TAX TRAPS IN BUSINESS FORMATIONS

First Run Broadcast: December 3, 2015

Live Replay: June 27, 2016

1:00 p.m. E.T./12:00 p.m. C.T./11:00 a.m. M.T./10:00 a.m. P.T. (60 minutes)

Forming a new business entity may seem like an easy process of filling in a few details on a

form, but in truth the process is laden with risks – tax risks and other risks. Often one of the

owners of the new company wants to contribute his or her services. Depending on how the

contribution is structured – what services the person is giving to and ownership interest the he or

she is receiving back from the company – there may be substantial and adverse tax

consequences. When property subject to debt or other encumbrances is contributed to the new

company there are also numerous tax implications for the company and the contributor – not to

mention creditor issues. There are also a host of subtle distinctions with outsized real-world

consequences when structuring economic rights such as the right to distributions versus the tax

allocations, if any. This program will provide you with a practical guide to the tax and other

major traps when forming a new business entity.

Taxability on the contribution of services – valuation, timing, and character

Understand how the receipt of different type economic rights impacts

stockholder/member/partner taxation

Transferring property subject to debt – credit and tax issues

Economic right to distributions v. tax allocations and responsibilities

Special issues involved in forming S Corps and LLCs

Valuation of ownership interests over time and relationship to transferability restrictions

Reviewing information and voting rights

Speaker:

Allen Sparkman is a partner in the Houston and Denver offices of Sparkman Foote, LLP. He

has practiced law for over thirty years in the areas of estate, tax, business, insurance, asset

protection, and charitable giving. He has written and lectured extensively on choice-of-entity,

charitable giving and estate planning topics. He is the Colorado reporter for the books "State

Limited Partnership Laws" and "State Limited Liability Company Laws," both published by

Aspen Law & Business. He has also served as president of the Rocky Mountain Estate Planning

Council. Mr. Sparkman received his A.B. with honors from Princeton University and his J.D.

with high honors from the University of Texas School of Law.

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Tax Traps in Business Formations Teleseminar

June 27, 2016 1:00PM – 2:00PM

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Please note: This form is for your records in the event you are audited Sponsor: Vermont Bar Association Date: June 27, 2016 Seminar Title: Tax Traps in Business Formations Location: Teleseminar - LIVE Credits: 1.0 MCLE General Credit Program Minutes: 60 General Luncheon addresses, business meetings, receptions are not to be included in the computation of credit. This form denotes full attendance. If you arrive late or leave prior to the program ending time, it is your responsibility to adjust CLE hours accordingly.

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PROFESSIONAL EDUCATION BROADCAST NETWORK

TAX TRAPS ON BUSINESS FORMATION

Allen SparkmanSPARKMAN + FOOTE LLP

1616 17th St., Ste. 564Denver, CO 80202-1278

303.396.0230 (voice)1.720.600.6771 (fax)

sparkman@sparkmanfoote.comwww.sparkmanfoote.com

AND

P.O. BOX 666892800 POST OAK BLVD., STE. 4100

Houston, TX 77266713.401.2922 (voice)1.281.783.6886 (fax)

I. Tax Effects of Formation.

A. Partnerships.1

1. General Rule. Generally, neither a partnership nor any of its partners recognize gain

or loss in the case of a contribution of property to the partnership in exchange for an

interest in the partnership.2 Exceptions to the general non-recognition rule include the

matters in paragraphs 2 to 8 below:

2. Services. See the discussion of “Equity Compensation in Tax Partnerships” below.3

1 In this paper, the term “partnership” refers to any unincorporated entity treated as a partnership for federal incometax purposes. Under the “check-the-box” regulations adopted in December, 1996, Treas. Reg. §§ 301.7701-2, etseq., with certain limited exceptions, absent election to the contrary, any domestic unincorporated entity (such as anLLC) with more than one owner will be classified as a partnership for federal tax purposes, and a single ownerunincorporated entity (such as an LLC) will be disregarded for federal income tax purposes. The exceptions to thecheck-the-box classification are a business entity that is organized under a state statute that describes or refers to theentity as a joint-stock company or joint-stock association, an insurance company, a state-chartered bank if any of itsdeposits are insured under the Federal Deposit Insurance Act, a business entity that is wholly owned by a state orpolitical subdivision of a state, and a business entity that is taxable as a corporation under another provision of theInternal Revenue Code. Treas. Reg. § 301.7701-2(b) (1996). Moreover, a single member unincorporated entity thatis disregarded for income tax purposes is not disregarded for employment tax purposes and certain excise taxpurposes. Treas. Reg. §§ 301.7701-2(c)(2)(iv) (1996) (employment taxes) and 303.7701-2(c)(2)(v) (1996) (certainexcise taxes). Also, for purposes of the regulations applying to the issuance of non-compensatory options bypartnerships, a disregarded entity that has not elected to be classified as a corporation is treated as a partnership.Treas. Reg. § 1.761-3(b)(2).2 I.R.C. § 721(a).3 Infra, notes 52-72 and accompanying text.

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3. Issuance of an Interest to Satisfy Debt. If a partnership issues a partnership interest to

a creditor in satisfaction of a debt, § 721 does not apply to the extent the transfer of

the partnership interest to the creditor is in exchange for the partnership’s

indebtedness for unpaid rent, royalties, or interest (including original issue discount)

that accrued on or after the beginning of the creditor’s holding period for the

indebtedness. The debtor partnership, however, will not recognize gain or loss from

such an exchange.4

4. Noncompensatory options. The non-recognition rule of § 721 will apply to a

partnership upon the exercise of a non-compensatory option.5 However, § 721 does

not apply to the option holder to the extent that the exercise price is satisfied by the

partnership’s obligation to the option holder for unpaid rent, royalties, or interest

(including original issue discount) that accrued on or after the beginning of the option

holder’s holding period for the obligation.6 Section 721 will apply to both the

partnership and the partner upon the transfer of property to a partnership in exchange

for convertible equity.7 In the case of debt that is convertible into a partnership

interest, the partnership will not recognize gain on the conversion, but the debt holder

will recognize income to the extent that the transfer at conversion is in satisfaction of

the partnership’s indebtedness for unpaid interest (including original issue discount)

that accrued on or after the beginning of the debt holder’s holding period for the

indebtedness.8

5. Transfers to investment companies. A transfer of property will be considered to be a

transfer to an investment company if (i) the transfer results, directly or indirectly, in

diversification of the transferor’s interests, and (ii) the transferee is a regulated

investment company, real estate investment trust, or partnership more than 80 percent

4 Treas. Reg. § 1.721-1(d)(2).5 Treas. Reg. § 1.721-2(a)(1). See Treas. Reg. § 1.763-3.6 Treas. Reg. § 1.721-2(a)(2).7 Treas. Reg. § 1.721-2(b)(2).8 Treas. Reg. § 1.721-2(e).

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of the value of whose assets are held for investment and are readily marketable

securities or similar interests.9

6. Disguised sales. A partner may recognize gain if (i) there is a direct or indirect

transfer of money or other property by a partner to a partnership, (ii) there is a related

direct or indirect transfer of money or other property by the partnership to such

partner (or another partner), and (iii) the transfers, when viewed together, are properly

characterized as a sale or exchange of property.10 If within a two-year period a partner

transfers property to a partnership and the partnership transfers money or other

consideration to the partner (without regard to the order of the transfers), the transfers

are presumed to be a sale of the property to the partnership unless the facts and

circumstances clearly establish that the transfers do not constitute a sale.11

7. Anti-Mixing Bowl Rules. If property contributed to a partnership by a partner is

distributed (directly or indirectly) by the partnership (other than to the contributing

partner) within seven years of being contributed, the contributing partner will be

treated as recognizing gain or loss (as the case may be) from the sale of such property

in an amount equal to the gain or loss that would have been allocated to such partner

taking into account the difference between the basis of the property to the partnership

and its fair market value at the time of contribution (that is, net pre-contribution

gain).12 Similarly, a partner who receives a distribution of property (other than

money) from a partnership will recognize gain in an amount equal to the lesser of (i)

the net pre-contribution gain related to all property contributed by such partner to the

partnership, or (ii) the fair market value of property (other than money) received in

the distribution minus the adjusted basis of the partner’s interest in the partnership

immediately prior to the distribution (reduced by money received).13 “Net pre-

9 I.R.C. § 721(b); Treas. Reg. § 1.351-1(c)(1).10 I.R.C. § 707(a)(2)(B).11 Treas. Reg. § 1.707-3(c)(1).12 I.R.C. § 704(c)(1)(B).13 I.R.C. § 737(a).

