Equity Compensation in a Pass-through World

1. Business Law Institute
May 2011
Equity Compensation in a Pass-through
World
Presented by:
David D. Brauer
Lurie Besikof Lapidus & Company
Kevin W. Kaiser
Lindquist & Vennum

2. Equity Compensation in a Pass-through World
ANY TAX ADVICE CONTAINED IN THIS COMMUNICATION IS NOT
INTENDED OR WRITTEN TO BE USED, AND CANNOT BE USED FOR
THE PURPOSE OF (i) AVOIDING PENALTIES THAT MAY BE
IMPOSED ON ANY TAXPAYER OR (ii) PROMOTING, MARKETING OR
RECOMMENDING TO ANOTHER PARTY ANY MATTERS
ADDRESSED HEREIN.
The information contained herein is general in nature and based on
authorities that are subject to change. Applicability to specific situations is
to be determined through consultation with your tax adviser.

3. Equity Compensation
Corporations have long used equity to compensate employees
During the 1990s and early 2000s, stock options became increasingly
important method of compensating corporate executives and
employees
Total compensation of executives of the largest public companies
In recent years, increasing proportions of total compensation
have been represented by equity, including various forms of
employee stock options and restricted shares
LLCs want in on the action…

4. Equity Compensation
Direct issuance of ownership interest
Equity
Common stock
Preferred stock
Partnership interest (general or limited)
LLC membership interest
Compensatory options
Options on equity interest
 A type of call option, although in the employment context
special rules apply
Equity Appreciation Rights
Cash compensation designed to mirror compensatory options

5. Terminology - Authority
LLC/Partnership rules (Subchapter K)
– Partner’s percentage interest
Capital interest
This is where the analysis
between LLCs and corporations
part company
Profits interest
 Contrast with interest in a corporation
– Partner capital account rules

6. Equity Compensation
Corporate treatment, generally…
Equity interest (unrestricted)
 Income to employee when issued
 Deduction to corporation
Note – If restricted, recognition occurs when restrictions lapse
Unless elect otherwise
Stock options
 Two types of compensatory options
- Incentive stock options (ISOs) – nontaxable/nondeductible
- Nonqualified options – taxable/deductible

7. Partnership Equity Compensation
The early cases…
Diamond v. Commissioner, 492 F.2d 286 (7th Cir. 1974)
Campbell v. Commissioner, 943 F.2d 815 (8th Cir. 1991)

8. Diamond v. Commissioner (1974)
1. K acquires option to
purchase building
2. K asks D to arrange
financing in exchange
for 60% profits Sold
interest in P/S
3. P/S formed and
K D
building acquired with
D arranged financing
40% P & L
4. No D cash outlay 60% P & L
100% Capital
5. D sells 60% profits
interest for $40K
(three weeks later)
6. Court rules D must K&D
recognize receipt of
P/S interest

9. Campbell v. Commissioner (1991)
1. C negotiates
employment contract
providing that C will
receive a % of
partnership profits in
exchange for services
2. C treats the receipt of S C
the profits interest as
nontaxable
3. IRS challenges
15% P & L
85% P & L
nontaxable treatment
100% Capital
4. Tax Court held
taxable
5. Appellate Court held
nontaxable because S&C
P/S interest had no
ascertainable value

10. The 40 Year Saga of Taxing Partnership
Profits Interests for Services
• Diamond v. Commissioner (1971)
• Proposed Partnership Regulation (1971)
• Campbell v. Commissioner (1991)
• Revenue Procedure 93-27
• Revenue Procedure 2001-43
• Proposed Regulation on noncompensatory options (2003)
• Private Letter Ruling 200329001 (only PLR on p/s interest for services)
• Proposed Partnership Regulations (2005)
• Proposed Revenue Procedure 2005-43
What’s the problem? Why is this so hard?

11. What’s the problem? Why is this so hard?
• Valuation
– Capital Account Interest
– Profits-only Interest
• Partner Issues
– Amount of income
– Timing of income
– Character of income
• Partnership Issues
– Partnership deduction – When? How much?
– When is the service provider considered a partner?
– How are capital accounts maintained?

12. Current Guidance
Revenue Procedure 93-27
Generally, the receipt of a partnership profits interest for
services is tax free to the recipient
– “Profits interest” defined as an interest that would not
give the holder a share of the proceeds if the partnership
sold all of its assets for FMV and liquidated immediately
upon issuance of the profits interest.
– Exceptions
 Predictable stream of cash flow (i.e., bonds, rents)
 Partner disposes of partnership interest within two
years
 Publicly traded partnership

13. Current Guidance
Revenue Procedure 93-27
Conflicts with Section 83 (remember the rules for corporate
stock)
Rev. Proc. 93-27 measures taxability of the interest at the
time of issuance
Section 83 measures the taxability of a transfer of
property at the later of the time of the transfer or the
vesting of the property
Example
 Ifan unvested partnership profits interest were issued
which was a profits interest under Rev. Proc. 93-27 on
the date of transfer but a capital interest on the date of
vesting, Rev. Proc. 93-27 and section 83 could be in
direct conflict.

