BUYING & SELLING PARTNERSHIP/LLC INTERESTS - ECONOMIC, MANAGEMENT & TAX ISSUES First Run Broadcast: February 4, 2015 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) This program will provide you with a practical guide to the tax and non-tax consequences of selling or exchanging partnership and LLC interests. Though these transactions are commonplace, they have complex tax consequences for the partnership or LLC, their sellers and buyers. There are many ways to structure these transactions to minimize adverse tax consequences short of a straight sale or exchange. There are also non-tax issues to consider, including what, if any, management and voting rights transfer to the buyer. This program will provide you with a detailed and practical guide to structuring and drafting the sale and exchange of partnership and LLC interests.

• Planning and drafting issues for selling/exchanging LLC and partnership interests – and effective alternatives

• Tax consequences to the entity and buyers/sellers in sales and exchanges of entity interests

• Using distributions as an effective alternative to sales and exchanges • Disguised sales of LLC/partnership interests – and techniques to avoid • Constructive terminations and their adverse tax consequences • Issuance of an interest in a disregarded entity for federal income tax purposes

Speaker:

Brian J. O'Connor is a partner in the Baltimore office of Venable, LLP, where he is co-chair of the firm’s tax and wealth planning group. He provides sophisticated tax and business advice to closely-held and publicly-traded businesses and their owners. Before joining Venable, Mr. O’Connor was an attorney-advisor in the Office of the Chief Counsel of the IRS, where he worked on high profile legislative projects, regulations and other published guidance relating to pass through entities. Mr. O’Connor received his J.D., magna cum laude, from Washington and Lee University School of Law and his LL.M. in tax law, with distinction, from Georgetown University Law Center.

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Buying & Selling Partnership/LLC Interests: Economic, Management & Tax Issues

Teleseminar February 4, 2015

1:00PM – 2:00PM 1.0 MCLE GENERAL CREDITS

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Please note: This form is for your records in the event you are audited Sponsor: Vermont Bar Association Date: February 4, 2015 Seminar Title: Buying & Selling Partnership.LLC Interests: Economic, Management & Tax

Issues

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.

Business and Transactional Issues in Connection with Sales/Exchanges of Partnership/LLC Interests

Rob Wollfarth Baker, Donelson, Bearman, Caldwell & Berkowitz, PC 201 St. Charles Avenue, Suite 3600 New Orleans, LA 70170 Direct: 504.566-8623 Fax: 504.585.6923 E-mail: rwollfarth@bakerdonelson.com www.bakerdonelson.com

Presentation Topics

In the mergers and acquisitions world there are a multitude of different

kinds of transactions involving partnership or llc interests. This portion of

the presentation will focus on two general categories of transactions

involving the transfer of these interests:

I. Buy-ins

II. Buy-outs

Key Buy-in Issues to Consider

• Acquisition structure

• Price

• Percentage Interest

• Effective Date

• Structuring Return on Investment

• Treatment of Existing and Contingent Entity Liabilities

• Management Rights

• Other Partnership/LLC Buy-in Terms

• Transactional Documents Potentially Required

Buy-in Acquisition Structure

• Purchase from one or more existing owners

• Purchase from the entity

• Combination

Buy-in Price

• What form of consideration is the buyer paying?

• cash and/or property

• conversion of debt to equity

• a note

• sweat equity

• combination

• How is payment secured?

Buy-in Percentage

• To what percentage ownership in the company is the buyer entitled?

• If the entity is the seller,

• Does the buyer’s negotiated percentage equal the ratio of the value

of the buyer’s payments to the entity’s total value?

• How much percentage ownership is the entity giving the buyer in

exchange for cash and other property? For sweat equity?

• To what extent is the percentage contingent?

Buy-in Effective Date

• “Effective as of” date versus execution date

• January 1 is often the cleanest

• Entity distribution schedules may play a role

• Financing can be a factor

• Timed needed to finalize terms

Structuring Buyer’s Return on Investment

• In accordance with percentage ownership interests

• A preferred return

• capital only

• 100%

• up to certain percentage of entity distributions

• percentage of capital only

• capital plus percentage of capital

• 100%

• up to certain percentage of entity distributions

Treatment of Existing and Contingent Entity Liabilities

• Post-closing Entity distributions may be redirected to cover negative

effects on entity value

• Buyer’s percentage ownership interest may be re-calculated

• Buyer may be granted withdrawal rights

Buyer’s Managements Rights

• Controlling

• In proportion to percentage ownership interest but not controlling

• Veto rights with respect to certain major decisions

Other Buy-in Terms

• Additional capital contributions

• Limitations on admission of other owners

• Preemptive rights

• Withdrawal

• Non-compete, Non-solicitation, Confidentiality, IP Protection

• Distributions

• Actions requiring member consent

• Drag-along rights

• Tag-along rights

• Right of First Refusal

• Spousal consent

Potential Buy-in Documentation Required

• Letter of Intent/Term Sheet

• Confidentiality Agreement

• Ownership Interest Purchase Agreement

• Assignment of Ownership Interest

• Certificate of Ownership

• Operating/Partnership Agreement

• Amended and Restated Organizational Document

• Authorizing Resolutions

• Private Placement Memorandum

• Arms-length agreements such as Employment, Consulting and

Management Agreements

• Loan Documents

Key Buy-out Issues to Consider

• Buy-out structure

• Price

• Percentage Interest

• Effective Date

• Mutual Release

• Mutual Indemnification

• Third-party Creditor Releases

• Other Buy-out Terms

• Transactional Documents Potentially Required

Buy-out Structure

• Redemption by the entity

• Purchase by one or more existing owners

• Purchase by unrelated third-party purchaser

• Combination

Buy-out Price

• What form of consideration is the buyer paying?

