Category Archives: Legal Documents

Improving Legal Documents in Crowdfunding: New Tax Audit Language for Operation Agreements

 

By: Steve Poulathas & Mark Roderick 

Last year I reported that Congress had changed the rules governing tax audits of limited liability companies and other entities that are treated as partnerships for tax purposes. The changes don’t become effective until tax years beginning on or after January 1, 2018, but because most LLCs created today will still be around in 2018, it’s a good idea to anticipate the changes in your Operating Agreements today.

Under the current rules, the IRS conducts audits of LLCs at the entity level through a “tax matters partner” (normally the Manager of the LLC), and collects taxes from the individual members. Under the new rules, the IRS will continue to conduct audits at the entity level, but will also collect taxes, interest, and penalties at the entity level. That puts the LLC in the position of paying the personal tax obligations of its members, a drain on cash flow every deal sponsor will want to avoid.

Naturally, there are exceptions to the new rules and exceptions to the exceptions. Trouble sleeping? I’ll send you a detailed summary.

Consult with your own tax advisors, of course, here’s some language for your Operating Agreements that gives the deal sponsor maximum flexibility:

Tax Matters.

  1. Appointment. The Manager shall serve as the “Tax Representative” of the Company for purposes of this section 1. The Tax Representative shall have the authority of both (i) a “tax matters partner” under Code section 6231 before it was amended by the Bipartisan Budget Act of 2015 (the “BBA”), and (ii) the “partnership representative” under Code section 6223(a) after it was amended.
  2. Tax Examinations and Audits. At the expense of the Company, the Tax Representative shall represent the Company in connection with all examinations of the Company’s affairs by the Internal Revenue Service and state taxing authorities (each, a “Taxing Authority”), including resulting administrative and judicial proceedings, and is authorized to engage accountants, attorneys, and other professionals in connection with such matters. No Member will act independently with respect to tax audits or tax litigation of the Company, unless previously authorized to do so in writing by the Tax Representative, which authorization may be withheld by the Tax Representative in his, her, or its sole and absolute discretion. The Tax Representative shall have sole discretion to determine whether the Company (either on its own behalf or on behalf of the Members) will contest or continue to contest any tax deficiencies assessed or proposed to be assessed by any Taxing Authority, recognizing that the decisions of the Tax Representative may be binding upon all of the Members.
  3. Tax Elections and Deficiencies. Except as otherwise provided in this Agreement, the Tax Representative, in his, her, or its sole discretion, shall have the right to make on behalf of the Company any and all elections under the Internal Revenue Code or provisions of State tax law. Without limiting the previous sentence, the Tax Representative, in his, her, or its sole discretion, shall have the right to make any and all elections and to take any actions that are available to be made or taken by the “partnership representative” or the Company under the BBA, including but not limited to an election under Code section 6226 as amended by the BBA, and the Members shall take such actions requested by the Tax Representative. To the extent that the Tax Representative does not make an election under Code section 6221(b) or Code section 6226 (each as amended by the BBA), the Company shall use commercially reasonable efforts to (i) make any modifications available under Code section 6225(c)(3), (4), and (5), as amended by the BBA, and (ii) if requested by a Member, provide to such Member information allowing such Member to file an amended federal income tax return, as described in Code section 6225(c)(2) as amended by the BBA, to the extent such amended return and payment of any related federal income taxes would reduce any taxes payable by the Company.
  4. Deficiencies. Any deficiency for taxes imposed on any Member (including penalties, additions to tax or interest imposed with respect to such taxes and any taxes imposed pursuant to Code section 6226 as amended by the BBA) will be paid by such Member and if required to be paid (and actually paid) by the Company, may  be recovered by the Company from such Member (i) by withholding from such Member any distributions otherwise due to such Member, or (ii) on demand. Similarly, if, by reason of changes in the interests of the Members in the Company, the Company, or any Member (or former Member) is required to pay any taxes (including penalties, additions to tax or interest imposed with respect to such taxes) that should properly be the obligation of another Member (or former Member), then the Member (or former Member) properly responsible for such taxes shall promptly reimburse the Company or Member who satisfied the audit obligation.
  5. Tax Returns. At the expense of the Company, the Tax Representative shall use commercially reasonable efforts to cause the preparation and timely filing (including extensions) of all tax returns required to be filed by the Company pursuant to the Code as well as all other required tax returns in each jurisdiction in which the Company is required to file returns. As soon as reasonably possible after the end of each taxable year of the Company, the Tax Representative will cause to be delivered to each person who was a Member at any time during such taxable year, IRS Schedule K-1 to Form 1065 and such other information with respect to the Company as may be necessary for the preparation of such person’s federal, state, and local income tax returns for such taxable year.
  6. Consistent Treatment of Tax Items. No Member shall treat any Company Tax Item inconsistently on such Member’s Federal, State, foreign or other income tax return with the treatment of such Company Tax Item on the Company’s tax return. For these purposes, the term “Company Tax Item” means any item of the Company of income, loss, deduction, credit, or otherwise reported (or not reported) on the Company’s tax returns.

