Time Is Running Out to Defer Income Recognition from Debt-Equity Exchanges
Restructures of financially distressed firms often involve debt-equity exchanges. The concept is straightforward: the company issues equity to its lenders in exchange for their cancellation of some of the company’s debt. The company’s debt burden and interest payment expenses are reduced and its balance sheet is strengthened.
On the downside, the company’s equity holders are diluted, often substantially. The alternative to the restructure, of course, may be a chapter 7 bankruptcy in which the equity owners are wiped out. Lenders don’t usually want to take equity in their debtors, but depending on its security position, a lender may view a debt-equity exchange as a preferable alternative to liquidation or as a necessary component of a chapter 11 case. The exchange will provide the lender with upside on the equity it receives, assuming the company survives and ultimately prospers.
The details of a debt-equity exchange are complex. Multiple classes of debt and equity may be involved. The company and the debtors will need to agree on valuations of different classes of debt and equity, on how much debt and how much equity to exchange, and on the classes and amounts of equity to be exchanged. And as with any major corporate transaction, the tax consequences have to be considered.
If the amount of debt that is cancelled exceeds the fair value of the equity issued in exchange for the debt, the company will recognize cancellation of debt (COD) income in the amount of the excess. I.R.C. § 61(a)(12), § 108(e)(8). If the debtor is an LLC, the equity may consist of either a capital or a profits interest in the LLC.
The Code provides several exceptions to recognition of COD income, including an insolvency exception. If the company issuing the equity is insolvent or in a title 11 bankruptcy case immediately before discharge of its debt, it will not recognize COD income. I.R.C. § 108(a). The tax obligation is deferred and not completely eliminated, because what would otherwise be COD income is applied to reduce several of the company’s tax attributes, beginning with its net operating loss carryovers. I.R.C. § 108(b).
The tax rules on debt-equity exchanges apply to corporations and to LLCs in the same way, with one significant exception. LLCs are taxed as partnerships and LLC income is passed through to the members. COD income of an insolvent LLC will therefore be allocated to the members, but they cannot use the § 108 insolvency exception based solely on the LLC’s insolvency. The members have the income, but the LLC has the insolvency. Not unless the member itself is insolvent can it claim the insolvency exception.
In many cases the member will not be insolvent, in which case the LLC’s COD income will be included in the member’s income unless any of several other exceptions apply to that member. And if the LLC is insolvent, there won’t be any cash distributions to the members to cover their tax bill from the COD income.
LLC members caught in this situation may be able to defer COD income from a debt-equity exchange, if the exchange occurs before the end of this year. The American Recovery and Reinvestment Act of 2009 added a new Code § 108(i), which allows taxpayers incurring COD income as a result of debt-equity exchanges occurring during 2009 or 2010 to elect to defer that income.
The deferred income will be included in the taxpayer’s income ratably over five years, starting in 2014 and ending in 2018. The deferral election is made by attaching a statement to the taxpayer’s return for the taxable year in which the debt-equity exchange takes place. The deferral is accelerated into any year in which the taxpayer’s death, sale of the LLC interest, or cessation of doing business occurs.
The deferral will be attractive for most LLC members receiving COD income. Whether it’s the right choice will depend on the taxpayer’s individual situation, and on what happens to income tax rates during 2014 through 2018.
But the clock is running down on this deferral opportunity. If an LLC restructures with a debt-equity exchange that closes after December 31, 2010, its members will no longer be able to elect the deferral. As the end of 2010 approaches, LLCs contemplating debt-equity exchanges should consider timing the transaction to ensure closing before the year end, in order to preserve the members’ ability to elect the deferral.
The IRS Again Loses in Attempt to Limit the Deductibility of LLC Losses
The Tax Court has again ruled against the Internal Revenue Service in a case on the deductibility of a member’s LLC losses. Newell v. Commissioner, T.C.M. 2010-23 (Feb. 16, 2010). Last year I wrote about the three prior cases, here.
