From Here to Eternity or San Juan! - Transitional Tax Planning with Pre-IPO or Appreciating Closely Held Stock

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Overview

Speaking of Eternity, I must admit that I am a big fan of gospel music. While I like old school or traditional gospel, I prefer the newer R&B urban sound popularized beginning with Andrew Crouch and later Fred Hammond and others. The fact of the matter is that I am a big fan of the Godfather of Soul – James Brown. He may not have been Citizen #1 but he was Soul Brother #1. Anyhow, what does that have to do with the PR?

One of the things that has happened over the last several decades in the PR and Latin America is Christian mission activity resulting in a strong movement towards Protestantism and particularly evangelical denominations and more specifically Pentecostal denominations. The impact on praise and worship music in Latin America and the PR has been significant. First, you need to know that the PR is the headquarters for Salsa music. As an entertainer or Salsa performer, you need to make it in the PR or you won’t make it at all. The Cuban “salsero” Willy Chirino laments this fact is a song.

The great band leader Ricardo Rey (aka Richie Rey) and his musical partner Bobby Cruz from the “Salsa Clasica” days, were big stars in the Salsa genre in the 1960’s and 1970’s. The both became evangelists and introduced the Salsa genre to Christian music. This is your Boricua tidbit for today!

One of the biggest obstacles facing U.S. business owners or individuals contemplating Puerto Rican residency is the taxation of pre-residency capital appreciation. This article focuses on the use of the classic partnership or LLC freeze as a technique to transfer the capital appreciation in the year of move so that the gain might be captured after obtaining Puerto Rican residency in order to maximize the potential tax benefits of Act 22.

Overview of Puerto Rican Tax Considerations and Residency

A. Puerto Rican Tax Basics

Two important pieces of legislation were passed by the Puerto Rican legislature in 2012. Both the Export Services Act (Act 20) and the Individual Investors Act (Act 22) were signed into law by the Governor of Puerto Rico on January 17, 2012.

A Puerto Rican entity is not sub­ject to U.S. income taxation unless the entity is en­gaged in a trade or business within the United States and its income is considered effectively connected income, or investment income.

What does it take to become a Puerto Rican resident in order to take advantage of Act 22? How about S50 for the application fee which is less than the cost of dinner in a good restaurant, and meeting three tax tests?

For federal income tax purposes the taxpayer will be considered a bona fide resident of Puerto Rico if you meet the following: (i) Substantial Presence Test -the physical presence test (generally spending 183 days in PR, or less than 90 days in the US); (ii) the tax home test; and (iii) Closer Connection Test - the closer connection test for the entire taxable year which means that you can’t have stronger personal connections to another jurisdiction that is not Puerto Rico.

(1) The Individual Investor's Act

Under the Individual Investors Act, neither capital gains (long-term or short-term), interest, nor dividends are subject to Puerto Ri­can taxation. Dividend income is subject to U.S. fed­eral income taxation for U.S.-sourced dividend income, as is interest income unless the interest income is exempt under the portfolio interest exemption.

If capital gain income is deemed to have accrued before the individual becomes a PR resident and the gains are recognized within ten years after the date of PR residency, the gains are taxed at a preferential rate for PR purposes. The rate is ten percent. Nevertheless, those gains are subject to U.S. taxation, and the taxpayer can take a credit on his personal return for any PR taxes paid. Pre-residency gain recognized after this ten year period is taxed at a five percent rate. These rules are designed to coincide with the expatriation rules of IRC Sec 877A.

Capital gains accrued after becoming a PR resident are subject to the rules of IRC Sec 933 receiving a 100 percent exemption from capital gains taxation for the gain accrued after becoming a PR resident while not being taxed for federal purposes.

The planning objective is to position a capital asset so that the capital appreciation occurs after PR residency. As a result, valuation of closely held stock for tax purposes is critical prior to becoming a PR Resident.