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contribution gain” means gain on property held by the partnership for less than seven

years.14

8. Liabilities.(a) Treatment of Liabilities in General. With respect to the transfer of property subject

to liabilities to a partnership, the fact that the sum of the amount of liabilities assumed

by the partnership exceeds the total adjusted basis of the property transferred does not

automatically cause the transferor partner to recognize gain. Any decrease in a

partner’s share of partnership liabilities, or any decrease in a partner’s individual

liabilities by reason of the partnership’s assumption of the individual liabilities of the

partner, is treated as a distribution of money by the partnership to that partner.15

(b) Conversely, any increase in a partner’s share of partnership liabilities, or any

increase in a partner’s individual liabilities by reason of the partner’s assumption of

partnership liabilities, is treated as a contribution of money by that partner to the

partnership.16 If, as a result of a single transaction, a partner incurs both an increase in

the partner’s share of partnership liabilities (or the partner’s individual liabilities) and

a decrease in the partner’s share of partnership liabilities (or the partner’s individual

liabilities), only the net decrease is treated as a distribution from the partnership, and

only the net increase is treated as a contribution of money to the partnership.17 A

partner will recognize gain to the extent that a distribution of money (deemed or

actual) exceeds the partner’s basis in his or her partnership interest.18

B. Corporations.

1. Section 351 Non-Recognition Principles. I.R.C. § 351 governs the federal income tax

consequences of contributing property to a corporation (whether a C corporation or an

S corporation). Section 351(a) provides that “[n]o gain or loss shall be recognized if

property is transferred to a corporation by one or more persons solely in exchange for

stock in such corporation and immediately after the exchange such person or persons

14 I.R.C. § 737(b).15 I.R.C. § 752(b); Treas. Reg. § 1.752-1(c).16 I.R.C. § 752(a); Treas. Reg. § 1.752-1(b).17 I.R.C. § 752; Treas. Reg. § 1.752-1(f).18 I.R.C. § 731(a)(1).

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are in control . . . of the corporation.” Certain of the key provisions under § 351(a) are

that the transfer must be a transfer of “property” “solely in exchange for stock” and

immediately after the transfer the transferors must be in “control” of the corporation.

If a transferor receives other property or money in addition to stock in the exchange,

then gain (but not loss) is recognized to the extent of the amount of money and the

fair market value of the other property received.19

2. Section 351 defines “control” as the ownership of stock possessing at least 80 percent

of the total combined voting power of all classes of stock entitled to vote and at least

80 percent of the total number of shares of all other classes of stock of the

corporation.20 In comparison to the partnership rule under § 721, the “control”

requirement of § 351 can make it more difficult to transfer appreciated property to a

corporation without recognizing gain, especially after the initial formation and

capitalization of the corporation. For example, if a shareholder conveys appreciated

real estate to an existing corporation in exchange for cash, the shareholder will

recognize gain on the sale of the appreciated real estate to the extent the net sales

price of the appreciated real estate exceeds the shareholder’s basis in the real estate.

Similarly, if the shareholder receives stock from the corporation in exchange for the

appreciated real estate, the shareholder will recognize the same gain unless the

number of shares issued to the shareholder (together with any other shares he or she

may then own) give the shareholder control of the corporation for § 351 purposes. In

that case, the contribution to the corporation would be tax free to the contributing

shareholder and the shareholder’s basis in his or her shares would be equal to the

shareholder’s basis in the contributed property.21 The following table illustrates these

principles:

Sale for Cash Sale for Stock without

Control

Sale for Stock with

Control

Appreciated Asset $2,000,000 $2,000,000 $2,000,000

19 I.R.C. § 351(b).20 I.R.C. §§ 351(a) and 368(c).21 I.R.C. § 1001(a). The corporation, however, will not recognize gain or loss on the issuance of its stock.

I.R.C. § 1032.

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(basis is $1,000,000)

Shares already owned Not relevant 0 600,000

Shares Issued (%) 0 (0%) 200,000 200,000

% owned following

transactionNot relevant 20% 80%

Tax obligation (20%

rate assumed)22 $200,000 $200,000 $0

Net cash after taxes $1,800,000 $(200,000) $0

Basis in shares Not relevant $2,000,000 $1,000,000

3. If an owner of real estate instead contributes the real estate to an existing LLC for an

interest in the LLC, the transfer of real estate will be non-taxable under § 721 no

matter what percentage interest in the LLC he or she receives.23

4. Section 351’s requirement that there be a transfer of property generally does not

create a problem, but stock issued for services is not considered issued for property

for purposes of § 351. For example, if A, B, and C form a new corporation and A

transfers land for 30 percent of the stock, B transfers cash for 40 percent of the stock,

and C receives 30 percent of the stock for C’s agreement to manage the development

of the land, A’s transfer of land will not be a tax-free transaction.

5. Section 351 is potentially applicable to avoid recognition of gain in the contribution

of appreciated property at the time an LLC is formed and elects corporate tax

treatment. Section 351 is also generally applicable when an operating LLC

subsequently elects corporate tax treatment or converts into a corporation. Thus, if an

LLC with appreciated property becomes taxable as a corporation, the LLC and its

members will recognize no gain or loss on the deemed contribution to the corporation

if the requirements of § 351 are satisfied.

6. On the other hand, the author knows from his legal practice of situations in which

LLCs did not go through with planned conversions because of the unavailability of

the non-recognition provisions of § 351. In these cases, the LLCs had issued to their

22 Individual long-term capital gain rate assumed to be applicable. Potential effect of state income taxes

ignored.23 Subject to the disguised sale and anti-mixing bowl rules. See supra, notes 10-14 and accompanying text.

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employees a large number of service warrants to acquire LLC units that would

become exercisable at very favorable prices immediately before the conversions. If,

as management of the LLCs expected, all of the service warrants were exercised, that

would have caused the resulting corporations to have issued more than 20 percent of

its stock to those employees. If, as is likely, the IRS took the position that, the

employees’ service warrants having been exercised on account of and immediately

before the conversions, the stock issued to the employees in the conversions would be

considered issued for services, the conversions would not have been tax free. The

transferors of property (the other LLC members) would not have acquired 80 percent

of the stock of the resulting corporations and therefore would not have satisfied the

requirement of § 351 that the transferors of property be in control of the corporations.

7. There are important exceptions to § 351 making it unavailable to protect the persons

contributing appreciated property to a corporation from recognizing gain:

a. Services. As noted above, stock issued for services does not qualify for non-

recognition under § 351.24 A person who receives stock in exchange for services must

include in gross income an amount equal to the excess of the fair market value of the

stock (as of the time that the person’s interest in the stock is transferable or not

subject to a substantial risk of forfeiture or, if earlier, at time of issuance if the

recipient makes a § 83(b) election) over the amount (if any) paid for the stock.25

(1) Where, as is usually the case in stock-for-services, the recipient pays nothing for

the stock except the services (or promise of services), the full fair value of the stock

will be attributed to the employee as taxable income. Unlike where the employee

receives a salary paid in cash and has the funds necessary to pay the taxes, the shares

are likely illiquid and the employee will have to pay taxes with other cash resources.

However, in the case of a new corporation that has no operating history, the parties

may be able to obtain a valuation stating that the stock is of no or very low value.

24 I R.C. § 351(d).25 I.R.C. § 83(a).

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(2) The corporation is entitled to a deduction in the same taxable year in which

the recipient recognizes income from the transaction.26 As discussed below,27

it is possible to structure the issuance of a partnership interest for services

without the recognition of income or gain by the partnership or the service

partner.

b. Investment Companies. The general non-recognition rule of § 351 does not apply

in the case of a transfer of property to an investment company.28 A transfer of

property will be considered to be a transfer to an investment company if (1) the

transfer results, directly or indirectly, in diversification of the transferor’s interests,

and (2) the transferee is a regulated investment company, real estate investment trust,

or corporation more than 80 percent of the value of whose assets are held for

investment and are readily marketable securities or similar interests.29

c. Liabilities. In the case of an exchange under § 351, if the sum of the liabilities

assumed by the corporation exceeds the total adjusted basis of the property

transferred in such exchange, then such excess is considered as gain from the sale or

exchange of a capital asset or property that is not a capital asset, as the case may be.30

Compare the income tax treatment of partnership liabilities, discussed above.31

8. Incorporation on Eve of Another Transaction. Incorporations on the eve of a stock

swap or initial offering may raise questions under the step-transaction doctrine

regarding whether the incorporators had control “immediately after” the

incorporation. If an LLC converts to a corporation, it will be treated for federal

income tax purposes as a transfer of all the assets of the LLC to the corporation in

exchange for the stock of the corporation, followed by liquidation of the LLC and

distribution of the stock to its members.32 Ordinarily, this transaction would be tax

free under § 351.33

26 I.R.C. § 83(h).27 Infra, notes 52-72 and accompanying text.28 I.R.C. § 351(e)(1).29 I.R.C. § 721(b); Treas. Reg. § 1.351-1(c)(1).30 I.R.C. § 357(c)(1).31 Supra, notes 15-18 and accompanying text.32 Rev. Rul. 2004-59, 2004-1 C.B. 1050.33 Rev. Rul. 1984-111, 1984-2 C.B. 88, Situation 1.