• cash and/or property

• a note

• release of liability

• combination

• How is payment secured?

Buy-out Percentage

• In the settlement context, 100% is probably preferred.

• However, there are a number of instances in which a partial buy-out

may be desired.

• owner assumes lesser role but seeks to maintain some economic

interest

• failure to contribute additional capital

• voluntary transfer to create some liquidity

Buy-out Effective Date

• “Effective as of” date versus execution date

• January 1 is often the cleanest

• Distribution schedules may play a role

• Financing can be a factor

• Timed needed to finalize terms

• Nature of claims to be released

Buy-out Mutual Release

• In a settlement context, parties want to separate cleanly.

• Generally, key terms are

• release is mutual

• full release from any claims arising before closing

• claims arising after closing or due to breach of settlement

agreement are typically carved out

• parties to be released and claims to be released are broadly defined

Buy-out Mutual Indemnification

• Mutual release may be necessary but is not sufficient, particularly in

connection with third-party claims.

• Generally, key terms are

• indemnifying and indemnified parties probably the same as for

mutual release

• nature of claims giving rise to indemnification – certainly released

claims, any assumed obligations and claims related to ownership

interest in entity

• limitation on scope of damages

• survival period of indemnification obligation

• security for indemnification

Third-party Creditor Releases in Buy-out

• Getting away clean often means for the former owner disentangling

him/her/it-self from personal guaranties and security pledged for

company debts.

• Maybe easier said than done.

Other Buy-out Terms

• Frequent buy-out misconceptions

• Ensuring distributions are properly accounted for

• Representations and Warranties

• Non-disparagement

• Withdrawal

• Spousal consent

Potential Buy-out Documentation

• Letter of Intent/Term Sheet

• Ownership Interest Purchase Agreement/Settlement Agreement

• Assignment of Ownership Interest

• Authorizing Resolutions

• Resignations/Termination of Arms-Length Agreements

• Dismissals from Litigation

• Loan Documents

BUYING & SELLING PARTNERSHIP/LLC INTERESTS

Professional Education Broadcast Network

Brian J. O’Connor

Venable LLP

February 4, 2015

BASIC ASSUMPTIONS

• Most, but not all, partnerships and LLCs are treated as partnerships for tax purposes.

• Most, but not all, transfers of partnership/LLC interests are respected as transfers of ownership interests in entities for tax purposes.

• Many, but not all, transferors will recognize gain for tax purposes to the extent that they receive consideration in excess of the basis of their partnership/LLC interests and loss to the extent that the basis of their partnership/LLC interests exceeds the consideration that they receive.

• Transfers of partnership/LLC interests can take the form of direct transfers or as “disguised” transfers.

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TREATMENT OF TRANSFERORS

• Any gain or loss realized upon a sale or exchange of a partnership/LLC interest is generally treated under IRC Section 741 as gain or loss from the sale of a capital asset.

• Gain or loss is computed under IRC Section 752(d) by adding the value of any cash or property received by the transferor to the transferor’s share of partnership liabilities and then comparing that amount to the transferor’s adjusted tax basis.

• If a transferor owns multiple types of partnership/LLC interests, the transferor still is treated as having only one unified basis in its overall partnership/LLC interest.

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TREATMENT OF TRANSFERORS (cont.)

• Notwithstanding the general rule, if the partnership/LLC holds ordinary income assets such as depreciation recapture, inventory or unrealized receivables (so-called “hot-assets”), the transferor will recognize ordinary income or loss under IRC Section 751(a) to the extent of its share of those assets.

• As a result of IRC Section 751(a), the transferor may recognize a mixture of capital gain and ordinary income as a result of a transfer of a partnership/LLC interest. It is also possible for the transferor to recognize ordinary income and a capital loss on a transfer.

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TREATMENT OF TRANSFERORS (cont.)

• As a general rule, gain recognized from the sale of a partnership/LLC interest will not be subject to the 3.8% Medicare tax under IRC Section 1411 if the transferor is “active” in the partnership/LLC for IRC Section 469 passive loss purposes.

• However, if the transferor holds the partnership/LLC interest as part of a passive activity under IRC Section 469, the 3.8% Medicare tax under IRC Section 1411 will apply to the transferor.

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TREATMENT OF TRANSFEREES

• The transferee’s initial tax basis in the partnership/LLC interest is determined under the general IRC Section 1012 cost basis rules and includes its applicable share of partnership/LLC liabilities.