Questions? Let us know.

 

Steve Poulathas is member of Flaster Greenberg’s Taxation, Business and Corporate, Trusts and Estates and Employee Benefits Practice Groups. He counsels and represents individuals, family-owned businesses and public companies in the tax, business and finance, and estate practices. He can be reached at 856.382.2255 or steve.poulathas@flastergreenberg.com.

 

 

Mark Roderick is one of the leading Crowdfunding lawyers in the United States. He represents platforms, portals, issuers, and others throughout the industry. For more information on Crowdfunding, including news, updates and links to important information pertaining to the JOBS Act and how Crowdfunding may affect your business, follow Mark’s blog, or his twitter handle: @CrowdfundAttny. He can also be reached at 856.661.2265 or mark.roderick@flastergreenberg.com.

 

Improving Legal Documents in Crowdfunding: Capital Calls

man beggingYou raise $2 million of equity from investors to buy an apartment complex and two years later want to make $500,000 of capital improvements. Where do you get the money?

Traditionally, your Operating Agreement might give you the right to make a “capital call,” asking your existing investors for the additional $500,000. Suppose you had 20 investors, each contributing $100,000 in the beginning. Exercising your right to make capital calls, you would ask each for another $25,000 (20 x $25,000 = $500,000).

If the Operating Agreement includes a capital call feature, then it should also describe the consequences if one or more investors fail to contribute. The simplest approach, which I have seen used in Crowdfunding offerings, provides for simple dilution based on capital contributed. Let’s say 19 investors send $25,000 checks but one does not. The Operating Agreement would provide that his ownership interest is reduced by 1% (100 basis points), the percentage that his failed contribution ($25,000) bears to the total capital contributed ($2,500,000).

A few things to bear in mind using capital calls in Crowdfunding:

  • If I am the Crowdfunding investor, I do not want a capital call. Once I write my initial check, I don’t want to be asked for more money.
  • If I am the sponsor, I don’t want to be obligated to ask my existing investors for additional capital, which is just another way of saying I don’t want to give my existing investors a so-called “preemptive right.” There might be 157 existing investors. It might be much easier to get the $500,000 from a single source, or even a new Crowdfunding round. I want to leave my options open.
  • If we include a capital call, simple dilution is often not the right answer. Suppose the real estate market deteriorates and I desperately need the $500,000 to keep the project afloat. If an investor fails to make good on the capital call, a much higher rate of dilution might be appropriate, 150% or 200%, or even more. I have drafted agreements where the failure to make good on a capital call results in the wholesale forfeiture of an interest.

Crowdfunding is like traditional private placements in many ways, but in other ways it isn’t. When we draft legal documents for Crowdfunding deals we need to figure out which is which.

Questions? Contact Mark Roderick.

IMPROVING LEGAL DOCUMENTS IN CROWDFUNDING: MODEL WHITE LABEL CONTRACT

I see a lot of contracts between would-be Crowdfunding portals and “white label” portal software providers. It would help the industry, in my opinion, if everyone used or at least started with the same agreement. So I’ve drafted a model agreement, accessible as a Microsoft Word document here.

An agreement for a white label platform is a software license agreement. I’ve drafted more software license agreements than I can count, representing both licensors and licensees. That gives me a very good feel for what’s important, what’s not so important, and what’s fair.