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9. Incorporation of an LLC on Eve of its Acquisition by a Corporation. Assume that a

public company has expressed interest in acquiring a clients’ LLC, and said it will

pay more if it uses its stock instead of cash. The LLC’s tax advisor recommends that

they work toward a tax-deferred, stock-for-stock swap with the public company that

has expressed an interest in acquiring their LLC by first completing a § 351 tax-free

incorporation of the LLC. In considering this recommendation to incorporate, the tax

advisor examines the LLC’s pre-incorporation tax-basis balance sheet to test for the

existence of either excess liabilities or liabilities unrelated to the business. To the

extent that liabilities transferred to the corporation exceed the bases of the assets

transferred, gain recognition will occur.

In addition, if any liabilities unrelated to the LLC’s business are transferred to the

corporation and the incorporators cannot establish a bona fide business purpose for

the transfer of the unrelated liabilities, all liabilities conveyed will be considered to

give rise to taxable boot to the incorporators.34

To avoid the possibility of double taxation, the tax advisor recommends that the LLC

make an S election after incorporation.35 As the negotiations for the sale of the

business proceed, the company will operate as an S corporation. If the negotiations

fail, the conversion from LLC to S status will not have significantly changed the

income tax structure of the business (assuming there are no special allocations at the

LLC level resulting in a second class of stock that would make the S election

unavailable). Conversely, if S status were not initially elected and the acquisition

failed, the owners would be trapped into potential double taxation on any future sale,

34 Treas. Reg. § 1.357-1(c).35 The LLC may become a state law corporation by incorporation or conversion. It may become an S

corporation for tax purposes by election. Election of S corporation status without becoming a state law

corporation is inadvisable in this instance, however, because the taxpayer will want, if possible, to establish

business reasons for changing to the corporate form.

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because the prior C status would cause the corporation to be subject to the § 1374

built-in gains tax.36

When the purchase agreement is finalized, the tax advisor recommends that it be

structured as a B reorganization (a stock-for-stock exchange).37 In a B

reorganization, one corporation, solely in exchange for its voting stock, acquires the

stock of another corporation and immediately thereafter has control of the acquired

corporation. No boot can be paid to the owners; they must receive only stock of the

acquiring company. Unlike an A or C reorganization, in a B reorganization, the

acquired corporation is not liquidated.38 The S status of the acquired corporation

terminates as of the date of the stock exchange since an S corporation cannot retain its

status when it has a corporate shareholder.39 This causes the filing of a short-period S

return and pass-through of income or loss to the owners as of the termination. If

properly structured and carefully executed, the stock exchange may not be taxable to

the owners until they eventually sell the acquiring corporation’s publicly traded stock.

Their adjusted tax basis in the former LLC carries over to their stock in the newly

formed corporation,40 and then to the publicly traded stock received in the stock-for-

stock exchange.41 Each owner now has the flexibility to sell shares of stock of the

publicly traded company (subject to restrictions that the acquiring company may

impose).

36 If a corporation that is a C corporation changes its status to that of an S corporation, it will be taxable on the

built-in gain as the date of change for dispositions of assets within 10 years of the change. The Small Business

Jobs Act reduced the 10-year period to five years for dispositions in taxable years beginning in 2011, and this

relief was extended to taxable years beginning in 2012 and 2013, but the statute has now reverted to the

previous 10-year period.37 I.R.C. § 368(a)(1)(B).38 The importance of avoiding liquidation of the acquired corporation is illustrated by the cases and rulings at

infra, notes 43-46 and accompanying text.39 I.R.C. § 1361(b)(1)(B). An exception that is unlikely to be applicable to this discussion does permit one S

corporation to be wholly owned by another S corporation if an election is made to treat the subsidiary S

corporation as a “qualified subchapter S subsidiary.” I.R.C. § 1361(b)(3).40 I.R.C. § 358(a)(1).41 Id.

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The former LLC owner(s) can defer income recognition even further where the

publicly traded stock produces sufficient income through dividend payments. In that

case, the former LLC owner(s) might consider holding the shares through their

eventual estates. Under the estate tax regime now in effect, at death, the tax basis of

assets included in the decedent’s estate is adjusted to equal the value of such assets at

date-of-death (or their value six months later if the available alternative valuation date

is elected).42 If a former LLC owner retains the stock received in the acquisition until

his or her death, the owner’s estate or heirs will be able to sell the stock without gain

recognition.

The overriding benefit to this complex scheme is that the former LLC owners may

succeed in deferring income taxation almost indefinitely by properly structuring a B

reorganization.

If the members of an LLC enter into a stock exchange agreement with another

corporation after converting the LLC to a corporation, the IRS may seek to treat the

transaction as a taxable exchange of the acquirer’s stock for LLC interests by

invoking the step transaction or substance over form doctrines. In such a case, the

IRS would assert that the LLC members did not actually acquire control of the

corporation formed by converting the LLC to a corporation,43 but rather never had

control because they received the stock of the resulting corporation as part of a pre-

conceived plan to transfer the stock in the stock exchange with the public acquiring

corporation.

The regulations under § 368 take seriously the business-purpose requirement. Treas.

Reg. § 1.368-1(b) states that the reorganization provisions are concerned with

42 I.R.C. § 1014.43 S. Klien on the Square, Inc. v. Comm’r, 188 F.2d 127 (2d Cir. 1951), cert. denied, 342 U.S. 824 (1951);

Hazeltine Corp. v. Comm’r, 89 F.2d 513 (3d Cir. 1937); Intermountain Lumber Co. v. Comm’r, 65 T.C. 1025

(1976); Rev. Rul. 1979-194, 1979-1 C.B. 145; Rev. Rul. 1979-70, 1979-1 C.B. 144; Rev. Rul. 1970-522,

1970-2 C.B. 81; see also, e.g., Abegg v. Comm’r, 429 F.2d 1209; King Enters., Inc. v. Comm’r, 418 F.2d 511

(Ct. Cl. 1969); McDonald’s Rests. of Illinois, Inc. v. Comm’r, 688 F.2d 520 (7th Cir. 1982); Rev. Rul. 2001-26,

2001-1 C.B. 1297 (all applying step transaction principles to a series of events taking place over several

months).

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“readjustments of corporate structures . . . required by business exigencies.” Treas.

Reg. § 1.368-1(c) provides that a scheme that involves an abrupt departure from

normal reorganization procedure in connection with a transaction on which the

imposition of a tax is imminent is not a plan of reorganization. This would include a

transaction where the corporate reorganization was considered a disguise for

concealing its real character, where the object and accomplishment is the

consummation of a preconceived plan having no business or corporate purpose other

than tax avoidance. See also Treas. Reg. § 1.368-2(g), which states that the

transactions must be “undertaken for reasons germane to the continuance of the

business of a corporation,” and that the statute “contemplates genuine corporate

reorganizations which are designed to effect a readjustment of continuing interests

under modified corporate forms.”

To make an LLC reorganization as a corporation work, the conversion to the

corporate form must be done before an agreement is reached about the sale; the

corporation’s existence should be at least somewhat “old and cold.” The conversion

of the partnership or LLC to a corporation should not be completed on the eve of

entering into the stock exchange agreement.

In Weikel v. Commissioner,44 a taxpayer transferred a patent he owned personally to a

newly formed corporation, Dispersalloy, Inc., and then four months later entered into

an Agreement and Plan of Reorganization for a share-for-share exchange (similar to a

type B reorganization). The Tax Court held that the taxpayer had a substantial

business purpose for the formation of Dispersalloy, Inc. and the transfer of his patent

to it in September 1973. In this case, the taxpayer was in negotiations with Johnson

& Johnson at the time of formation of his corporation. He was also talking to other

potential acquirers at the time. Perhaps most importantly for the determination of a

“business purpose,” the taxpayer’s attorney had advised him that he should

incorporate whether or not he did a deal with Johnson & Johnson since:

44 51 T.C.M. 432 (1986).

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• It was clear that any acquirer would want to structure an acquisition of the

taxpayer’s business so that it could be treated as a pooling of interests; and

• It made sense to incorporate because the taxpayer’s business was beginning to

generate profits.

In objecting to the non-recognition of gain on the appreciated asset (the patent), the

IRS relied on West Coast Marketing Corp. v. Commissioner45 and Rev. Rul. 1970-

140.46 The court in Weikel distinguished West Coast Marketing on the grounds that:

(1) The taxpayer in West Coast Marketing transferred real estate to a new corporation

solely to facilitate a transfer to an unrelated corporation;

(2) All of the detail of the transfer to the acquiring corporation had been agreed on at

the time of the transfer; and

(3) The taxpayer’s corporation was liquidated soon after the acquisition.

Likewise, the court distinguished Rev. Rul. 1970-140 on the basis that the taxpayer in

the ruling had already agreed to transfer the stock of the new corporation before the

taxpayer incorporated it and transferred property to it. In both cases, the new

corporation was not “old and cold” before the transaction was finalized.

Weikel illustrates the importance of establishing a business purpose for the

incorporation of the LLC apart from the potential acquisition and incorporating the

LLC before there is a binding agreement to dispose of the shares received by the

members. Interestingly, in a case arising out of the same transaction that was held in

abeyance pending the decision in Weikel, Johnson & Johnson argued that its

acquisition of Dispersalloy should be treated as a taxable purchase. Johnson &

Johnson wanted a cost basis.