Preferred Partnership or LLC Freezes

Preferred Partnerships are sophisticated “estate freezing” techniques designed to allow the senior generation to retain voting control and preferred income interests, and a liquidation preference while transferring capital appreciation on family wealth to younger generations. This structure was the classic “estate freeze” device up to the early 1990’s.  The classic example is the senior generation contributing assets in exchange for voting preferred interests with liquidation preferences and other “bells and whistles” in order to weaken the value of the common equity interests. The common equity interests would be gifted to children or a family trust. The senior generation would retain voting control, an income preference and high income, and a liquidation preference. The common equity holders would be entitled to all of the future growth with no voting rights. 

A preferred partnership or LLC is a limited partnership or a limited liability company (either of which is referred as “preferred partnership”) and taxed as a partnership) with at least two classes of equity interests, preferred interests and non-preferred interests. The preferred interests may have been issued in exchange for capital contributions at the inception of the LLC, or they may have been issued when interests in an existing regular family limited partnership or limited liability company ("LLC") were exchanged for preferred interests as part of a recapitalization. The intent in each situation is that the preferred interests are received for the capital contributions. In the case of a LLC, two shares of LLC interest might be structured – Class A – Common equity and Class B – Preferred.

The preferred interests may be either general or limited partner interests, but they are more commonly limited partner interests. Safety and security are primary reasons for holding preferred interests. The economic rights of the holder of preferred interests closely resemble the rights of preferred stockholders, although there will be no double taxation at both the entity and equity holder levels as would be the case for a corporation with an issued and outstanding class of preferred stock:

Cumulative annual net cash flow and dissolution preferences will make the preferred interests much safer and more secure than the pre-contribution assets or pre-recapitalization non-preferred interests. The preferred interests will have a preferential right to partnership net cash flow. This net cash flow preference is generally expressed as a specified percent of the stated dissolution preference, although a variable rate is also permitted if that variable rate has a fixed relationship to a specified interest rate.  

The common equity interests were typically designed with “bells and whistles” such as put options et al designed to reduce the value of the common equity interests while bolstering the value of the preferred interests. IRC Sec 2701-2704 were added to the Internal Revenue Code to discourage and limit the ability to use these techniques. To a large extent, the technique went away. However, the strategies are still very powerful in a number of different scenarios with or without consideration of IRC 2701-2704.

The rules of IRC 2701 do not apply to a situation where the senior generation gifts the preferred partnership interest instead of the common equity interests as is the case in the classical partnership freeze. Valuation of preferred partnership interests and tax valuation litigation have always supported the idea that the preferred interests in a closely held context should always have a high yield. The economic reality is that the combination of the high yield right is likely to absorb all or most of the growth with the partnership.

Under Chapter 14 (IRC Sec 2701-2704), the net cash flow preference must be payable (but not necessarily paid) at least annually. The net cash flow preference must also be cumulative. S

If the partnership dissolves, the holders of the preferred interests will receive the stated dissolution preference before any liquidating distributions are made to the holders of the non-preferred interests.

The greater safety and security enjoyed by the holders of the preferred interests will be accompanied by an important trade-off. The dissolution and net cash flow preferences will put an effective cap on the value of the preferred interests, subject to possible swings in preferred return rates generally.

The non-preferred interests will generally consist of non-preferred general partner interests and non-preferred limited partner interests. The primary difference between these classes of non-preferred interests typically relates to management and voting rights. The non-preferred general partner interests will have the right to manage the partnership, or share management with any preferred general partner interests, but many important actions, such as dissolution of the partnership, the withdrawal of a partner, the transfer of a partner interest, disproportionate distributions to the partners, and the sale of substantially all of the partnership's assets, are likely to require the approval of a majority, a supermajority, or even all of the non-preferred and preferred limited partner interests as well as the general partner interests.

In the LLC context, the Class A (Common Equity) and Class B (Preferred) may be designed without voting rights. The operating agreement may provide that the Manager of the LLC provides all of the management and control of the entity.

Economically, the partnership's managers are entitled to reasonable compensation.  Otherwise, as a general rule, the non-preferred general partner interest and limited partner interests proportionately share distributions from the partnership, including dissolution proceeds as well as periodic net cash flow distributions, but only after the preferred interests' dissolution and net cash flow preferences are satisfied.

