Can Foreign Partners Now Exit Partnerships Tax Free?

Guest article by Elizabeth L. McGinley,  Michele J. Alexander,  Anne E. Holth – Bracewell LLP

In Grecian Magnesite Mining v. Commissioner1 (“Grecian Magnesite”) the Tax Court held that a non-U.S. partner’s gain from the redemption of its partnership interest was neither U.S. source income nor income effectively connected with a U.S. trade or business (“ECI”), despite the partnership’s conduct of a trade or business in the United States. The foreign partner was “therefore not liable for U.S. income tax on the disputed gain.” This taxpayer victory is significant primarily because the Tax Court’s decision rejects longstanding Internal Revenue Service (“Service”) guidance and addresses ambiguities in the rules governing partnership and international taxation.

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Effectively Connected Income and Penny Warrants

Guest post by Nicholas Jacobus and Sung Hwang – Venable LLP

There is a case currently proceeding in the U.S. Tax Court (TELOS CLO 2006-1, Ltd. v. Commissioner, T.C., No. 6786-17, petitions filed 3/22/17) that deals with the question of whether non-U.S. investors inadvertently realized “ECI” from the sale of “penny warrants” (a/k/a “hope notes”).  This is a reminder that careful deal structuring is crucial for funds that have a significant non-U.S. investor base or otherwise have a covenant to avoid income that is “effectively connected” with the conduct of a U.S. trade or business (ECI). 

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Should You Pay Someone Else’s Tax?

Guest Post by Sung Hyun Hwang, Partner, Venable LLP

The answer is a resounding yes under the new U.S. tax audit rules applicable to VC funds organized as partnerships (including LLCs treated as partnerships) for U.S. federal income tax purposes, and this article explores steps a VC fund may consider taking to mitigate this draconian outcome.

Background: A partnership is a “flow-through” or “pass-through” entity for U.S. federal income tax purposes. This means that the partnership does not pay income tax itself. Instead, for each taxable year, it will determine the character and amount of its items of income, gain, loss, deduction, and credit, and allocate them among its partners, who will take them into account when they determine their own income tax liability for the same taxable year.

For decades, the U.S. tax audit of most partnership matters has been handled at the partnership level, where the partnership items and their allocations were reviewed, with the resulting adjustments flowing to the partners, who would pick up the tab by amending their own tax returns and pay additional taxes owed.

The IRS has not been happy with this two-tiered system of partnership audits because, often, an audit takes place a long time after a tax return is filed and, by the time the audit is completed, either the statute of limitations has run on assessing taxes at the partner level, the agency had to start new proceedings against the individual partners, or the partners were simply nowhere to be found, given the lapse of time.

This practical difficulty has been keenly felt, especially in the case of tiered partnerships in the investment space, where multiple tiers of partnerships are common, because of the layers of the partnerships that need to be looked at, and because the many changes in the ownership of each partnership in the chain have discouraged IRS auditors. A good example of a tiered partnership in the VC space would be a fund-of-funds investing in a VC fund, or a VC fund investing in a portfolio company through a partnership.

New Partnership Audit Rules: In late 2015, Congress passed a law changing the existing partnership tax audit rules effective with taxable years beginning after 2017 (with limited elective retroactive application), aiming to significantly improve the IRS’s ability to handle partnership tax audits by centralizing both audit and collection at the same partnership-level. There is a fair amount of uncertainty regarding the application of the new law because it is new and was passed in haste.

A “technical corrections act” is currently pending in Congress to improve certain aspects of the new law, but, given the current political excitement about revamping the tax law, it is not clear whether the technical corrections act will pass in its current form in the near future. The IRS proposed a set of regulations to implement the new law and to clarify its scope, but it was withdrawn because of the new administration’s executive order temporarily freezing new regulatory guidance actions. To make the matter more complicated, a few states have already started adopting similar changes to their partnership audit regimes, while others are taking a wait-and-see approach.

In the short term at least, VC funds will have to deal with a new, centralized partnership audit and collection regime, with looming uncertainty and potential changes in the background. One key aspect of the new law in particular warrants the VC community’s attention now: the “collection” feature of the new audit rules (i.e., imposition of entity-level taxation for adjustments arising from VC fund tax audits). Under the new law, at the conclusion of a VC fund audit, the IRS will determine tax liability at the fund level, by solely taking into account all adjustments of the fund’s items of income, gain, loss, and deduction, in a manner similar to how funds calculate tax distributions. If the IRS determines that taxes are owned based on this determination, the tax will be payable by the partnership at the highest individual and corporate tax rates in the year of the adjustment (as opposed to allocating the adjustments to the investors who were partners in the year under audit (the “Audit-Year”)).