10. Basis.

In general, the tax basis of stock received by a shareholder in exchange for property

contributed to a corporation is the same as the tax basis of the property transferred to

45 46 T.C. 32 (1966).46 1970-1 C.B. 73.

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the corporation.47 Unlike partnerships, liabilities incurred by a corporation do not

increase the adjusted basis of a shareholder’s stock. Similarly, a corporation’s tax

basis in property received in a transaction to which § 351 applies will be equal to the

basis of such property in the hands of the transferor shareholder, increased by any

gain recognized by the transferor.48

II. Equity Compensation in Alternative Entities Differs from the Corporate Setting.

A. Tax Differences. One key difference between equity compensation in alternative

entities and in corporations derives from the fundamental difference between the tax

consequences of issuing equity in exchange for services in each form of entity. Receipt

of stock from a corporation in exchange for services is generally taxable, absent use of an

incentive stock option plan, while receipt of interests in an LLC or partnership may be

non-taxable if the interests issued are profits interests.

B. Securities Laws. Some securities law differences exist. A share of corporate

stock is always a “security.”49 Whether an interest in an LLC or partnership is a security

depends on the facts and circumstances of the particular case.50

C. Document Drafting. Document drafting in alternative entities often presents

challenges not encountered in the corporate world. The flexibility afforded by alternative

entity statutes prevents extensive use of forms. Attorneys should avoid using corporate

terms without an understanding of how they might differ in an alternative entity. See the

materials for a program at the 2015 annual meeting of the Business Law Section of the

American Bar Association: “Corporate-Like Terms: The Dangers and Pitfalls of Using

Corporate Concepts.”51

III. Equity Compensation in Tax Partnerships.

A. Issuance of Interest for Services.

1. Background. Generally, no gain or loss is recognized to a partnership or

its partners upon the contribution of property to the partnership in exchange for a

47 I.R.C. § 358(a).48 I.R.C. § 362(a).49 Securities Act of 1933 §2(a)(3)50 See Herrick K. Lidstone, Jr, and Allen Sparkman LIMITED LIABILITY COMPANIES AND PARTNERSHIPS IN

COLORADO § 13.2 (CLE in Colorado 2015) (hereafter, Lidstone and Sparkman).51 Available to members of the Business Law Section of the ABA on the ABA website.

15

partnership interest. However, Treas. Reg. §1.721-1(b)(1) states: “[t]o the extent

any of the partners gives up part of his right to be repaid his contributions (as

distinguished from a share in partnership profits) in favor of another partner as

compensation for services … [IRC §] 721 does not apply.” The regulation seems

to indicate by negative implication that the receipt of an interest solely in future

partnership profits is not a taxable event even though the recipient has received

economic value. Courts differed. Compare Diamond v. Commissioner, 56 T.C.

530 (1971), aff’d, 492 F.2d 286 (7th Cir. 1974) with Campbell v. Commissioner,

943 F. 2d 815 (8th Cir. 1991). Much of the early debate over the taxation of

receipts of profits interests centered on the difficulty of valuing such an interest.

For example, in St. John v. United States, 84-1 USTC ¶ 9158 (C.D. Ill. 1983), the

court held the taxpayer was not required to report income from the receipt of a

partnership interest that did not entitle the taxpayer to assets upon liquidation of

the partnership until all other partners were repaid their initial capital

contributions and the value of the partnership assets in the year of receipt of the

interest did not exceed the value of the initial contributions by the other partners.

2. IRS Provides Some Certainty for Planning Purposes.

a. Profits Interest Generally Not Taxable. Rev. Proc. 93-27, 1993-2

C. B. 343, as clarified by Rev. Proc. 2001-43, 2001-34 I. R. B. 1, provides

some certainty for planning purposes. Rev. Proc. 93-27 declares that the

receipt of a profits interest in exchange for services in a partner capacity,

or in anticipation of becoming a partner, will not be treated as taxable

event to either the recipient partner or the partnership. Rev. Proc. 93-27

provides that a “profits interest” is anything other than a capital interest,

and a “capital interest’ is “an interest that would give the holder a share of

the proceeds if the partnership’s assets were sold at fair market value and

then the proceeds were distributed in a complete liquidation of the

partnership.” However, Rev. Proc. 93-27 does not apply if (a) the profits

interest relates to a substantially certain and predictable stream of income

from partnership assets; (b) if within two years of receipt the partner

16

disposes of the profits interest; or (c) if the profits interest is a limited

partnership interest in a publicly traded partnership.

b. Time of Determination. Rev. Proc. 93-27 provides that the

determination whether an interest is capital in nature is made at the time of

receipt of the interest. Rev. Proc. 2001-43 provides that the determination

is made at the time of the grant of the interest, regardless whether the

interest is substantially vested (under IRC §83) if: (a) the partnership and

service provider treat the service provider as the owner of the interest from

the date of grant, and the service provider takes into account the

distributive share of partnership income, gain, loss, etc. associated with

that interest for purposes of computing the service provider’s income tax

liability; and (b) upon the grant of the interest or at the time it becomes

substantially vested, neither the partnership nor any other partner deduct

any amount for the fair market value of the interest.

c. Contributions of Services and Cash. What if a partnership

transfers an interest intended to be a profits interest to a service provider

who also makes a cash capital contribution for an interest? Under the

partnership tax regulations, a taxpayer has a single capital account so

arguably the profits interest would not qualify as such because upon a

deemed liquidation of the partnership the service provider would receive

his cash contribution. Notwithstanding that the service provider has a

single capital account, the better view appears to be that if in the deemed

liquidation of the partnership the only property the service provider

receives is his cash capital contribution, he has received nothing in respect

of his service interest and the service interest, accordingly, should qualify

as a profits interest.

d. Transfer of Capital Interest. If a partnership transfers a capital

interest as compensation for services, the service provider will be taxable

under IRC §83. If the capital interest is not subject to a substantial risk of

forfeiture at the time of grant, the service provider will immediately

recognize income in the amount of the fair market value of the capital

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interest, reduced by the amount, if any, the service provider pays for the

interest. All of this income will be ordinary compensation income, subject

to wage withholding and payroll taxes if the service provider is an

employee.52

Upon receipt of the capital interest, the service provider generally

should become a partner in the partnership for both state and tax law

purposes.53 The service provider should be treated as a partner because,

among other reasons, the amount that the service provider receives in

respect of the service provider’s partnership interest is subject to

entrepreneurial risk of the partnership. Crescent Holdings, LLC v.

Commissioner54 sheds some light on the tax consequences of issuing a

capital interest. In that case, the taxpayer was granted “a 2% restricted

membership interest” in Crescent Holdings LLC (“Crescent”).55 The

interest was not vested when granted, and the taxpayer did not make a

section 83(b) election.56 Crescent Holdings allocated substantial amounts

to the taxpayer in respect of the restricted membership interest but did not

make any partnership distributions to the taxpayer.57 In the final

partnership administrative adjustments issued to Crescent Holdings, the

Commissioner took the position that the taxpayer was a partner in

Crescent Holdings for purposes of allocating partnership items.58

However, at trial, the Commissioner took the position that the taxpayer

was not the owner for tax purposes of the restricted membership interest.59

After reviewing the distribution provisions of the Crescent Holdings

operating agreement, the court determined that the restricted membership

52 See Treas. Reg. § 1.721-1(b)(1); See also McKee, Nelson & Whitmire, Federal Taxation of Partnerships, Warren,Gorham & Lamont, 3d edition at ¶ 5.01 (1997).53 See Gary C. Karch, Equity Compensation by Partnership Operating Businesses, Taxes, December 1996 at 725.54 141 T. C. 478 (2013).55 141 T. C. at 480.56 141 T. C. at 481.57 Crescent Holdings did, after several pleas by the taxpayer, distribute money to him for taxes, but did not treat thatpayment as a partnership distribution. 141 T. C at 482.58 141 T. C. at 484.59 141 T. C. at 486.

18

interest taxpayer received was a capital interest, not a profits interest.60

The court then stated that section 83 applied to capital interests.61 The

court then held that, pursuant to Treas. Reg. § 1.83-1(a)(1), the transferor

of an unvested capital interest must include in income the undistributed

allocations of income with respect to the interest.62 If, along with the

other partners, the service provider/partner is subsequently allocated a

distributive share of partnership income, the character of such income will

be capital or ordinary, depending on the character at the partnership level.

If a capital interest is conveyed, the partnership should be entitled

to a deduction equal to the amount of income recognized by the service

provider at the time of issuance (provided that such an expense is not

required to be capitalized by the partnership because it is a direct expense

of acquiring or constructing a capital asset). If capitalization is required,

the partnership should be entitled to recover that capitalized cost through

depreciation or amortization deductions, and the partnership may want to

consider allocating those deductions to partners other than the service

provider.