In these cases the IRS has taken the position that its regulations require a presumption that LLC losses are “passive activity losses” (passive losses). Under the regulations this presumption is difficult to overturn, so in many cases LLC losses are treated as passive losses. And for most taxpayers, passive losses are far less useful than active losses (losses not resulting from passive activities). Taxpayers generally prefer to use losses to offset taxable income, but passive losses can only be used to offset income from other passive activities, and not against income such as wages, interest, and dividends.
The Tax Court ruling in Newell is consistent with the prior cases in its interpretation of the IRS’s regulations. The regulations create a presumption that losses incurred by a limited partner in a limited partnership are passive losses, and make it difficult to overcome the presumption. The IRS has taken the position that a member of an LLC should be treated like a limited partner of a limited partnership for purposes of the regulation. The courts, including the Tax Court last month in Newell, have rejected the IRS’s argument.
This latest case should give additional comfort to LLC members, that they should be able to use LLC losses to offset “active” income such as wages. LLC members will still need to demonstrate that they materially participate in the LLC’s management, but they will be able to use the more flexible rules of the IRS’s regulations, without the need to overcome the presumption against material participation.
The IRS could of course change these regulations to explicitly treat LLCs in the same way that limited partnerships are treated. Because LLCs are relatively new, the IRS may still be trying to figure out how to deal with them while limiting the potential for abuse.
Confusion Over LLC Units
LLC operating agreements often use the term “units” to describe member rights in the LLC. It is convenient to have a word like “units” to label the members’ rights, and “units” is widely used. But “units” has no uniform definition or generally accepted meaning when applied to LLCs.
Andrew Immerman recently authored an article that examines the inherent ambiguity and the confusion that often results from using units to describe LLC member rights. L. Andrew Immerman, Is There Any Such Thing as an LLC Unit?, 11 No. 4 Bus. Entities 20 (July/Aug. 2009), 2009 WL 2563091. The article is a good review of how and why the units terminology is used and misunderstood. It provides examples of the mistaken conclusions that business people can reach when they ignore the differences between shares of stock in a corporation and the rights of a member in an LLC.
Immerman ascribes this confusion to three principal causes. First, business people and sometimes lawyers often think of an LLC as essentially similar to a corporation. Second, the state laws that authorize LLCs do not expressly authorize the issuance of LLC units or define an LLC unit. Third, LLC members are taxed differently than shareholders. LLC taxation can cause units in the same LLC to unexpectedly provide different benefits to their owners, unlike shares of stock, which are usually interchangeable.
There is no concept of “units” in the various state LLC statutes. For example, Washington’s LLC Act makes no reference to units, and simply defines a member’s LLC interest as personal property comprising the member’s share of the profits and losses of an LLC, and the right to receive distributions of the LLC’s assets. Wash. Rev. Code §§ 25.15.005(6), 25.15.245(1).
Delaware’s LLC Act likewise makes no reference to units, and has an almost identical definition of a member’s LLC interest. Del. Code Ann. tit. 6, §§ 18-101(8), 18-701. And neither NCCUSL’s Revised Uniform Limited Liability Act nor the Revised Prototype Limited Liability Company Act from the American Bar Association uses that terminology.
LLCs are distinct from corporations in a number of ways. One major difference is that an LLC is much more a creature of contract than is a corporation. LLC member rights are normally defined by the members’ operating agreement, and only secondarily by the LLC Act. Members are parties to the operating agreement, whereas corporate shareholders hold shares of stock but need not be parties to any contract. Most of a shareholder’s rights will generally be defined by the applicable corporate statute, while an LLC member’s rights will be defined by the terms of the operating agreement. A potential investor in an LLC cannot know what rights the holder of a unit will have without a careful examination of the operating agreement.
Another difference between LLCs and corporations is that the rights associated with ownership of a share of stock are not normally divided. If a share of stock is sold, the rights to receive dividends, to vote, and to receive corporate information will usually all go with the share of stock. Transfer of a member’s interest in an LLC, on the other hand, will convey the right to receive profits, losses and distributions, but it will not necessarily carry with it the right to vote and participate in management of the LLC. All the members must approve the transferee’s admission as a member and participation in management, or the operating agreement may provide for the transferee’s admission as a member. E.g., Wash. Rev. Code §§ 25.15.250, 25.15.260; Del. Code Ann. tit. 6, §§ 18-702, 18-703.
LLCs are taxed as partnerships (absent an election to be taxed as a corporation), so items of profit and loss are allocated directly to the members. The LLC is not a taxpayer. Corporations, in contrast, are taxpaying entities and do not pass profits or losses through to shareholders. (One exception: a corporation can make a Subchapter S election, in which case its shareholders will each be allocated their proportionate share of the corporation’s profits and losses. An S corporation, however, can have only one class of stock and cannot have nonresident aliens or certain types of entities as shareholders.)
LLC members generally want the LLC’s allocations to be respected for tax purposes. This is a matter of predictability and being able to accurately assess and plan for the economic benefits and tax consequences of their LLC investment. For the LLC’s allocations of profit and loss to be respected for federal income tax purposes, the allocations in the operating agreement must comply with a set of complicated Treasury regulations intended to ensure that the allocations have “substantial economic effect.” I.R.C. § 704(b)(2). One of those requirements is that a capital account be maintained for each member. A member’s capital account is increased by the member’s contributions to the LLC’s capital, by profits allocated to the member, and by LLC liabilities assumed by the member, and decreased by distributions paid and losses allocated to the member, and by liabilities of the member assumed by the LLC.
The regulations also require, when the LLC is dissolved and its assets liquidated, that liquidating distributions be made to the members in accordance with the positive balances in their capital accounts. This is a key requirement of the allocation regulations, and has the effect of truing up the final, liquidating distributions with the effects of the LLC’s history. All the prior member capital contributions, distributions to members, and allocations of profits and losses would have impacted each member’s capital account in ways that may have varied from member to member.
Assuming the LLC’s operating agreement complies with these rules, the result is that on liquidation one member may receive substantially more or less per unit than another member receives per unit. A corollary is that at any point in the life of the LLC, one member’s unit may be worth more or less than a different member’s unit. One might try to define “unit” in the operating agreement to take capital account variations into effect, but then the definition would likely not work well for attributes such as voting and establishing percentages for profit and loss allocations.
In corporations it’s different and much simpler. At any given time the corporation’s capital per share is the same amount for all outstanding shares of common stock. If a corporation is dissolved and liquidated, the liquidating distributions per share of common stock will be the same amount for all the shares. “Holders of corporate stock need not worry about capital accounts, and the superficial resemblance of LLC units to corporate stock may create the impression that LLC members can safely ignore the concept as well. It can be perilous, however, to ignore LLC capital accounts.” Immerman, supra, at 62.
In all states LLCs now lead corporations in formations of new business entities. For many business people LLCs are relatively new and sometimes perplexing. Their lawyer or the other parties may present them with operating agreements that describe their interests as “units.” They may be familiar with corporations, but should not be misled by the surface similarities and assume that those units are comparable to shares of stock. The operating agreement should be read and analyzed carefully. The ways in which units are handled in the agreement needs to be thoroughly understood. Because many of the results of a member’s investment will depend on the tax treatment of allocations and capital accounts, an experienced tax advisor should usually be consulted.
Former LLC Member: Why Does My K-1 Show All This Income?
An LLC member, Mr. Smith, sells his member interest and terminates all connections with the LLC. The sale agreement ends Smith’s rights in the LLC. Smith moves on and doesn’t think much more about the LLC. Many months later, Smith receives a Schedule K-1 from the LLC. >
Schedule K-1 is the form an LLC uses to inform each member of the member’s share of income, losses, deductions, credits and so on. Like almost all LLCs, Smith’s former LLC is taxed as a partnership for federal income tax purposes, and the LLC’s income and losses for each tax year are allocated to its members. The members then each pay taxes on their share of the LLC’s income for that year, or use the losses to shelter other income. (The ability to use losses to shelter other income is subject to various limitations. See my prior post on passive income loss limitations, here.)