This clearly can lead to a result where one investor makes money in one year and a different investor picks up the tab in a later year. This also raises many technical questions without ready answers: among others, do the investors who are the partners in the year of adjustment (the “Adjustment Year”) get credit for their allocable share of the adjusted partnership items, or for tax paid by the partnership for purposes of calculating their own income tax? How will it affect the capital accounts of these partners? This will be especially relevant for VC funds using the “forced allocation” or “target allocation” or any tiered or special allocation regime for allocating items of income, gain, loss, deduction, and credit.

The new law provides certain mitigating options that would allow a VC fund to either keep the old audit regime (i.e., investors who were Audit-Year partners pick up the tab in the Audit Year) or “push out” the tax liability to the Audit-Year partners in the Adjustment Year, as follows:

Opting Out: A VC Fund can opt out of the new audit regime with respect to a taxable year if, for that taxable year: (i) it issues no more than 100 Schedule K-1s, and (ii) its partners are only individuals, C corporations, S corporations, estates of deceased partners, or foreign entities that would be C corporations if they were domestic entities. Thus, if a VC fund can limit its partner count to 100 or less, and is closed to investors organized as partnerships, LLCs, trusts, mutual funds (taxed as “regulated investment companies”), or REITs, it will enjoy the greener pasture of the old audit regime, in which the Audit-Year partners pick up the tab as of the Audit Year.

Second Bite at the Old Regime: The VC fund will not be subject to the entity-level tax to the extent of adjustments allocated to any Audit-Year partner if such investor files an amended return for the Audit Year taking into account its allocable share of the adjustments and pays the tax in full. If the audit results in reallocation of the partnership items among the partners, all Audit-Year partners must file amended returns and pay taxes for this to work. The technical corrections act was aimed, in part, at improving the taste of this second bite. While it is hard to rely on the good nature of investors alone, adding a provision in the operating agreement to this effect may prompt some (and, hopefully, all) investors if that provision is backed by an indemnity provision and survives the investors’ redemption or transfer of their interests in the VC fund, and the dissolution of the VC fund.

Third Bite at the Old Regime: The VC fund will have one last chance to shift the tax to the Audit-Year partners if it makes an election, within 45 days of the receipt of the notice of the proposed adjustments at the end of the audit, to “push out” the adjustments to the Audit-Year partners. In such case, the Audit-Year partners will be treated as if they have reported the adjustments in the Audit Report but paying tax when they actually pay (most likely in the Adjustment Year), including by paying penalties, additions, interest, etc. The fund’s general partner or managing member, as applicable, should be given the discretion (but should not be compelled) to make this election.

More Ways to Reduce the Pain: If all else fails, the VC fund can still reduce the tax bill to the extent of adjustments allocable to C corporations or individuals (with respect to capital gains and qualified dividend income) and tax-exempt investors (with respect to their income and gain not taxed as unrelated business taxable income). Therefore, a VC fund may consider adding to its existing tax information reporting provisions a concept to the effect that the partners would provide such information as is necessary or appropriate for reducing the partnership-level tax resulting from a tax audit.

Tax Indemnity: Last, VC funds may review and amend their existing operating agreements to include concepts such as (i) adding tax audit costs to the existing tax indemnity provision (e.g., for withholding tax) and (ii) the obligation to re-contribute or “claw back” prior distributions in their operating agreement that survive the transfer or redemption of an investor’s interest or dissolution of the fund.

**This article was prepared for marketing purposes and does not constitute tax opinion or advice to any taxpayer. Each taxpayer should consult its own tax advisor for the application of the tax laws to its own facts. In addition, this article is based on current U.S. federal income tax law, and the author will not update any reader on any future changes, including those with retroactive effect, in U.S. federal income tax law.

Author

Sung Hyun Hwang is a partner in Venable’s Tax and Wealth Planning practice. He focuses on the full spectrum of business tax law, from complex structured financial products to multi-partner business joint ventures. For more information, visit http://www.venable.com.

Venable LLP

Venable (www.venable.com) has taken a two-pronged approach to building its global reach, one which delivers superior value, and maximizes the quality lawyering and client service that its clients expect. In many cases, it provides counsel directly to U.S. and foreign-based companies, institutions and individuals. Venable frequently deliver value to its clients in a number of very specialized areas where international recognition and scope are imperative. Examples include: FCPA; Tax; Privacy, Data Protection and Internet; International Trade; Intellectual Property; Advertising, Marketing and New Media.

Top 10 Mistakes Companies Make During Acquisitions

Guest Post by: Don Keller (Partner, Emerging Companies Practice in Silicon Valley, Orrick, Herrington & Sutcliffe LLP)

It used to be that when entrepreneurs started their companies, the idea of going public and making it big was on top of every founder or CEO’s checklist.  Nowadays, it seems that startups are constantly looking to build a great product that will attract the most users and then cross their fingers that the Googles or Microsofts of the world will acquire the company (or the team).  I gave a presentation yesterday at RocketSpace, an accelerator for seed-funded technologies in San Francisco, about best practices and top mistakes companies make during acquisitions. So for those of you who are interested in going down that route, here are some things to note as you prepare your company and team for the road to acquisition-ville.