It is uncertain whether the transfer of a capital interest will cause

the partnership to recognize gain from the issuance, especially if the

partnership has appreciated assets. Under general principles of taxation,

the satisfaction of an obligation with appreciated property is a taxable

event.63 Therefore, the issuance of the capital interest could be viewed to

involve a deemed transfer of an undivided interest in the partnership’s

assets to the service provider followed immediately by the recontribution

of such assets to the partnership. This treatment should mark-to-market

the tax basis of the assets deemed transferred to the service provider and

60 141 T. C. at 490-494.61 141 T. C. at 495, citing Larson v. Commissioner, 1988 T. C. Memo. 387.62 141 T. C. at 502.63 See generally, McKee, supra note 52 at ¶ 5.08[2][b].

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the service provider should enjoy the benefit of the basis adjustment.64

Generally, it is appropriate to “book-up” the capital accounts65

immediately prior to the transfer of the capital interest, and to allocate the

compensation or other deductions with respect to the capital interest

transfer to the historical partners in accordance with the partnership

agreement.

Alternatively, the partnership could be viewed as having paid to

the service provider cash equivalent to the income recognized by the

service provider. The service provider would then be viewed as having

contributed to the partnership the cash deemed transferred to the service

provider. Under this so-called “cash-out cash-in” approach no gain is

recognized by the partnership upon grant of a capital interest to the service

provider. The deduction attributable to the partnership’s deemed

compensatory payment of cash to the service provider should be allocated

entirely to the historical partners in accordance with the partnership

agreement. It is clearly appropriate, and generally recommended, to book-

up the capital accounts under the cash-out cash-in approach.

If the capital interest is subject to a substantial risk of forfeiture,

then the service provider will not be taxed upon the issuance of the

interest.66 The timing of the payment of the tax will be at the point when

the restrictions lapse. The character of the income, in part, will depend on

whether the service provider made an election under Section 83(b). The

service provider may elect, under IRC §83(b), to be taxed currently on the

fair market value of the issued capital interest.

64 The amount of gain or loss recognized on the transfer would equal the sum of the amount, if any, paid by theservice provider, the amount of the partnership’s compensation deduction, and the service provider's share ofpartnership liabilities, minus the partnership’s basis in the assets deemed transferred to the service provider.65 See Treas. Reg. § 1.704-1(b)(2)(iv)(f).66 Note that the rules of Section 83 will apply to any interest received by a service provider, even if the serviceprovider has paid fair market value for the interest when obtained. Alves v. Commissioner, 79 T. C. 864 (1982), aff'd734 F.2d 478 (9th Cir. 1984). As a result, it will generally be prudent for partners who purchase interests from thepartnership (i.e., receive them in exchange for a capital contribution) but who may have to resell them to the entityfor a discounted price to make a Section 83(b) election.

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If a Section 83(b) election is not made, at the time the capital

interest vests in the future, the service provider will recognize income in

the amount of the fair market value of the capital interest on the date of

vesting (less any amount the service provider paid for the interest). The

gain will be ordinary compensation income. Note that the amount of gain

could be substantial due to the possible appreciation of the capital interest

between the time of issuance and the time of vesting.

Under Section 1.83-1(a)(1) of the Treasury Regulations, the

service provider is not treated as the owner of the capital interest until the

service provider’s capital interest vests.67 This likely means that: (1)

items of partnership income and loss should not be allocated to the service

provider before vesting; and (2) any distributions made by the partnership

to the service provider will constitute ordinary compensation income. If

income is allocated to the capital interest but not distributed, the other

partners will be taxed on their allocable shares of the undistributed

income. Crescent Holdings, LLC v. Commissioner, 141 T. C. 478 (2013).

After the capital interest vests, the service provider will likely be

recognized as a partner for tax purposes; the service provider’s distributive

share of partnership profits and losses, however, will be either capital or

ordinary, depending on the character at the partnership level.

If a Section 83(b) election is made, the service provider will

recognize gain immediately upon the issuance of the capital interest (fair

market value over amount paid by the service provider). The future

vesting of the capital interest will be a non-event from a tax standpoint. It

appears that the filing of a Section 83(b) election causes the service

provider to become a partner for tax purposes at the time of issuance, even

though the capital interest will still be “substantially nonvested.”68

67 See Treas. Reg. § 1.83-1(a)(1) ("[u]ntil [unvested] property becomes substantially vested, the transferor shall beregarded as the owner of such property, and any income from such property received by the service performer . . .constitutes additional compensation").68 See Treas. Reg. § 1.83-2(a) (“[i]f this election is made, the substantial vesting rules of Section 83(a) and theregulations thereunder do not apply with respect to such property . . . property with respect to which this election ismade shall be includible in gross income as of the time of transfer even though such property is substantially

21

If the service provider is regarded as the “owner” of the capital

interest once a Section 83(b) election is made and the service provider

satisfies the traditional requirements to become a partner for tax purposes,

then future allocations of partnership gain or loss made to the service

provider should be either capital or ordinary, depending on the character at

the partnership level.

At the time the service provider recognizes income (either at the

time of vesting or at the time of issuance if a Section 83(b) election is

filed), the partnership generally will be entitled to a corresponding

compensation deduction. It is unclear whether the partnership will

recognize gain upon a deemed capital shift of partnership assets to the

service provider.69 If a Section 83(b) election is not filed, any

distributions with respect to the partnership interest before the restrictions

lapse should be treated as compensation paid by the partnership.70

Note: The foregoing sets forth the applicable law as of the date of finalization of this

paper. Proposed Regulations relating to the issuance of partnership interests for services were

published in the Federal Register for May 24, 2005, and Notice 2005—43 was published in

2005-24 I. R. B on June 13, 2005. These proposed regulations and this Notice would impose

new technical requirements and requirements for an election under IRC §83 to continue the

liquidation-value basis for the determination of the existence of a profits interest. The required

election could not be made effective before its execution.

3. Examples.

a. Assume Joe and Bill form a new LLC to purchase a building and

operate a restaurant. Joe and Bill each contribute $500,000 in cash to enable the LLC to

purchase the building and necessary equipment. They agree with Chuck Cook to grant Cook a

1/3 interest in the LLC in exchange for Cook’s agreement to be the executive chef. Under the

nonvested”). The regulations do not, however, specifically address the tax ownership of property with respect towhich a Section 83(b) election has been made, and this situation was not before the court in Crescent Holdings asthe restricted membership interest in that case never vested.69 See text accompanying notes 63-65, supra.70 Treas. Reg. § 1.83-1(a)(1).

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analysis above, so long as the LLC’s operating agreement provides for liquidation in accordance

with capital accounts, no more is needed for Cook’s interest to be considered a profits interest. If

the LLC liquidated immediately after Cook’s admission as a member, Joe and Bill would each be

entitled to receive back the $500,000 each had contributed, and Cook would receive nothing

because he has a zero capital account at that time.

b. Assume the restaurant operates for a number of years and is very

successful. Unfortunately, Chuck Cook one day eats some bad mushrooms and dies. Cook’s

heirs receive the buy-out provided by the operating agreement, and Joe and Bill begin looking

for another executive chef. They make a deal with Jane Goodcook to become a 1/3 member in

exchange for her agreement to serve as executive chef. Assume that the restaurant building has

appreciated in value to $10,000,000, and an appraisal of the LLC performed in connection with

the buy-out of Chuck Cook’s interest found that it had a total value of $15,000,000, including the

building, goodwill, and intellectual property that has been developed for the LLC. Unlike the

first example, unless the operating agreement provides that the members’ capital accounts will be

booked up immediately before the admission of Goodcook, if the LLC were to liquidate

immediately after Goodcook’s admission, Joe, Bill, and Goodcook each would be entitled to

receive $5,000,000. Not only would this result in Goodcook realizing $5,000,000 of ordinary

income, this allocation of pre-existing value to Goodcook almost certainly is not what Joe and

Bill desire or intend.71

4. Alternative to Booking Up. Clients sometimes prefer to avoid the technical

booking up procedure in the regulations. An alternative that achieves the same economic result

is as follows:

The Class B Membership Interests are intended to constitute “profits interests” as

that term (or any term of similar import) is used in Internal Revenue Service

Revenue Procedure 93-27, 1993-2 C. B. 343 and Revenue Procedure 2001-43,

2001-2 C. B. 191, and any successor provisions of the Code, Treasury

Regulations, IRS Revenue Procedures or Revenue Rulings, or other

administrative notices or announcements, with the intended results that: (A) no

compensation or other income shall be recognized by an owner of the Class B

71 See, Herrick K. Lidstone, Jr., Admitting New Members to an LLC and “Booking Up” Capital Accounts, 37 COLO.LAW. 19 (2008).

23

Membership Interests by reason of the issuance of such Class B Membership

Interests; and (B) no compensation expense shall be deducted by the Company by

reason of the issuance of such Class B Membership Interests. The Managers shall

designate a threshold value, not less than zero (such value, the “Threshold

Value”) applicable to each Class B Membership Interest to the extent necessary to

cause such Class B Membership Interest to constitute a “profits interest” as

provided in this Section. The Class B Membership Interests to be issued on the

date of this Agreement (if any) have a Threshold Value of $[___]. The Threshold

Value for each additional Class B Membership Interest issued after the date of

this Agreement shall equal the amount that would, in the reasonable determination

of the Managers, be distributed with respect to existing Members with respect to

their Economic Interests if, immediately prior to the issuance of such additional

series Class B Membership Interests the assets of the Company were sold for their

fair market values and the proceeds (net of any liabilities of the Company) were

distributed pursuant to Section _____.