Smith is shocked to see that the K-1 shows a whopping allocation of income to him for the last year of his membership in the LLC. He realizes that that income will have to be reported on his own personal tax return and will substantially increase his tax bill, and he didn’t receive any cash distribution from the LLC to cover those extra taxes. Based on what he knows about the LLC’s operations and finances towards the end of his involvement with it, he doesn’t understand how or why so much income was allocated to him. What does he do?
Naturally Smith starts asking questions. He requests copies of the LLC’s financial records so his CPA can evaluate the correctness of the LLC’s allocations. The LLC, however, points out that Smith is no longer a member, so its operating agreement gives him no right to see the records. The LLC also notes that the state LLC Act only allows members, not former members, to access LLC records. In short, he is politely told to go roll his hoop.
The plaintiffs in Abdalla v. Qadorh-Zidan, 913 N.E.2d 280 (Ind. Ct. App. Sept. 10, 2009), were faced with this situation. The Qadorh-Zidans (Zidans) and the Abdallas had formed five LLCs to own and operate apartment properties. Later the Abdallas filed a lawsuit against the Zidans alleging breach of fiduciary duty and usurpation of corporate opportunities. That suit was resolved through a settlement that included a buyout – the Zidans sold their membership interests in the LLCs to the Abdallas in August 2006.
In the fall of 2007 the Zidans received tax returns and K-1 Schedules from the LLCs for the tax year ending on the date of the buyout. The Zidans alleged discrepancies in the K-1s and requested accounting information and records from the LLCs for the time period when they were members. The Abdallas refused, so the Zidans filed a complaint alleging breach of fiduciary duty and seeking declaratory relief to inspect the books and records of the LLCs for the period when they were members. The Zidans sought discovery of the requested information, which was stayed pending a summary judgment motion by the Abdallas. The trial court’s denial of the Abdallas’ motion was appealed.
The Abdallas contended that any fiduciary duties owed to the Zidans terminated when they ceased being members of the LLCs, because the Zidans no longer had any rights under the operating agreements and because their settlement agreement in the first lawsuit included a relinquishment of all of the Zidans’ rights as members. The Zidans maintained that fiduciary duties should remain intact with respect to the resolution of pre-separation business, and that therefore the fiduciary relationship covered the preparation of the tax return which was completed after the Zidans sold out.
The court held that the Abdallas owed a fiduciary duty to the Zidans regarding the preparation of tax returns for the period during which the Zidans were members of the LLCs. Abdalla, 913 N.E.2d at 286. As the court said, “To hold otherwise would give the Abdallas the freedom to allocate tax burdens to the Zidans and retain tax benefits for themselves without allowing the Zidans any recourse to verify or rectify this allocation.” Id.
The court reached a similar result on the question of whether the Zidans had a right of access to the LLCs’ books. Although the Indiana LLC Act only gives members the right to access an LLC’s records, Ind. Code § 23-18-4-8(b), the court held that the Zidans, as former members, had a right to access the records covering the time period while they were still members of the LLCs. Abdalla, 913 N.E.2d at 287.
Many state LLC Acts, like Indiana’s, do not address what inspection rights former LLC members have. For example, the LLC Acts of Washington, Oregon and Delaware are silent on inspection rights for former members. There’s no reason why state statutes can’t address this issue, though. The Illinois LLC Act, for example, provides that former members have a right of access for a proper purpose to LLC records pertaining to the period when they were members. 805 Ill. Comp. Stat. 180/10-15. The Revised Uniform Limited Liability Company Act and the Uniform Limited Partnership Act also have comparable provisions giving former members limited access rights.
When the Zidans resolved their first dispute with the Abdallas through a buyout of the Zidans’ interests in the LLCs, they apparently did not consider the inevitable entanglement resulting from the tax flow-through treatment of the LLCs. In an LLC buyout there will usually be a time lag from the buyout to the computation and allocation of the LLC’s profits and losses, and the distribution of the Schedule K-1s.
