissolution of an entity chartered for a broad business purpose remains possible upon a strong showing that a confluence of situationally specific adverse financial, market, product, managerial, or corporate governance circumstances make it nihilistic for the entity to continue. 

A company suffering disappointing financial returns resulting from a downturn in general economic conditions did not meet this standard.    

For most companies, including a broad purpose of formation clause in the operating agreement makes sense because it provides management with flexibility to adapt to changing business conditions. But founders of start-up companies should accept that the company’s eventual trajectory may not follow the one they initially conceived. 

To address this unknown and unknowable future, LLC operating agreements can institute appropriate governance procedures and potential exit provisions that would allow management and the company’s members to resolve significant disputes, or, if necessary, to part ways. Members of LLCs with substantial minority stakes, for example, may be given veto rights over certain material managerial decisions (such as when capital calls may be made to fund new business ventures) or exit rights that would allow a withdrawal from the LLC under narrowly specified conditions.        

Nobody won in the case of Arrow Investment Advisors. Hamman remains bound to a company he no longer wants to be a part of, management must continue to deal with a contrary minority investor, and the LLC itself has lost valuable time and money in defending this lawsuit. 

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LBO deals are typically done through limited liability companies, while venture capital deals are typically done through corporations. The difference is governed by tax considerations and the expected exit strategy.

Leveraged Buyout (LBO) Deals

In LBO deals, the acquired company is typically generating taxable income—the same taxable income used to repay the debt incurred to buy the company in the first place. In venture capital deals, the company is typically not generating taxable income, as it is spending money on people and technology at least as fast as it is generating revenues. When revenues do catch up, it can shelter the income awhile longer as it burns through the accumulated net operating losses. As a result, LBO deals typically favor a legal structure that minimizes tax liability (such as the limited liability company), while venture capital deals typically don’t care about taxes, and therefore use a taxable corporation.

Venture Capital Deals

Venture capital deals, and other companies that expect to be publicly traded, are typically organized as corporations.  Corporate shares are designed to be liquid and easily traded on national stock exchanges. For this reason, most venture capital deals are made through corporations with multiple classes of preferred stock, each convertible into common shares, as hope springs eternal that the company will one day go public and mint money for the original investors.

At the present time, corporate law is more thoroughly developed than LLC law and is therefore more predictable from a legal standpoint, although this difference is quickly fading away.

Another reason that corporations are favored in venture capital deals is that they better accommodate stock options. It is difficult to grant traditional stock options to key management of an LLC. The tax code does not permit LLCs to issue incentive stock options, which are treated as capital assets rather than ordinary income, and therefore provide a significant advantage in recruiting management. Also, the exercise of the options in the LLC context can raise tricky tax issues, as capital accounts must be rearranged.  

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The limited liability company, or LLC, is by far one of the most favored legal entities for businesses. 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 limited liability operating 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 the limited liability company operating 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 a limited liability company, 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 than 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 for highly leveraged companies, 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. 

Sub-chapter S Corporations

Companies that expect to maintain a simple capital structure can in theory be set up as 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 limited liability company. 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 several types of business owners. 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 limited liability companies, 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.

Formation of an LLC

An LLC is formed by filing a one-page certificate with the appropriate state office. The owners then sign a private operating agreement setting out the provisions governing management, transferability of interests, voting rights, allocation of profits and losses, distributions, issuing new interests, and other matters.  The internal ownership structure and control of the entity remains private because the LLC operating 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.

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