Category Archives: Tax

New Tax Law Should Boost Crowdfunding

Whatever you think of the new tax law as public policy, adding to the country’s fiscal deficit and favoring the wealthy over the poor and the middle class, it includes several provisions that should make Crowdfunding investments more attractive, especially for real estate:

  • Income from “pass-thru” entities like limited liability companies and limited partnerships is eligible for a 20% deduction, off the top. This immediately makes investing in a pass-thru interest more attractive than investing in a publicly-traded stock, despite the one-time increase in value for publicly-traded corporations (all of them “C” corporations for tax purposes) due to the decrease in corporate tax rates.
  • Real property may now be depreciated faster, resulting in higher depreciation deductions – and thus lower taxable income – in the early years.
  • Depreciation of personal property (equipment, etc.) is also accelerated.

Lucky for me, the new law also presents many opportunities to change the structure of your business to save taxes, penalizing some activities, rewarding others. If you’d like to talk about maximizing the benefits for your business, let me know.

Improving Legal Documents in Crowdfunding: New IRS Audit Rules

In the Crowdfunding world, almost every equity investment involves a limited limited liability company. Because (1) limited liability companies are treated as partnerships for tax purposes, and (2) Congress has just turned the law governing tax audits of partnerships on its head, all those LLCs will need to revise their Operating Agreements. And all new LLCs will have to follow suit.

Until now, tax disputes involving partnership were conducted at the partner level. That means the IRS had to pursue partners individually, based on each partner’s personal tax situation. With its budget cut and manpower reduced, the IRS was unable to pursue everybody.

Seeking to streamline partnership audits and ultimately collect more taxes, the (bipartisan) law just passed reverses that rule.  Now, the IRS conducts audits at the partnership level and no longer has to argue with all those partners and their accountants. In fact, even though partnerships are not normally subject to tax, under the new law the partnership itself must pay any tax deficiency arising from the audit, unless it makes a special election.

EXAMPLE: NewCo, LLC owns an apartment building. The IRS decides NewCo used the wrong method of depreciation, and adds $1 million to NewCo’s taxable income. Under the new law, NewCo itself is liable for tax on $1 million, calculated at the highest possible tax rate. However, NewCo may elect to make its members personally liable instead.

Under old law, every partnership had a “tax matters partner” with broad administrative responsibilities. The new law creates a much more powerful position, the “partnership representative,” with the power to bind the partnership and all of its partners on tax matters. The partnership representative doesn’t even have to be a partner, just a person or entity with a substantial U.S. presence:  an accounting firm, for example.

The law becomes effective in 2018. Between now and then, all existing limited liability companies should revise their Operating Agreements to:

  • Provide whether taxes due as a result of tax return audit will be paid at the partnership or partner level
  • If the tax is paid at the partnership level, how the economic cost will be shared by the partners
  • Designate a partnership representative
  • Describe the duties and powers of the taxpayer representative, within the statutory limits
  • Describe the obligations of the partnership and partners to share tax-related information

Obviously, all new limited liability companies should deal with those issues at the outset.

Questions? Let me know.

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.

 

Crowdfunding? Form a “C” Corporation

One of the earliest decisions for every entrepreneur is the form of his or her company – whether a C corporation, an S corporation, a partnership, or a limited liability company. Designed as the perfect business entity, combining the flow-through tax treatment of a partnership with the liability protection of a corporation, the LLC is the first choice of many.

Things look different in the Crowdfunding universe, however. A company raising money on the Internet – whether in a true Crowdfunding offering or in a Rule 506 offering to accredited investors – will by definition end up with lots of investors, at least dozens, perhaps hundreds. Practically speaking, a company with dozens or hundreds of investors must be a C corporation.

Start with the tax filing requirements for partnerships, LLCs, and S corporations. At the end of each tax year the company must send a K-1 schedule to each owner. More exactly, two K-1 schedules, one for Federal taxes and one for state taxes. If a company has a dozen investors preparing all the K-1s is hard enough. For a small company with 100 investors the burden would be untenable.

On top of that, some states impose a per-head fee based on the number of owners. In New Jersey, for example, the fee is $150 per owner. Multiply that by 100 or more and we are talking about a serious cost for a startup company.

The lesson is unavoidable:  absent very unusual circumstances, a crowdfunded company must be a C corporation.

But that does not mean that all of the LLCs looking to the JOBS Act for funding will have to convert to C corporations. Instead, we anticipate that an existing LLC will form a separate C corporation as a member, and that the “crowd” investors will own stock in that company. The LLC will issue only one K-1 schedule and the separate C corporation will count as only one owner, despite having hundreds of stockholders.

For example, suppose Newco, LLC wants to raise $500,000 in exchange for 30% of its stock. Newco, LLC will issue 30% of its stock to a newly-formed C corporation, Investor Corp, Inc. Investors will purchase stock in Investor Corp, Inc., not Newco, LLC.

Using a C corporation will potentially impose a second level of tax if Newco, LLC is sold, and investors who purchase stock in Investor Corp, Inc. will not be entitled to write off “pass thru” losses for tax purposes. But in the Crowdfunding universe, that’s the lay of the land.

%d bloggers like this: