Godfrey & Kahn Updates
Return of Tax Distributions upon Forfeiture of Unvested LLC UnitsNovember 13, 2013
Many limited liability companies (LLCs) grant service providers equity representing an interest in future income and appreciation of the business without any right to the value of the LLC on the date of grant. If structured properly, these “profits interests” are tax-free to the service provider on the grant date.1 Further, as income or capital gain is realized by the LLC, owners of profits interests receive allocations of income or capital gain dependent on the character generated by the LLC. Thus, an owner of a profits interest often recognizes capital gain rather than ordinary income upon the sale of the LLC.
Profits interests are often granted subject to a temporal vesting schedule to incent the recipient to make a long term commitment to the LLC. If a service provider does not receive grants of income and share in distributions prior to vesting, IRS may argue that the profits interest has not truly been granted until it vests.2 This can be problematic if the LLC appreciates between the date the interest was nominally granted and the date of vesting because the recipient’s share of such appreciation would be taxable to the recipient as ordinary income on the date of vesting. In order to avoid a profits interest being treated as granted upon vesting, most LLCs allow unvested profits interests to participate in allocations and distributions.
If a service provider receives income allocations with respect to an unvested profits interest, the service provider will likely also be entitled to tax distributions to provide the service provider funds to pay the tax attributable to the allocation. For example, if the service provider receives a $100 income allocation, the service provider is typically distributed $40 so the service provider can pay the tax on the income, leaving the service provider with a $60 capital account. If the profits interest is subsequently forfeited, the $60 of capital is re-allocated to the other members of the LLC and the forfeiting service partner receives a tax deduction or loss of $60.
According to proposed regulations from the IRS, the capital account attributable to a forfeited interest is reallocated to the other Members through “forfeiture allocations” of tax deduction items equal to the capital accounts of the forfeited Units.3 Using the numbers in the example in the preceding paragraph, the service provider would be specially allocated $60 of the LLC’s deductions, causing his capital account balance to be zero. Use of the deduction in the special allocation would increase the other Members’ share of taxable income for the year by $60.
The forfeiture allocation results in a windfall to the service provider in the sense that the service provider used tax distributions from the LLC to pay the tax on the increase in his capital account, but receives deductions he can use to offset other income when the capital account is forfeited. Similarly, the other Members are unfairly harmed in that the LLC paid tax distributions to the forfeiting service provider and now must make additional tax distributions on the same income to the other Members when the capital is re-allocated to the other Members.
The following alternatives should be considered when drafting the LLC’s Operating Agreement and the Grant Agreement:
- Draft the Operating Agreement in a manner which allows the LLC to take the position that the proposed regulations do not apply. Instead of making forfeiture allocations, the LLC would report the shift of capital from the forfeiting member to the other members as tax free to the other members. While this position entails tax risk for the other members in that it is contrary to the proposed regulations, the regulations were proposed in 2005 and have not yet been finalized.
- Require the service provider to pay back all tax distributions with respect to the forfeited Units. This solution has intuitive appeal in that the service provider is receiving a windfall tax benefit at the time of forfeiture equal to the unintended detriment suffered by the other members. Note that the repayment itself will generate basis (and a further loss) for the terminated service provider and additional income to the other members. The problem with this solution is that the forfeiting service provider has already used the tax distributions to pay tax in the year of allocation and may not be able to use the deduction in the year of forfeiture. Thus, the forfeiting service provider could effectively be required to pay an amount equal to the tax distributions out of his own unrelated funds. Alternatively, the forfeiting service provider’s obligation to repay the tax distributions could be limited to the amount of tax benefit received by the service provider.
- Reduce other payments to the service provider by the amount of tax distributions received with respect to the forfeited Units. The LLC may want to avoid requiring full repayment of prior tax distributions in order to avoid requiring the service provider to use unrelated funds for the repayment. In such case, the LLC could take the interim position of requiring an offset of other amounts due to the terminating service provider to the extent of prior tax distributions. For instance, if the service provider also owns some vested Units which the LLC will redeem in connection with the service provider’s termination, the redemption price could be reduced to the extent of prior tax distributions.
If you would like to discuss any of these alternatives in more detail or would like sample language implementing these provisions, please contact any member of the tax team.
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Pursuant to Circular 230 promulgated by the Internal Revenue Service, if this correspondence, or any attachment hereto, contains advice concerning any federal tax issue or submission, please be advised that it was not intended or written to be used, and that it cannot be used, for the purpose of avoiding federal tax penalties unless otherwise expressly indicated.
2 See Rev. Proc. 2001-43.
3 Prop. Reg. § 1.704-1(b)(4)(xii)(b) (2005).