Because the rights of the non-preferred interests are subordinate to the dissolution and net cash flow preferences of the preferred interests, the non-preferred interests are riskier. To the extent that the PLP capital structure is more heavily weighted toward preferred interests, the non-preferred interests become that much riskier. However, the upside potential for the non-preferred interests is correspondingly greater.

Any increase in the value of the partnership's assets, whether attributable to net cash flow or appreciation in value, will be allocable to the non-preferred interests once the preferred interests' net cash flow preferences are fully satisfied. Thus, the non-preferred interests inherently have a higher risk, and a higher potential for reward, than the preferred interests.

The LLC or partnership in this case is primarily intended to bifurcate the interests between pre-residency and post-residency appreciation. The idea behind the planning is reduce and freeze the value of the preferred interests at the current fair market value based upon a valuation study. The art and science of business valuation should focus on those factors such as lack of marketability and lack of control among other factors that serve to reduce the valuation of the company prior to obtaining PR residency.

IRC § 2701 impacts the value of preferred interests in preferred limited partnerships in the following manner: When Chapter 14 is applicable, only a preferred interest with a cumulative net cash flow preference will be valued. Any noncumulative cash flow preference feature of a preferred interest will be treated as having no value. Nevertheless, the Chapter 14 considerations are not the important consideration in this exercise unless federal estate planning enters the planning equation.

Example

Dr. Mike Jones is a successful cardiologist and is a successful investor.  Over the last five years, he has accumulation a stock position in a small pharmaceutical with a promising cancer drug. He has eight million shares with an average basis of eighty cents per share. The current trading value of the company on the NYSE is ninety cents. The company is entering into its final phase of testing with the FDA for wider approval. Dr. Jones feels that the value of the stock could easily appreciate three-four times or more over the next eighteen months.

Dr. Jones went to medical school in the Caribbean and enjoys island living. He has the problem of timing his move to Puerto Rico and does not want to wait too long so that he misses the opportunity along with the sale of his practice to an associate. He forms a new LLC with two classes of interests – Class A (common equity) and Class B (preferred). He transfers his interests in the pharmaceutical to the LLC receiving Class B preferred interests equal to his contribution to the LLC with a six percent preferred return that is non-cumulative.

The Class B interests have a liquidation preference as well. The value of the preferred before any valuation discounts associated is $7.2 million. The valuation analyst also applies a blockage discount of ten percent due to the percentage of ownership and the low trading volume in the company. The value of the Class B interests after these considerations is $6 million. He also receives Class A interests. The Class A interests are entitled to all of the growth in excess of the Class B interests. Dr. Jones becomes a PR resident in 2014. The value of the Class A interests has a small residual value on the date of PR residency. All of the value in excess of $6 million and the current year’s income preference will accrue for the benefit of the Class A members.

The stock price of the company increases to $5.oo in January 2015. The value of the Class A interests from virtually zero to $34 million, the difference between the stock price and the Class B interests. The LLC redeems all of the Class A interests for $34 million.

All of the capital gain is post residency capital gain income and not subject to federal taxation or PR taxation under the provisions of Act 22. The funds are reinvested within a Puerto Rican funds that provide for interest and dividend income that are not subject to federal taxation or PR taxation.

Summary

Everyone has a different situation and their own fact pattern to consider.  Rarely in life are the facts an “easy lay-up”. This article is designed to outline some of the planning techniques in the planning arsenal that might be considered to position the taxpayer who wants to become a PR resident in a better position to realize capital appreciation and capital gain income after becoming a PR resident. It is never easy but always harder if you don’t try!

Don’t forget to count your blessings today.

Topics:  Business Taxes, Closely Held Businesses, Corporate Taxes, IPO, Startups, Tax Planning

Published In: Business Organization Updates, General Business Updates, Finance & Banking Updates, Tax Updates

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

© Gerald Nowotny, Osborne & Osborne, PA | Attorney Advertising

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