• If an interest is acquired from a decedent, the transferee’s basis in the interest is the date of death value less the decedent’s share of income in respect of a decedent items.

• If an interest is acquired by gift, carryover basis rules apply with adjustments for any gift tax paid.

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TREATMENT OF TRANSFEREES (cont.)

• As a general rule, the basis of the assets in the partnership/LLC is not adjusted as a result of a transfer of a partnership/LLC interest.

• Notwithstanding the general rule, if the partnership/LLC has a substantial built-in loss (a “SBL”), the basis of partnership/LLC assets will be reduced to take such SBL into account.

• Also notwithstanding the general rule, if the partnership/LLC makes an election under IRC Section 754, the basis of partnership/LLC assets may be adjusted. Increases in basis as a result of an election under IRC Section 754 are referred to as “positive adjustments” and decreases in basis under such circumstances are referred to as “negative adjustments”.

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TREATMENT OF TRANSFEREES (cont.)

• Transfers of partnership/LLC interests generally will not change the holding periods of partnership/LLC assets.

• If a transferee acquires 100% of the interests in a partnership/LLC, the transferee is treated as if it acquired the assets of the partnership/LLC for tax purposes. The transferor, however, is generally still treated as selling partnership/LLC interests.

• Under these circumstances, the basis and holding periods of partnership/LLC assets will be adjusted to mirror an actual purchase of partnership/LLC assets.

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TRANSFERS OF PARTNERSHIP/LLC INTERESTS

IN DISREGARDED ENTITIES • A transfer of all of the partnership/LLC interests in a

disregarded entity is treated as a transfer of assets from the transferor to the transferee for both the transferor and the transferee.

• A transfer of less than all of the partnership/LLC interests in a disregarded entity is treated as a partial asset transfer to the transferee and partial asset transfer to a new regarded partnership/LLC.

• The technical aspects of these transactions are described in Rev. Rul. 99-5.

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PARTNERSHIP/LLC TERMINATIONS

• A transfer or exchange of 50% or more of the total

interests in partnership/LLC capital and profits within a 12-month period will “terminate” the partnership/LLC for income tax purposes under IRC Section 708(b)(1)(B).

• If a partnership/LLC “terminates”, the partnership/LLC is deemed to transfer its assets to a new partnership/LLC in exchange for interests in such new partnership/LLC and then distribute such interests to its partners/members in liquidation.

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PARTNERSHIP/LLC TERMINATIONS

(cont.)

• If a partnership/LLC terminates under IRC Section 708(b)(1)(B), the tax year closes on the day of the termination.

• As a result, a short-year partnership/LLC tax return will be due.

• Also, if the partnership/LLC holds depreciable assets, the partnership/LLC must “restart” its depreciation of those assets.

• Other consequences.

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PARTNERSHIP/LLC TERMINATIONS

(cont.) • Partners/members sometimes can avoid a

partnership/LLC termination by waiting to fully transfer an interest until 12-months and one day.

• Gifts of partnership/LLC interests and redemptions of partnership/LLC interests generally do not count toward determining if a partnership/LLC termination takes place but tax-free transfers to other partnerships/LLCs or corporations generally are taken into account.

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OTHER TRANSFER ISSUES

• Installment sales of partnership/LLC interests.

• Transfers of interests in partnerships/LLCs holding installment notes.

• Abandonments.

• Treatment of partners/members other than the transferor and transferee.

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BASIS ADJUSTMENTS

• As stated above, general rule is no adjustment to the basis of partnership/LLC assets upon a transfer of a partnership/LLC interest.

• Mandatory adjustments when SBL – which exists when the basis of all partnership/LLC property exceeds its fair market value by at least $250,000.

• Optional adjustments if partnership/LLC makes an election under IRC Section 754.

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BASIS ADJUSTMENTS (cont.)

• If partnership/LLC makes an election under IRC Section 754, transferee receives the benefits under IRC Section 743(b) of a basis adjustment to partnership/LLC assets equal to difference between the transferee’s initial “outside basis” and the transferee’s share of the “inside basis” of partnership/LLC assets.

• This basis adjustment can be positive or negative and is “special” to the transferee partner/member.

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BASIS ADJUSTMENTS (cont.)

• IRC Section 743(b) adjustments are intended to provide the transferee with basis benefits similar to what the transferee would have received if it had purchased partnership/LLC assets directly (although not pure aggregate approach).

• IRC Section 743(b) basis adjustment generally acts as additional basis for all purposes.

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PLANNING/DRAFTING ISSUES

• If you represent a transferee who may benefit from an IRC Section 754 election, you should insist upon the partnership/LLC making the election for the year of the transfer.

• If an IRC Section 754 election would result in a negative basis adjustment, then you would not want the election to be made (although the adjustment would apply anyway if there is a SBL).

• In representing the transferee, you should also consider a “closing of the books” approach for partnership/LLC income in the year of the transfer.

• Regardless of who you represent, you should consider having a purchase price allocation that specifically provides for the values of any “hot assets.”

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Contact Information

Brian J. O’Connor

Venable LLP

(410) 244-7863

bjoconnor@venable.com

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