B. Issuance of Options and Other Interests by LLCs. Although a less frequent

occurrence than the issuance of profits interest, LLCs might also issue options to acquire

membership interests in exchange for services. The proposed regulations referenced

above would apply IRC §83 to the issuance of compensatory options by LLCs. As

discussed below in connection with the issuance of options by corporations, section 83

generally does not apply to the grant of an option. Upon exercise of a compensatory

option, the service provider recognizes income if the property received is substantially

vested or if the service provider makes a section 83(b) election. LLCs may also have

plans that provide compensation on a basis similar to that discussed below under

Phantom Stock Plans and Stock Appreciation Rights.72

IV. Corporations.

A. Issuance of Stock for Services. If a corporation issues stock to an employee or

independent contractor, the recipient will realize compensation income equal to the value

72 The Treasury Department has promulgated regulations that apply complex rules to non-compensatory optionsissued by partnerships. Treas. Reg. §1.761-3. These regulations do not apply to compensatory options issued bypartnerships.

24

of the stock over the amount, if any, paid for the stock unless the stock is subject to a

substantial risk of forfeiture.73 The value of the stock is determined without regard to any

restriction other than a restriction that by its terms will never lapse.74

1. A substantial risk of forfeiture exists if the rights of the recipient to full

enjoyment of the stock are conditioned upon the future performance of substantial

services by any person.75

2. Unless the recipient makes the section 83(b) election described below, the

recipient will realize compensation income when the stock is no longer subject to

a substantial risk of forfeiture or becomes transferable and the stock in the hands

of a transferee will not be subject to a substantial risk of forfeiture.76 The

amount of the compensation will be the value of the stock at the time of

realization of the income less any amount paid for the stock.77

3. The recipient may elect to include the value of the stock determined at the

time of receipt.78 The election must be made no later than 30 days after receipt of

the stock. Once made, the election may be revoked only if the recipient was

under a mistake of fact as to the underlying transaction and the recipient requests

revocation within 60 days of the date on which the mistake of fact first became

known to the recipient. A mistake of fact as to the value of the property received

is not sufficient to support a revocation.79 The election must state:

a. Name, address, and taxpayer identification number of the taxpayer.

b. Description of the property with respect to which the election is

being made.

c. Date on which the property was transferred.

d. Taxable year to which the election relates.

e. Nature of the restrictions to which the property is subject.

73 IRC § 83(a)(1).74 Id.75 IRC § 83(c)(1).76 IRC § 83(a).77 Id.78 IRC § 83(b).79 Treas. Reg. §1.83-2(f).

25

f. The fair market value of the property at the time of transfer

(determined without regard to any restriction other than a restriction which

by its terms will never lapse).

g. The amount, if any, paid for the property.

h. A copy of this statement has been furnished to the [employer].

4. If a recipient who has made a section 83(b) election later forfeits the stock,

the recipient’s loss deduction is limited to the amount, if any, paid for the stock

less the amount, if any, received upon forfeiture. If the stock is a capital asset in

the hands of the recipient, any loss realized upon forfeiture will be a capital loss.80

B. Advantage to Recipient of Restricted Stock Versus Stock Options. If, instead of

restricted stock, an employee or independent contractor receives an option to acquire the

employer’s stock, unless the option is an incentive stock option, discussed below, the

recipient will be taxable under IRC §83 when the option is exercised. In many cases, this

will result in greater compensation income because of appreciation in the value of the

stock during the period before the option is exercised. The grant of an option is not

taxable under IRC § 83 unless the option has a readily ascertainable fair market value.81

Treas. Reg. §1.83-3(a)(2). Note that, if the recipient of a stock grant pays for the stock

with a nonrecourse note, the transaction may be treated as the grant of an option.82

C. Taxation of Stock Options Other than Incentive Stock Options. As noted above,

the grant of an option is not taxable unless the option has a readily ascertainable fair

market value. Upon exercise of the option, the recipient will realize compensation

income under the rules of section 83 discussed above based on the value of the stock

when the option is exercised. If the stock received is subject to a substantial risk of

forfeiture, the compensation income will not be realized until the substantial risk of

forfeiture expires unless the recipient makes an election under section 83(b) to be taxed

when the stock is received.

D. Taxation of Incentive Stock Options.1. Grants Only to Employees. An incentive stock option may be granted

only by a corporation to an individual who is an employee of the corporation

80 Treas. Reg. §1.83-2(a).81 Treas. Reg. §1.83-3(a)(2).82 Id.

26

granting the option, a parent or subsidiary corporation of the granting corporation,

or a corporation (or a parent or subsidiary corporation of such corporation)

substituting or assuming a stock option in a corporate merger, consolidation,

acquisition of property or stock, separation, reorganization or liquidation or a

distribution (excluding ordinary dividends and certain stock splits and stock

dividends) or change in the terms or number of outstanding shares of such

corporation.83 The recipient of the option must satisfy the employment

requirement at all times during the period beginning on the date of grant of the

option and ending on the day that is three months before the date on which the

option is exercised (one year if the employee is disabled).84

2. Adjustments for Stock Dividends and Stock Splits. The exercise price and

number of shares subject to an incentive stock option may be proportionately

adjusted to reflect a stock split (including a reverse stock split) or stock dividend.

This rule applies only if the only effect of the stock split or stock dividend is to

increase (or decrease) on a pro rata basis the number of shares owned by each

shareholder of the class of shares subject to the option, and the option is

proportionately adjusted to reflect the stock split or stock dividend and the

aggregate exercise price of the option is not less than the aggregate exercise price

of the option before the stock split or stock dividend.85

3. Other Requirements of Incentive Stock Options. An incentive stock option

must be—

a. granted pursuant to a plan that specifies the aggregate number of shares

that may be issued under options, the employees or class of employees

eligible to receive options and that is approved by the shareholders of the

granting corporation within twelve months of the date the plan is adopted;

b. granted within ten years from the earlier of the date the plan is adopted

or the date it is approved by the shareholders;

c. exercisable only within ten years of the date it is granted;

83 IRC § 422(a)(1); Treas. Reg. § 1.422-1(a)(1(i)(B).84 Id.; IRC § 422(c)(6).85 Treas. Reg. §§ 1.422-1(a)(i)(B); 1.424-1(a)(1)(i); 1.424-1(a)(3); 1.424-1(e)(4)(v).

27

d. exercisable only at an option price that is not less than the fair market

value of the stock at the time the option is granted;

e. nontransferable by the employee otherwise than by will or the laws of

descent and distribution and exercisable only by the employee during the

employee’s lifetime;

f. granted only to an employee who does not, at the time of the grant, own

more than ten percent of the total combined voting power of all classes of

stock of the employer corporation or of its parent or subsidiary

corporation; provided, that this rule does not apply of the exercise price of

the option is at least 110 percent of the fair market value of the stock

subject to the option and is not exercisable after five years from the date it

is granted;

g. an option that does not by its terms provide that it will not be treated as

an incentive stock option.

h. exercisable for the first time during a calendar year only to the extent of

stock worth $100,000 (determined at time of grant).86

4. Favorable Tax Treatment of Incentive Stock Options. If an option

qualifying as an incentive option is exercised, and the employee holds the stock

for at least two years from the date of grant of the option and at least one year

from date of exercise, the employee will not recognize income from the exercise

of the option.87 If the employee sells the stock after satisfying these holding

requirements, any gain recognized will be long-term capital gain. If the employee

fails to satisfy these holding requirements, the income from exercise of the option

(and the employer’s deduction) shall be included or deducted in the year of

disposition of the stock. No income tax withholding is required with respect to

income realized as a result of an early disposition of the stock.88 Note that the

spread on the exercise of an incentive stock option is an item of tax preference for

purposes of the alternative minimum tax unless the taxpayer exercises the

86 IRC §§ 422(b); 422(c)(5); 422(d).87 IRC §§ 421(a)(1); 422(a)(1).88 IRC § 421(b).

28

incentive stock option in the same year the option is granted.89 If the taxpayer

does exercise an incentive stock option in the same year the option is granted, the

favorable tax treatment described above in this paragraph will not apply.

E. Phantom Stock Plans and Stock Appreciation Rights. Corporations often have

compensation plans for executives under which the compensation is measured by

distributions paid on, or appreciation in value of the actual stock of the corporation.

Income received under such a plan is ordinary compensation income.