My model agreement is designed to be a very fair document. It protects what’s important to the white label provider, and also protects what’s important to the would-be portal licensing the platform. It is also designed to be a comprehensive document, meaning it covers what’s important without overkill. I hope it’s easy to read and understand, as legal contracts go. And it’s completely flexible in terms of what the customer gets and how much the customer pays.

Multi-million-dollar portal businesses are being created based on the relationship created by this contract. It’s not a back-of-the-napkin kind of thing.

Because there could be special situations that the model agreement doesn’t cover, white label providers and their customers should have this model agreement reviewed by their own lawyers. Also, I haven’t provided a Service Level Agreement, because response times might vary significantly among white label providers.

But using one standard agreement should make things easier for everyone. Fewer transaction costs, less friction, greater certainty, faster to market. That’s what the industry needs.

 

IMPROVING LEGAL DOCUMENTS IN CROWDFUNDING: TAX ALLOCATIONS

Because I started life as a tax shelter lawyer, I’m especially sensitive to how income and losses are allocated within partnerships and limited liability companies (limited liability companies are taxed as partnerships). Agreements in the Crowdfunding space leave something to be desired.

As we all know, partnerships are not themselves taxable entities. The items of income and loss of the dollar handshakepartnership “flow through” and are reported on the personal tax returns of the owners. Allocating income and losses is simple when you have one class of partnership interest and everything is pro rata, e.g., you get 70% of everything and I get 30%. It becomes a lot more complicated in the real world.

Say, for example:

  • The sponsor of a deal takes a 30% promote in operating cash flow after investors received an 8% annual preferred return.
  • On a sale or refinancing, the sponsor takes a 40% promote after the investors receive a 10% internal rate of return.
  • In the early years of the deal the project generates ordinary losses, then generates cash flow sheltered by depreciation deductions, then generates section 1231 gain.

The allocation of income and loss in a partnership is governed by section 704(b) of the Internal Revenue Code. Long ago, the IRS issued regulations under section 704(b) that use the concept of “capital accounts” to determine whether a given allocation has “substantial economic effect.” Rules within rules, exceptions within exceptions, definitions within definitions, the section 704(b) regulations are a delight for the kind of person (I admit it) who wasn’t necessarily the coolest in high school.

For years afterward, tax shelter lawyers vied with one another to include as many of the rules and definitions of the regulations as possible in their partnership agreements, verbatim. That lasted until we recognized that (1) no matter how hard we tried, it was impossible to be 100% sure that the allocations would come out right; and (2) there was a better way.

The better way is to give management the right to allocate income on a year-to-year basis, with the mandate that the allocation of income should follow the distribution of cash. To wit:

Company shall seek to allocate its income, gains, losses, deductions, and expenses (“Tax Items”) in a manner so that (i) such allocations have “substantial economic effect” as defined in Section 704(b) of the Code and the regulations issued thereunder (the “Regulations”) and otherwise comply with applicable tax laws; (ii) each Member is allocated income equal to the sum of (A) the losses he or it is allocated, and (B) the cash profits he or it receives; and (iii) after taking into account the allocations for each year as well as such factors as the value of the Company’s assets, the allocations likely to be made to each Member in the future, and the distributions each Member is likely to receive, the balance of each Member’s capital account at the time of the liquidation of the Company will be equal to the amount such Member is entitled to receive pursuant to this Agreement. That is, the allocation of the Company’s Tax Items, should, to the extent reasonably possible, following the actual and anticipated distributions of cash, in the discretion of the Manager. In making allocations the Manager shall use reasonable efforts to comply with applicable tax laws, including without limitation through incorporation of a “qualified income offset,” a “gross income allocation,” and a “minimum gain chargeback,” as such terms or concepts are specified in the Regulations. The Manager shall be conclusively deemed to have used reasonable effort if it has sought and obtained advice from counsel.

Even today, I see partnership agreements that devote pages to the allocation of tax items. The approach in the paragraph above is much simpler and, even more important, much more likely to achieve the right result.

Questions? Contact Mark Roderick at Flaster/Greenberg PC.

 

IMPROVING LEGAL DOCUMENTS IN CROWDFUNDING: INTERNAL RATE OF RETURN

Internal rate of return, a financial concept, is not always used correctly in Crowdfunding documents.