There’s a moral here. A member selling its interest in an LLC should consider adding provisions to the buyout agreement for later access to the LLC’s accounting records and for consultation with the LLC’s manager or CPA over the tax allocations and the preparation of tax returns, for the period when the seller was a member. The seller should also consider provisions for notice, access to records and consultation regarding any later amendment to the LLC’s previously filed tax returns, or any IRS contact with the LLC or tax audit for the period before the buyout. These provisions can help the former member avoid unpleasant tax-related surprises, and can give the former member the tools necessary to investigate unexpected tax allocations.
Court of Federal Claims Upholds Deductibility of LLC Losses
Most business people who are familiar with the tax treatment of LLCs understand that LLCs are tax-efficient. LLCs are taxed as partnerships (except in the rare event that they elect to be taxed as corporations). Since they are taxed as partnerships, LLC profits and losses are passed through to the members. The pass-through of LLC profits avoids double taxation—profits are not taxed to the LLC and are only taxed to the members. The pass-through of LLC losses allows members to use the losses to offset against their other income, reducing their tax bills.
What is less well known, except by tax lawyers and CPAs, is that the IRS has interpreted its regulations so that LLC losses are presumed to be “passive activity losses” (passive losses). Furthermore, the presumption is difficult to overturn. The result is that under the IRS’s interpretation of its regulations, LLC losses are often treated as passive losses.
For most taxpayers, passive losses are much less useful than active losses (losses not resulting from passive activities). The reason is that passive losses may only be used to offset income from other passive activities, and not to offset “active” income such as wages, interest, dividends, etc. Internal Revenue Code (IRC) § 469. Instead, any passive losses that exceed “passive” income must be carried over to subsequent tax years until the taxpayer either has enough passive income to use the losses or disposes of the activity that generated the passive losses. Active losses, on the other hand, can be used to offset either active income or passive income. The IRS’s position greatly limits the income-sheltering benefits of losses for LLC members.
There are three reported opinions in which courts have ruled on this issue. The IRS lost in all three courts, most recently in Thompson v. United States, 87 Fed. Cl. 728 (July 20, 2009). (The IRS also lost in Garnett v. Commissioner, 132 T.C. No. 19 (June 30, 2009), and in Gregg v. United States, 186 F. Supp. 2d 1123 (D. Or. 2000).)
The plaintiff in Thompson had formed Mountain Air Charter, LLC to operate an on-demand air charter business. Thompson held 99% of the member interests in Mountain Air directly, and 1% through a subchapter S corporation. On his 2002 and 2003 individual income tax returns, Thompson claimed a total of $2.1 million of losses from Mountain Air and used those losses to offset against other income. The IRS disallowed all but $156,000 of those losses, contending that they were passive activity losses and could not be offset against non-passive activity income. Thompson paid the taxes assessed by the IRS and sought a refund, and when it was denied he brought suit, seeking a tax refund of $781,241 plus interest.
The Thompson case turned on the interpretation of IRS regulations that were adopted under the authority of IRC § 469. Section 469 was adopted as part of the Tax Reform Act of 1986 to address the growth in the 1980s of perceived abusive tax shelters. Many of those tax shelters were formed as limited partnerships that allowed investors to use partnership tax losses to shelter their income from wages or self-employment.
Section 469 establishes limitations on passive activity losses and defines a “passive activity” as a business activity in which the taxpayer does not “materially participate.” It also requires, in the case of limited partnerships, that a limited partner’s participation not be treated as “material participation,” except as provided in IRS regulations. IRC § 469(h)(2). Following the passage of IRC § 469, the IRS adopted temporary regulations that define how an investor can demonstrate material participation in an activity, but that also greatly restrict the ways in which a limited partner can demonstrate material participation in a limited partnership. Treas. Reg. § 1.469-5T. Limited liability companies were new and were used very little at that time, so the temporary regulation did not explicitly address LLCs.