V. S Corporations and Restricted Stock and Stock Options.

A. S Corporations may not have more than 100 shareholders, may not have more

than one class of stock and may not have a shareholder who is not an individual United

States citizen or resident alien, an estate, a trust described in IRC §1361(c)(2) or a tax

exempt organization described in IRC §401 or 501(c)(3).90

B. Nonvested restricted stock issued by an S corporation with respect to which a

section 83(b) election has been made is not treated as a second class of stock if the

restricted stock is identical to other outstanding stock with respect to distributions and

liquidation proceeds.91 Because of the requirement that the restricted stock be identical to

other stock with respect to distributions and liquidation proceeds, the employer could not

provide that dividends would not be paid on nonvested restricted stock if a section 83(b)

election has been made. If restricted stock is nonvested and no section 83(b) election has

been made, the stock is disregarded for purposes of the second class of stock rule.92

C. Stock options issued to an employee or independent contractor in connection with

the performance of services for the corporation are not considered a second class of stock

so long as the options are not excessive in reference to the services performed, the

options are nontransferable within the meaning of Treas. Reg. §1.83-3(d) and do not have

a readily ascertainable fair market value when issued.93 This rule would include incentive

stock options

89 IRC §56(b)(3).90 IRC §1361(b)(1).91 Treas. Reg. §1361-1(b)(3).92 Treas. Reg. §1361-1(b)(4).93 Treas. Reg. §1.1361-1(l)(4)(iii)(B)(2).

29

D. An S corporation that desires to issue restricted stock or stock options must insure

that the issuance of the restricted stock or the issuance of stock upon exercise of the

options will not cause the corporation to exceed the 100 shareholder limit or cause the

corporation to have an ineligible shareholder.

E. S corporations may also have phantom stock plans and stock appreciation rights

so long as the plans or rights provide only the right to cash payments and do not confer

voting rights.94

VI. IRC 409A.

A. IRC §409A and Restricted Stock, Stock Options and SARs. IRC §409A provides

for the inclusion in income and the imposition of an extra 20% tax on compensation

deferred under a nonqualified deferred compensation plan. Section 409A does not apply

to incentive stock options.95 Section 409A also does not apply to other stock options

granted to service providers if the exercise price of the option may never be less than the

fair market value of the underlying stock on the date of grant, the number of shares is

fixed on the original date of grant of the option, the transfer or exercise of the option is

taxable under IRC §83 and the option does not include any feature for the deferral of

compensation other than the deferral of recognition of income until the later of (i) the

exercise or disposition of the option under Treas. Reg. §1.83-7 or (ii) the date the stock

acquired pursuant to exercise of the option first becomes substantially vested as defined

in Treas. Reg. 1.83-3(b). If an employer issues restricted stock pursuant to a plan, there

is no deferral of compensation for purposes of IRC §409A merely because the restricted

stock is substantially nonvested as defined in Treas. Reg. §1.83-3(b) or is includible in

income solely because of a valid election under section 83(b).96 Finally, IRC §409A does

not apply to a stock appreciation right if the compensation payable under the stock

appreciation right cannot be greater than the excess of the fair market value of the stock

on the date the stock appreciation right is exercised over an amount specified on the date

the stock appreciation right is granted with respect to a number of shares fixed on or

before the date the right is granted, the exercise price of the right may never be less than

94 Treas. Reg. §1.1361-1(b)(4); PLR 9119041; GCM 39750 (May 18, 1988).95 Treas. Reg. §1.409A-1(b)(5)(ii).96 Treas. Reg. §1.409A-1(b)(6).

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the fair market value of the underlying stock on the date the right is granted and the stock

appreciation right does not include any feature for the deferral of income other than the

deferral of recognition until the exercise of the stock appreciation right.97

B. IRC §409A and Partnership Interests. Section III G of the preamble to the final

regulations under section 409A, TD 9321 states:

Until further guidance is issued, taxpayers may continue to rely on Notice2005-1, Q&A-7 and section II. E. of the preamble to the proposedregulations. Notice 2005-1, Q&A-7 provided that until further guidance isissued for purposes of section 409A, taxpayers may treat the issuance of apartnership interest (including a profits interest) or an option to purchase apartnership interest, granted in connection with the performance ofservices under the same principles that govern the issuance of stock. Forthis purpose, taxpayers may apply the principles applicable to stockoptions or stock appreciation rights under these final regulations, aseffective and applicable, to equivalent rights with respect to partnershipinterests.

VII. Transferring Property Subject to Debt.

A. Partnerships.

With respect to the transfer of property subject to liabilities to a partnership, the fact

that the sum of the amount of liabilities assumed by the partnership exceeds the total

adjusted basis of the property transferred does not automatically cause the transferor

partner to recognize gain. Any decrease in a partner’s share of partnership liabilities,

or any decrease in a partner’s individual liabilities by reason of the partnership’s

assumption of the individual liabilities of the partner, is treated as a distribution of

money by the partnership to that partner.98

Conversely, any increase in a partner’s share of partnership liabilities, or any increase

in a partner’s individual liabilities by reason of the partner’s assumption of

partnership liabilities, is treated as a contribution of money by that partner to the

partnership.99 If, as a result of a single transaction, a partner incurs both an increase in

the partner’s share of partnership liabilities (or the partner’s individual liabilities) and

97 Treas. Reg. §1.409A(1)(b)(5)(B).98 I.R.C. § 752(b); Treas. Reg. § 1.752-1(c).99 I.R.C. § 752(a); Treas. Reg. § 1.752-1(b).

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a decrease in the partner’s share of partnership liabilities (or the partner’s individual

liabilities), only the net decrease is treated as a distribution from the partnership, and

only the net increase is treated as a contribution of money to the partnership.100 A

partner will recognize gain to the extent that a distribution of money (deemed or

actual) exceeds the partner’s basis in his or her partnership interest.101

B. Corporations.

In the case of an exchange under section 351, if the sum of the liabilities assumed by

the corporation exceeds the total adjusted basis of the property transferred in such

exchange, then such excess is considered as gain from the sale or exchange of a

capital asset or property that is not a capital asset, as the case may be.102 Note that

section 351 does not provide for a netting of liabilities.

VIII. Valuation of Ownership Interests Over Time and Relationship to Transferability

Restrictions.

A. Valuation of the ownership interests of any closely-held business, incorporated or not,

often causes dissention. The circumstances in which the entity or the other owners, or

both, will have the right or obligation to purchase the interest of an owner, and the price

that will be paid, should be determined at the outset when the owners are optimistic and

do not know which one will be the first to need to rely on the buy-sell provisions.

Valuation should be addressed though a procedure that does not require annual updating.

For example, the agreement might provide that the governing persons of the entity will

determine the value—with or with not a requirement that they use a third-party appraiser.

The selling owner will then have the right to challenge the valuation of the governing

persons and appoint a third-party appraiser to determine the purchase price. The author

recommends providing that the appraiser named by the governing persons and the

appraiser named by the selling owner will name a third appraiser, who will alone make

100 I.R.C. § 752; Treas. Reg. § 1.752-1(f).101 I.R.C. § 731(a)(1).102 I.R.C. § 357(c)(1).

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the final determination of the purchase price. The owners’ agreement also should specify

who pays for the third appraiser.103

B. Typical circumstances that trigger a buy-sell are death, disability, divorce, and

bankruptcy.104 The shareholders of S corporations generally will want to prohibit

transfers to any person who is not an eligible shareholder of an S corporation.

IX. Economic Rights to Distributions and Tax Allocations and Responsibilities.

A. C corporations. Except for possible preferred stock provisions, shareholders are

entitled to dividends as, if, when, and in the amounts determined by the board of

directors.

B. S corporations. Preferred stock not permitted. Shareholders are entitled to dividends

as, if, when, and in the amounts determined by the board of directors. Shareholders

of S corporations, however, are taxable on their pro rata shares of the corporation’s

income whether or not distributed. Accordingly, shareholders may wish to have a

shareholder agreement that provides for minimum distributions to allow payment of

taxes.

C. Partnerships. Partnerships and LLCs distribute income as provided in the partnership

or company agreement. Partners, however, are taxable on their pro rata shares of the

partnership’s income whether or not distributed. Accordingly, partners and members

may wish to provide in the partnership or company agreement for minimum

distributions to allow payment of taxes.

D. Partnerships—Contributions of Appreciated Property. If a partner contributes

property to a partnership and the property has a fair market in excess of the taxpayer’s

basis, the partnership’s basis in the property will be equal to the contributing

taxpayer’s basis.105 However the rules with respect to partnership allocations under §

704 require that the contributing taxpayer’s capital account be credited with the net

103 For a discussion of buy-sell agreements, see Lidstone and Sparkman, supra note 50 at §§ 3.1.8-3.1.9.104 For a discussion of issues that arise when a partner or member files for bankruptcy, see Herrick K. Lidstone, Jr.and Allen Sparkman, Pick Your Partner Versus the United States Bankruptcy Code, forthcoming, TEX. J. OF BUS. L.,available on SSRN at http://ssrn.com/abstract=2686418.105 Id.

