Don’t Be So Fast To Convert LLCs To Corporations

Confronted with a buyout or growth-equity deal involving a limited liability company, subchapter S corporation, or other flow-through entity, many private equity funds automatically insist that the business convert to the corporate form. But are they hurting their chances to win the deal and missing opportunities to improve returns?

For private-equity funds, the most common reason for insisting on using the corporate form is to prevent unrelated business taxable income (UBTI) from reaching the fund’s limited partners. Historically, many tax-exempt investors, such as pension plans, university endowments and the like, have been averse to UBTI. According to accepted lore, tax-exempt investors do not want to file tax returns (and pay tax) on this type of income. Similar issues arise with respect to foreign investors and income effectively connected to a U.S. trade or business, also known as ECI.

In recent years, resistance to UBTI has decreased as investors come to understand the benefits of flow-through taxation and its potential impact on returns. General partners should address this issue at fund formation and press for fund documents that allow for UBTI. In our experience, funds that can invest in flow-through entities have a competitive advantage over those that cannot.

If limited partners insist on UBTI limitations, private equity fund documents often require the fund to prevent UBTI or to use commercially reasonable efforts to do so. A corporate buying entity will satisfy the concern and “block” UBTI from reaching the fund’s LPs.

Using a corporate buying entity, however, is usually an inefficient solution because it unnecessarily denies all of the investors flow-through tax treatment. There are better methods of “blocking” UBTI from reaching limited partners. For example, for UBTI-sensitive LPs, some private equity funds segregate those partners from the rest of the LPs, usually through a separate fund that invests in the target business indirectly through a “splitter limited partnership” that contains a blocker corporation. Alternatively, and likely as a last resort, a fund could invest indirectly in the flow-through entity through its own blocker corporation. These techniques preserve (in varying degrees) the flow-through benefits of the investment for the general partner, other investors (including rollover sellers) and management, while still protecting UBTI-sensitive LPs.

Winning The Deal

Preserving flow-through tax status can help private equity buyers improve their chances to win more deals, particularly in the lower and middle market. Many businesses, including family-owned businesses, utilize a flow-through entity. Generally, owners of flow-through entities are taxed on their shares of the income of the business, but not on distributions, and the entity itself is not taxed by the federal government. The sellers and management of a flow-through are already familiar with its principal economic benefit— a single layer of taxation.

Many potential buyers, especially in this environment, count on a rollover investment from the sellers and/or management, and the higher the rollover amount the better. Insisting that the acquired company convert into a corporation as part of the transaction will likely be viewed negatively by the sellers and management, as the business will lose the single layer of taxation benefit going forward. This is especially true if the buyer structures the transaction as a sale under Section 338(h)(10) of the Federal tax code (a very common technique), which will also result in the sellers recognizing tax at closing on the rollover equity. Conversely, a properly structured transaction using an LLC will allow the buyer to achieve a step-up in basis in its pro rata share of the target’s assets (usually through a Section 754 election), while also enabling the sellers and management to defer tax on the rollover equity. It is a win-win outcome.

In most deals, buy-in from the existing management team is essential, and the management incentive plan is an important factor. In a quirk of the tax code, a “profits interest” in an LLC affords the recipient potential capital gains tax treatment upon a sale. The equity incentive equivalent in a corporation is usually a stock option grant, which will typically produce ordinary income rather than capital gains at exit. The tax savings from profits interests can be significant, and is valued by the management team.

Better Returns

Clearly, a single layer of taxation is better than two. In contrast to a flow-through entity, a “C” corporation pays income tax on its earnings, and, when dividends are paid or stock is sold, the owner of the corporation pays tax on the dividends and on the gain from the sale of the stock, which means that there are two layers of income tax.

Take the following simple example, which disregards state tax for simplicity. In a flow-through entity that has a $20 million profit and pays $20 million of distributions to its owners, it and its owners will have, for federal tax purposes, $20 million of taxable income. Assuming that all owners of the flow-through are U.S. taxpayers and the $20 million is taxed at the highest marginal U.S. income tax rate for 2009 (currently 35 percent), the federal tax on the $20 million of profit is $7 million.