The key regulatory provision that was at issue in Thompson provides:
(i) In general. Except as provided in paragraph (e)(3)(ii) of this section, for purposes of section 469(h)(2) and this paragraph (e), a partnership interest shall be treated as a limited partnership interest if—
(A) Such interest is designated a limited partnership interest in the limited partnership agreement or the certificate of limited partnership, without regard to whether the liability of the holder of such interest for obligations of the partnership is limited under the applicable State law; or
(B) The liability of the holder of such interest for obligations of the partnership is limited, under the law of the State in which the partnership is organized, to a determinable fixed amount (for example, the sum of the holder’s capital contributions to the partnership and contractual obligations to make additional capital contributions to the partnership).
Treas. Reg. § 1.469-5T(e)(3)(i).
Although Mountain Air Charter, LLC was formed as an LLC under Texas state law, the IRS contended that the regulation applied to Thompson’s LLC member interests because Mountain Air was taxed as a partnership for income tax purposes and because the liability of the members of Mountain Air was limited under Texas law. Thompson’s response was simply that Mountain Air was not a limited partnership so his member interest could not be that of a limited partner. In short, the IRS wanted the LLC to be treated as a limited partnership for purposes of the regulation, and Thompson wanted the text of the regulation to be applied literally.
The court began its analysis by pointing out that an LLC is not a partnership. After a lengthy analysis of the language and purpose of the regulation, the court concluded that “[o]nce [the regulation] is read in context and with due regard to its text, structure, and purpose, it becomes abundantly clear that it is simply inapplicable to a membership interest in an LLC.” Thompson, 87 Fed. Cl. at 738.
Since the court ruled that the regulation did not apply, Thompson’s member interests were not presumed to be interests in a limited partnership. Thompson still needed to demonstrate that he was a “material participant” in the activities of the LLC, but in his case the IRS had already stipulated that if he did not hold a limited partnership interest under the regulation, his losses from Mountain Air would not be limited by the passive loss rules of Section 469. The upshot was that the court entered a judgment in Thompson’s favor in the amount of $781,241 on July 21, 2009, plus interest until paid.
The court’s holding in Thompson does not mean that all owners of LLCs will be out from under the passive loss rules. Instead, what Thompson stands for is that losses passed through to LLC owners will not be treated as per se passive. Owners of LLCs must still prove to the IRS that they materially participate in the LLC’s activity in order to use losses and credits from that activity against active income, but they can use the more flexible rules of Treas. Reg. § 1.469-5T(a).
For example, assume that one spouse owns a restaurant in an LLC while the other spouse works at a separate job as an employee. The LLC structure was chosen because it offered limited liability to the owner while not requiring the use of a corporation. The spouse who owns the LLC works full time managing the restaurant, including supervision of employees. The owner spouse should have little difficulty establishing that they materially participate in the restaurant business. Therefore, if the restaurant in any year incurs a tax loss, that tax loss should be available to offset the wage income of the employee spouse, assuming the husband and wife file a joint return.
Thompson enhances the flexibility that LLCs offer to entrepreneurs and small businesses. Their use will still require advance tax planning to ensure that owners will be treated as materially participating. Clarification that the per se passive rule does not apply to LLCs, however, means that owners who do materially participate need no longer fear that tax losses cannot be used to offset “active” income.
One last word of caution. The Thompson, Garnett and Gregg cases are not the last word on this .jpg)
issue, even though the IRS is apparently not appealing Garnett or Thompson. All three courts were trial courts, not appellate courts, so their decisions are not binding on the IRS in other taxpayer disputes. Nonetheless, after three at-bats and three strikeouts, it seems unlikely that the IRS would continue to attempt to apply Treasury Regulation § 1.469-5T to LLCs in the same restrictive manner as in Thompson. The Service might, however, continue to assert the same loss-limiting position that it did in these cases, against other taxpayers on audit in order to leverage higher settlements. Or, the Service could change its regulations to explicitly require that LLC losses be presumed to be passive losses. Watch for future developments.