14. Current Guidance
Revenue Procedure 93-27
Conflicts with Section 83 (remember the rules for corporate
stock)
Rev. Proc. 93-27 measures taxability of the interest at the
time of issuance
Section 83 measures the taxability of a transfer of
property at the later of the time of the transfer or the
vesting of the property

15. Current Guidance
Revenue Procedure 93-27
Conflicts with Section 83 (remember the rules for corporate
stock)
Example
If an unvested partnership profits interest were issued which
was a profits interest under Rev. Proc. 93-27 on the date of
transfer but a capital interest on the date of vesting, Rev. Proc.
93-27 and section 83 could be in direct conflict.

16. Current Guidance
Revenue Procedure 2001-43
Rev. Proc. 2001-43 issued to resolve this conflict between section 83 and
Rev. Proc. 93-27
The time for testing whether the interest qualifies as a profits interest is,
under certain circumstances, when the interest is granted (Note – section
83(b) election not required, see PLR 200329001)
The service provider must be treated as a partner from the time of grant
Neither the partnership nor the other partners could deduct any amount
in respect to the vesting of the interest, and
The interest otherwise must qualify as a profits interest under Rev.
Proc. 93-27

17. Valuation
What is the correct method for valuing a capital interest for
services?
Under current law:
Relinquishment of capital
Value added
Cost of services
Discounted value

18. Valuation of Capital interest
Example: X and Y each contribute $10,000 to a newly formed LLC, in
exchange for 50% capital interest in LLC. Shortly thereafter, Z is issued
a 33 1/3% vested capital partner interest solely in exchange for
services being rendered to the partnership at that time. X’s and Y’s
capital interests are each reduced to 33 1/3% to reflect this change.
Query – What is the proper amount for Z to include in compensation
income (and LLC to deduct for Z’s services)?

19. Valuation of Capital interest
Y
X Z
$10K
Service
Partner
$10K
X&Y&Z

20. Carried Interest
Definition of "Carried Interest"
The Carried Interest is a share of fund net profits allocated to the
General Partner that is disproportionate to the General Partner’s capital
commitment to the fund.
The total compensation received by an investment advisor to a private
investment fund ordinarily will comprise a management fee and the
performance fee. A traditional arrangement will award the advisor a
management fee of 2% of net assets under management, and a 20%
performance fee, or "Carried Interest".

21. Carried Interest
Fund Capitalization
Capital Committed by Investors: 99%
Capital Committed by General Partner: 1%

22. Carried Interest
Typical Allocation of Fund Net Profits
• Proportionate Allocation:
 80% to all Partners (including the General Partner) in
proportion to their respective capital commitments
• Carried Interest Allocation:
 20% to the General Partner

23. Simple Fund Structure
General U.S. Taxable Investors
(limited partners)
Partner
99%
1%
20% Carried
Interest
Investment
Limited Partnership Prime Broker
Advisor (U.S.)
2% Mgmt
Fee
Administrator

24. Carried Interest
Carried Interest under scrutiny by Congress:
The previous Congress proposed legislation designed to treat the
Carried Interest income as ordinary income received as compensation.
Why the proposed change? What's the problem?

25. Carried Interest
Carried Interest under scrutiny by Congress:
• Congress views the Carried Interest arrangement as abusive
 Compensation income can be characterized as capital
 Compensation income can deferred

26. Carried Interest
Carried Interest under scrutiny by Congress:
• Legislative changes have been proposed since 2007
• Targeted primarily at partners performing investment management
services
• Easy to discuss, hard to design a law that addresses the issue

27. Carried Interest
Carried Interest under scrutiny by Congress:
• Recent proposed legislation was introduced in September 2010
 In addition to other changes, the proposal directed ordinary
income treatment at any person (including corporation or
partnership) that holds an investment services partnership
interest ("ISPI"). The proposal included:
o ISPI related income must be treated as ordinary
o Dispositions of ISPIs treated as ordinary and must be taxable
o Property distributions treated as ordinary
o Deferring losses allocated to ISPI holders
o Subjecting ISPI income to self-employment taxes

28. Carried Interest
Carried Interest under scrutiny by Congress:
Questions and concerns about "Carried Interest" changes.
• How will Carried Interest rules be applied to real estate
partnerships?
 Does the ISPI definition extend to real estate?
• Corporate joint ventures?
• Normal return on invested capital?
• Mergers and Acquisitions (M&A) transactions?

29. Plans To Mirror Equity
Phantom Stock or Phantom Equity
Financial Rights
No Voting Authority
Section 409A Scared Many Away

30. Plans To Mirror Equity
Section 409A Merely Adds Hurdles
Documentation Is The Key
No Acceleration But Lots Of Creativity

31. Q&A

32. Contact Information
Kevin W. Kaiser
Lindquist & Vennum PLLP
Phone: (612) 371-2467
E-mail: kkaiser@lindquist.com
David D. Brauer
Lurie Besikof Lapidus & Company LLP
Phone: (612) 381-8838
E-mail: dBrauer@lblco.com