A corporation that has $20 million of profit will have $20 million of taxable income, which is currently taxed at the rate of 35 percent (using 2009 rates). If the corporation pays the entire after-tax balance of $13 million to its stockholders in the form of a dividend, the stockholders will have $13 million of taxable income, currently taxed at the 15 percent rate. So, the combined federal tax on the $20 million of profit is about $9 million, which is $2 million (or about 25 percent) more than the flow-through entity example. In addition, tax-financed distributions of an LLC often can be tax-deferred, an enormous benefit in the case of a leveraged recapitalization.

Perhaps the greatest advantage that an LLC buyer has over its corporate counterpart is the ability to sell a step-up in basis to the next buyer, giving the buyer a way to lower taxes over time as the value of the acquired assets depreciates. Both the LLC buyer and the corporate buyer will likely get a step-up in basis on the assets of the business acquired, if the seller’s business is in a flow-through entity. When the time comes to sell the business again, the LLC buyer can sell a step-up to the next buyer. A corporation, however, rarely can sell its assets with a step-up in basis because that would result in a double tax (at the corporate level and at the stockholder level). The parties are therefore forced to a stock sale and no step-up will result.

A buyer who gets a step-up in asset basis acquires tax shelter that is worth real money, and therefore the buyer will likely pay more. Assuming that the step-up is goodwill and amortizable over a 15-year period, each $15 million of step-up will produce a yearly tax shield of $1 million. The present value of such a tax shield can make a tremendous difference in investment performance. Buyers have been known to offer upwards of a 20 percent premium for an asset step-up.

If a fund is required to invest in the flow-through entity through a blocker corporation, special consideration must be given in the legal documents to allow the fund to sell the blocker at exit. This will ensure that the fund incurs only a single level of tax at exit. The trade-off is that the buyer will not be able to realize a step-up on the percentage of the business owned by the fund’s blocker. Nevertheless, a partial step-up is better than none, and many buyers will still pay a premium (albeit lower) for it.

Another appealing aspect of flow-through entities are tax distributions. The flow-through entity is typically required to pay its owners (including the fund) quarterly distributions at least sufficient to cover the tax on their allocated share of the business income. The fund, in turn, distributes these amounts to its partners. In most funds, all distributions received by the LPs (including tax distributions) count for purposes of calculating the GP’s carried interest and also in computing the investors’ IRR. Thus, over time, tax distributions can provide a meaningful boost to the GP’s returns as well as improving the fund’s reported performance. As a bonus, tax distributions often exceed the actual tax liability.

Potential Drawbacks

Although the advantages of maintaining the flow-through characteristics of an acquired business are considerable, there are some drawbacks, a few of which are described below. First, the LLC form is ill-suited for an IPO or the public markets, and there are very few publicly traded LLCs or other unincorporated businesses. An LLC can always convert into a corporation prior to its IPO, but, although not common, there may be some adverse tax consequences from the conversion.

Another downside to the LLC structure is additional administrative complexity, including administration of tax returns (K-1 reporting), potential self-employment issues for management, and documentation.

Also, changes in federal or state tax rates (including increases in ordinary income rates for individuals) could reduce the tax advantage that flow-through entities now enjoy. Similarly, as more states adopt a franchise tax or other entity level tax, the single layer of taxation at the state level is diminished.

Potential investors in a business that is already in a flow-through entity should evaluate all of their options with legal counsel. A bid package that preserves flow-through tax status usually helps win the deal. In addition, preserving flow-through tax status usually improves returns, as compared to a potential corporate buyer. In these challenging economic times, or in any economic environment, why pass up either advantage?

Kevin Tormey and T.J. Murphy are partners in the Private Equity and M&A Groups at Choate, Hall & Stewart LLP in Boston. They can be reached at and