1.  Founder Equity – Make sure founder equity is held in the form of shares, not options.  Shares allow founders to get all of the appreciation taxed at capital gain rates, whereas options typically result in the appreciation being taxed at ordinary income rates.  This can make a huge difference in the amount of take home pay.

2.  Protect Your IP – One of the biggest mistakes companies make in the early stages of their development, is not dotting all their i’s and crossing their t’s when it comes to protecting their intellectual property.  Make sure that when IP is involved, you work with a good lawyer to ensure that your IP is not owned by a former employer and that all of the IP has been properly assigned to the company.  The last thing you want is for your company to take off and then get hit with a notice that your IP is not actually your IP.

3.  Keep Your Options Open – To maximize your price, companies should leave themselves with alternatives to the buyers they are targeting.  You want to make sure that you’re not selling yourself short and putting all your eggs in one basket.  This does not make for a good negotiation strategy and is less likely to get you the best price.  If a buyer knows that you have only one alternative, the price will fall like a rock.

4.  What to Avoid Selling – Avoid selling the company for private company shares in a transaction that is taxable.  There is typically no market for private company shares so getting someone else’s private shares in an acquisition and having to pay tax on those shares, leaves you with an out of pocket cost and nothing to show for it other than some shares you cannot sell.  If the transaction is properly structured, the receipt of the buyer’s shares can be nontaxable (at least until you sell those shares) which is what you want.

5.  The Art of Negotiating – When negotiating on price, make sure you understand all of the adjustments to the price such as escrows, legal fees, balance sheet adjustments, and special indemnities.  Once you sign the 60 or 90 days no shop agreement, the buyer has all the leverage.  You don’t want to learn at that point that the price they said they would pay is before massive deductions.  It’s important to negotiate the terms right out of the gate so there are no surprises when it comes time to seal the deal.

6.  Open Source – Make sure you understand open source and how it’s used in your product.  Always double check to make sure that you have complied with the open source license terms.  It doesn’t happen often, but every now and then, this can be a deal breaker for buyers.

7. Keep Up with the Kardashians…I mean Housekeeping – Do not, and I repeat, do not wait until the last minute to catch up on cleaning your minute books and stock option pricing (409A issues).  It is important that your documents are maintained and updated on a regular basis.  If you wait until the last minute, it can create unnecessary headaches and disorganization.  The last thing a buyer wants to see is a company that can’t keep their documents up to par.

8.  Don’t Wait Until the Last Minute – Rolling over from #7, another important thing to note is that you shouldn’t leave the negotiation of employment and non-compete agreements until the last minute.  These are things that should be brought up as soon as discussions begin.  Time and again, these agreements are negotiated at the last minute with lots of pressure on the founders to sign and be happy.  Don’t let that be your situation.

9. Be Wary of Earn-Outs – Earn outs are a lawyer’s dream.  They almost always end in disputes about whether the buyer tried hard enough to generate revenue to meet the earn out thresholds.  Don’t count on any earn out payments and negotiate accordingly.

10.  Pay Attention to Your Board Members and Investors – It’s very important to listen to what your board members and investors are saying during this time.  You want to keep an ear out for biases for or against a sale and also take heed to strategic investor reactions to a sale.

There is no full proof way of being certain that by following the advice above, the road to acquisition will be an easy route.  However, best practices can provide entrepreneurs a clearer path and hopefully increase the likelihood of your company’s success.

About Don Keller:  Don is a Partner in the Emerging Companies Practice at Orrick’s Silicon Valley office. He advises emerging companies, public companies, venture capital firms and investment banks and has represented clients on more than 60 public offerings, 75 acquisition transactions and several hundred venture financings.  Don has worked on transactions for companies including Apple, Google, Oracle, and Rambus and represents clients such as eHarmony, OPOWER, and LS9, among many others.  For more information, you can visit his full biography.

IRS Tax Section 1202: Excluding Your Gains on Small Business Investments

Guest post by Daniel I. DeWolf and Rachel Gholston – Mintz, Levin, Cohn, Ferris, Glovsky and Popeo, P.C.

2016 promises to be another very good year to invest in start-ups because of the extension of significant tax breaks for investors who invest in early stage companies. Investors who invest in small businesses can realize exclusions on capital gains if they choose the right type of company. The Section 1202 exclusion of 100% of gains on qualified small business stock has recently been extended, but this time there is no end is in sight for this extension. When enacted, Section 1202 of the Internal Revenue Code provided a 50% exclusion from income of gains on stock of a qualifying small business held by an investor for more than 5 years. In recent years, this exclusion amount has been increased to 75% then to 100% and then returned to 50%; but these higher exclusion rates have only been extended in short intervals. Now, thanks to the Protecting Americans from Tax Hikes Act, the “PATH Act”, signed into law in December of 2015, gains on qualifying small business stock obtained any time after December 31, 2014 and onward are eligible for the 100% exclusion.

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