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fair market value of the contributed property.106 If the partnership sells the property, §

704(c) requires that the gain realized by the partnership be allocated to the partner

who contributed the property to the extent of the excess of the fair market value of the

property over its basis to the contributing partner at the time of the contribution. This

allocation of pre-contribution gain to the partner who contributed the appreciated

property:

• Must be recognized by the contributing partner even though the operating or

partnership agreement may provide differently;

• Does not affect the contributing partner’s capital account; and

• Should be taken into account in the negotiation and drafting of the tax

distribution provisions of the operating or partnership agreement.

X. Special Issues Regarding LLCs as S Corporations.

A. General. Although it is possible for an LLC to be treated (for tax purposes) as an S

corporation, is it a wise decision? Such a structure should be utilized only if it

responds to a defined need to resolve a particular set of problems. Generally, the

answer is “no, an LLC should not elect to be treated as an S corporation for federal

(and state) tax purposes.”

B. Issues Arising When an LLC Makes an Election to be Treated as an Association

Taxable as a Corporation:

1. Typically, the most troubling limitation of an S corporation is that an S

corporation may have only a single class of stock.107 This removes a significant

amount of flexibility granted to LLCs for differing economic return to the owners

based on their contributions or other agreements.

2. State statutes authorizing LLCs distinguish between “members,” which have

economic, management, and other rights, and “assignees,” which have economic

rights but do not have the right to participate in management, inspection of

106 Treas. Reg. § 1.704-1(b)(2)(iv)(b)(2).107 See I.R.C. § 1361(b)(1)(D); Treas. Reg. § 1.1361-1(b)(1)(iv). Differences in voting rights (but not economic

rights) are permitted. I.R.C. § 1361(c)(4).

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records, or other rights of a member.108 There are no statutory limitations on the

rights of shareholders of a corporation to transfer their shares, but shareholders of

any corporation can protect themselves through a properly drafted shareholder

buy-sell agreement.109

3. There have been arguments that, since the statute provides that the rights of a

creditor against a member are limited to the charging order (and possible

foreclosure),110 the LLC form may be a better form for the owners to protect

themselves from creditors than the corporation. Especially in the case of a single-

member LLC, this is questionable.111

4. Some attorneys and accountants consider the corporate form, which is defined

by statute, to be too inflexible, especially in a state like Colorado where there is

no “close corporation act.” LLC acts provide a significant amount of flexibility in

organizational structure.

5. Some commentators believe that the election of S corporation treatment for an

LLC is not a tax strategy but is an effort to take advantage of the more lenient

operational characteristics of the LLC Act as compared to the typical corporation

statute while obtaining limited liability and pass-through taxation.112 However,

the author is aware that many accountants recommend that an LLC elect to be an

S corporation to attempt to gain an advantage under the self-employment tax

system.

C. Determining if Election to be treated as an S corporation is Desirable.

1. The determination of whether taxation as an S corporation or under subchapter K

is preferable is an involved process and must be based on pro forma expectations,

especially where there is no history of operations by the business in question. In a

business in which capital is a material income-producing item (such as real estate

108 See, infra, notes 117-118 and accompanying text.109

For a discussion of buy-sell agreements, see Lidstone and Sparkman, supra note 50 at §§ 3.1.8-3.1.9.110 C.R.S. § 7-80-703.111 See Herrick K. Lidstone, Jr., “Single-Member LLCs and Asset Protection,” 41 Colo. Law. 39 (March 2012).112 See Stephen R. Looney and Ronald A. Levitt, “Operating as an S Corporation Through a State Law Limited

Liability Company,” 66 N.Y.U. Annual Inst. Fed. Tax’n 17.03 (2008).

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development), often the advantages of subchapter K will significantly overwhelm

those of subchapter S and subchapter C, both as to the treatment of current

distributions as well as the tax treatment on liquidation of the entity.

2. In an S corporation, a certain amount of distributions to the owners will be

classified as “salary” where the owners are involved in the business of the S

corporation. Salary is subject to FICA113 while the balance of an S corporation

distribution is not subject to FICA. Conversely, in most situations (although the

IRS has not issued definitive guidance), all of the amounts distributed to an LLC

member may be subject to SECA (the self-employment version of FICA),114 and

an LLC does not have the option to subdivide those distributions between salary

and distributions.

3. This leads to the temptation to make an S corporation election and allocate $1 per

year to salary and take the balance as distributions. Such an action will spark IRS

interest and likely lead to a reallocation of the split, generally not to the benefit of

the taxpayers. For example, in David E. Watson, P.C. v. United States,115 the

court considered a case in which a professional shareholder in an S corporation

was paid a “salary” of $24,000 per year and (in 2003) received “distributions” of

$175,470. The IRS successfully asserted that the entire amount should be treated

as a salary.

4. Furthermore, S corporation status should be elected for purposes of self-

employment tax planning only if the member of the LLC will be performing

services that would support the desired salary number. In one situation of which

113 FICA tax has two components: (i) Old Age, Survivors and Disability Insurance (OASDI) is assessed at the

2015 rate of 6.2 percent on the employee and 6.2 percent on the employer, both subject to an annual adjusted

cap ($118,500 for 2015 and 2016); and (ii) Medicare component is 1.45 percent on each of the employee and

the employer with no wage cap applicable to either. Beginning in 2014, an additional 0.9 percent Medicare

component is imposed on certain higher-income taxpayers.114 Under the self-employment tax regime, a taxpayer owes tax on his or her income from self-employment at

the combined employer and employee rates for FICA, with the same cap. See Treas. Reg. § 1.1401-1(b). One-

half of a taxpayer’s self-employment tax for a taxable year is an above the line deduction from taxable income

for that year.115 David E. Watson, P.C. v. United States, 714 F. Supp. 2d 954 (S.D. Iowa 2010).

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the author is aware, an individual owned an interest in a multi-member LLC

though the individual’s single-member LLC. The individual was performing

services for the multi-member LLC as a contractor or employee. The individual’s

accountant recommended S corporation status for the individual’s single-member

LLC. The single-member LLC, however, was conducting no business activities

and only served as a conduit for the allocations and distributions from the multi-

member LLC to the individual. It did not appear that any sustainable self-

employment tax planning could be achieved because the individual was not

performing any services for the single-member LLC. This appears to have been

an instance in which the accountant’s recommendation was not based on any

meaningful analysis of the actual facts.

5. An LLC member who guarantees the debt of the LLC can increase the member’s

basis in the LLC by the amount of debt guaranteed. Losses can be taken against

this increased basis. In an S corporation, however, a shareholder can only

increase his or her basis when he or she becomes personally and directly liable on

the obligation — not as a guarantor but as a maker.

6. I.R.C. § 754 provides planning opportunities with respect to basis step-ups on

transfers of ownership interests in a subchapter K entity (a partnership or LLC),

sometimes referred to as “booking up.”116 This is an opportunity that does not

exist in the C corporation or S corporation context.

D. The Operating Agreement for an LLC S Corporation.

1. LLC operating agreements can be very flexible. However, the writing of an

effective operating agreement for an LLC that is to be an S corporation entails an

understanding of the various requirements and limitations imposed on S

corporations and a willingness to review them against the entirety of the LLC Act

to determine where the LLC Act provides a default rule that is inconsistent with S

corporation treatment. The authors has seen too many times situations where an

116 For a more detailed discussion, see Lidstone, supra note 71. In general, however, failure to book up capital

accounts when a new member is admitted may cause adverse economic consequences to the historic members

and, if the new member is receiving a “profits interest,” that interest may be characterized by the IRS as a

capital interest and result in the realization of taxable compensation income.

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LLC made an S election after electing to be treated as a corporation for tax

purposes, but continued to use its partnership-based operating agreement. Our

speculation is that the attorney formed the LLC as a partnership under subchapter

K, and thereafter the accountant became involved in the S election without ever

involving the attorney in the decision.

2. It is important to note that, for the LLC’s election to be treated as an S corporation

to be effective, the operating agreement must be considered a governing provision

under Treas. Reg. § 1.1361-1(l)(2)(i). As such, it must be a binding agreement

that defines the members’ rights to distributions and liquidation proceeds and

cannot, by its terms, create equity interests that would be treated as different

classes of stock for the purposes of § 1361(b)(1)(D). One can question whether

the transactional costs associated with this effort are worth whatever perceived

benefits are gained.

XI. Reviewing Information and Voting Rights.

Shareholders, partners, and members all have statutory rights to certain information.

Some statutes require that a request to examine information be in writing and for a proper

purpose. A transferee of corporate shares receives all the rights of the transferor, including the

right to vote and the right to examine books and records. With the exception of the Texas LLC

statute,117 LLC and partnership statutes provide that, unless otherwise provided by agreement, a

transferee of an LLC or partnership interest is only an assignee and, as such, has no right to vote

or right to examine books and records.118

117 TEX. BUS. ORGS. CODE § 101.109(a)(3), (4).118 Revised Uniform Partnership Act § 503(a)(3); Revised Uniform Limited Partnership Act (“RULPA”) §702(a)(3); Revised Uniform Limited Liability Company Act (“RULLCA”) §§ 410, 410(f), 502(a)(3). Notably,RULPA and RULLCA extend information rights to the legal representative of a deceased partner or member.RULPA § 704; RULLCA § 504.