The internal rate of return, often referred to as IRR, calculates the total rate of return of an investment, expressed as a percentage. Suppose you invested $100 in a bond that paid $5 at the end of each year for four years and were redeemed at the end of the fifth year for $105. Not surprisingly, that investment has an IRR of 5%.

Suppose you try to calculate IRR at the end of the fourth year? You tell Microsoft Excel that you paid $100 and have received $5 per year for four years and Excel says your IRR is minus 43.25%, i.e., you’ve made a terrible investment. What went wrong?

What went wrong is that you didn’t give Excel all the information it needs. It’s like the George Carlin joke, when he plays a sportscaster and announces “Here’s a partial score: Yankees 3.”

To get the right answer for IRR at the end of the fourth year, you have to tell Excel that the bond is still worth $100. When you do that, Excel calculates that your IRR is 5%.

And so it is in Crowdfunding. Often, the sponsor promises that upon any “capital transaction” – a sale or a refinancing, typically – the investors receive an IRR of X% before the sponsor receives his “promote.” Typical language:

The net proceeds of a Capital Transaction shall be distributed first to Investors, until they have received an internal rate of return of 8%, and then 70% to Investors and 30% to Sponsor.

But that’s like “Yankees 3.” It works if the Capital Transaction was a sale of the entire business, but it doesn’t work if the Capital Transaction was anything else, like a refinancing or a sale of only part of the business. With this language the investors are going to receive a complete return of their investment even if only a portion of the project has been sold, which might not be what the parties intended.

To get the right result you need to say something like this:

The net proceeds of a Capital Transaction shall be distributed first to Investors, until they have received an internal rate of return of 8%, and then 70% to Investors and 30% to Sponsor. If the Capital Transaction does not consist of the sale of all of the Company’s property and the distribution of all of the net proceeds to the Members, then the internal rate of return shall be calculated by (i) assigning to the remaining assets of the Company a value determined in good faith by the Manager, and (ii) assuming a residual value to the Investors equal to the amount they would receive if all such remaining assets were sold for such value and distributed in a Capital Transaction.

As for a definition of internal rate of return:

The term “internal rate of return” means the internal rate of return calculated using the XIRR function in Microsoft Excel.

Questions? Contact Mark Roderick at Flaster/Greenberg PC.

IMPROVING CROWDFUNDING LEGAL DOCUMENTS

I don’t know much about videos or marketing, but I know a lot about legal documents. In a series of posts I’m going to suggest improvements to some of the legal documents used in Crowdfunding. Most of the time, I’ll suggest actual language a portal or issuer can cut and paste – after talking with a lawyer, of course.

By and large, the legal documents you see on Crowdfunding websites were pulled from other deals. For example, the Operating Agreement you see on a real estate Crowdfunding website is usually the same document the lawyer used for pre-Crowdfunding deals. And in many respects that’s okay because legal documents are pretty agnostic as to industry.

But in other respects it’s not okay. Sometimes you have to tailor the legal document to the industry.

An example is the section of the Operating Agreement that talks about an investor’s right to information. The provision from one well-known site says that the records of the company “. . . shall be available at the Company’s principal office for inspection and copying by any Member at any and all reasonable times during normal business hours at such Member’s expense.” Another says “A Member and the Member’s authorized representative shall, upon reasonable request and for purposes related to the interest of that Member, have reasonable access to, and may inspect and copy, during normal business hours all books, records and other materials pertaining to the Company or its activities.”

No! These provisions were typical in the pre-Crowdfunding world, but they don’t work with Crowdfunding.

You might have 218 investors in a Crowdfunding deal. You have to limit the right of investors to come to your office to inspect the books, and you have to limit what they can see. Under the Delaware limited liability company statute, if you don’t provide otherwise, your investors have the right to see basically everything, including a list of all the other investors. With one or two unscrupulous or irrational investors, that’s a recipe for losing sleep.

We want to:

  • Be fair to investors and provide all the information they need
  • Avoid spending an inordinate amount of management time dealing with bad apples
  • Protect your confidential information
  • Avoid dealing with 218 investors each asking for the same information
  • Give you discretion to protect your business and the interests of your investors

For an example of actual legal language that does just that while, I believe, fully complying with the Delaware Limited Liability Company Act, click here.

Questions? Contact Mark Roderick at Flaster/Greenberg PC.

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