Structuring Waterfall Provisions in LLC and Partnership Agreements Navigating Complex Distribution Structures, Minimizing Negative Tax Consequences
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Presenting a live 90-minute webinar with interactive Q&A Structuring Waterfall Provisions in LLC and Partnership Agreements Navigating Complex Distribution Structures, Minimizing Negative Tax Consequences WEDNESDAY, APRIL 24, 2019 1pm Eastern | 12pm Central | 11am Mountain | 10am Pacific Today’s faculty features: James R. Browne, Partner, Barnes & Thornburg, Dallas Phyllis A. Schwartz, Partner, Schulte Roth & Zabel, New York The audio portion of the conference may be accessed via the telephone or by using your computer's speakers. Please refer to the instructions emailed to registrants for additional information. If you have any questions, please contact Customer Service at 1-800-926-7926 ext. 1. NOTE: If you are seeking CPE credit, you must listen via your computer — phone listening is no longer permitted. 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Program Materials FOR LIVE EVENT ONLY If you have not printed the conference materials for this program, please complete the following steps: • Click on the ^ symbol next to “Conference Materials” in the middle of the left- hand column on your screen. • Click on the tab labeled “Handouts” that appears, and there you will see a PDF of the slides for today's program. • Double click on the PDF and a separate page will open. • Print the slides by clicking on the printer icon. STRUCTURING WATERFALL PROVISIONS IN LLC AND PARTNERSHIP AGREEMENTS Phyllis A. Schwartz, Partner James R. Browne, Partner Schulte Roth & Zabel LLP Barnes & Thornburg LLP 919 Third Avenue 2100 McKinney Avenue, Suite 1250 New York, NY 10022 Dallas, TX 75201-6908 [email protected] [email protected] April 24, 2019 Agenda I. Waterfall Provisions Generally II. Determining and Drafting Waterfall Provisions III. Understanding Economic Arrangements of Parties IV. Tailoring Accounting and Tax Allocations V. Implications of New IRS Partnership Audit Rules Nomenclature This presentation generally uses the terms “partnership” and “partner” to mean either (a) a partnership that is classified as such for tax purposes and its partners, or (b) a limited liability company (LLC) that is so classified and its members. The business, legal, and tax considerations for both types of entities and their owners are the same unless otherwise noted. STRUCTURING WATERFALL PROVISIONS | 6 IN LLC AND PARTNERSHIP AGREEMENTS I. Waterfall Provisions Generally I. Waterfall Provisions Generally A. Waterfall provisions define how money and other property are distributed by a partnership to its partners 1. Distributions to partners are analogous to dividends paid by corporations, but partnership and limited liability company laws provide greater flexibility in deciding how to apportion such payments 2. Waterfalls are used in partnership agreements for a wide range of investment and operating businesses, including private equity funds and real estate partnerships B. Distribution provisions specify when distributions are made to partners and to which partners 1. Distributions can be made to redeem equity interests in partnerships, but are more commonly made to allow partners to participate in the cash flows and profits of investment funds and operating businesses C. The term "waterfall" implies that certain partners are granted priority distribution rights over other partners 1. Without such priorities, distributions would be made in accordance with state laws and generally would be made to partners in proportion to amount invested by the partners in the partnership 2. Partnership agreements override applicable laws in determining how to make distributions STRUCTURING WATERFALL PROVISIONS | 8 IN LLC AND PARTNERSHIP AGREEMENTS II. Determining and Drafting Waterfall Provisions II. Determining and Drafting Waterfall Provisions A. Relative Economic Rights 1. If all partners share in all distributions proportionately to their capital invested in the partnership, then a waterfall is unnecessary 2. Waterfalls are designed to allow a partner to receive a percentage of profits of the partnership that exceed that partner's relative capital contributed to the partnership a. The percentage of profits that does not correlate with the percentage of capital contributed to the partnership is referred to as the "carried interest" in private equity funds b. It is important to distinguish profits interests from capital distributions, which have different tax implications 3. When some partners have priorities to distributions over others, the nature of those priorities are specified in partnership agreements 4. Types of priorities are defined in waterfall provisions (e.g., return of capital; "preferred return"; "catch-up" and "carried interest") 5. Waterfall provisions are typically categorized in two ways: (1) "back-ended" or "European" or (2) "deal-by-deal" 6. Types of distribution matter (e.g., cash flow, dispositions, tax, in-kind) B. Timing of Distributions 1. Specific times – Quarterly, Annually, Estimated Taxes 2. Specific events – Capital Events, Receipt of Cash STRUCTURING WATERFALL PROVISIONS | 11 IN LLC AND PARTNERSHIP AGREEMENTS II. Determining and Drafting Waterfall Provisions, Continued C. Amount of Distributions 1. Proceeds from dispositions, after payment of expenses and obligations 2. Reinvestment 3. Preconditions to making distributions Repayment of debt, payment of fees, reserves, etc. D. Recalls of Distributions 1. Distributions are subject to recall rights by a private equity fund under specified situations a. Distributions made out of the initial capital contributions made by new partners b. Distributions made from the proceeds of a company sold within a "quick flip" period (generally 12 – 24 months), up to the amount invested by the fund in the company sold c. Distributions recalled to allow a fund to make indemnification payments d. Distributions of up to the amount previously contributed by partners to the partnership that were used for partnership expenses e. Distributions recalled to fund partnership audit adjustments under new partnership audit rules f. Excess tax distributions 2. Such recalls are subject to time limits and other partnership restrictions and limits STRUCTURING WATERFALL PROVISIONS | 12 IN LLC AND PARTNERSHIP AGREEMENTS II. Determining and Drafting Waterfall Provisions, Continued E. Waterfall provisions should only address distributions to partners, not payments of fees, liabilities F. Include a catch-all provision to address orphaned money or non-investment income G. If the partnership agreement includes tag-along, drag-along, change of control provisions, they should also incorporate waterfall apportionments STRUCTURING WATERFALL PROVISIONS | 13 IN LLC AND PARTNERSHIP AGREEMENTS III. Understanding Economic Arrangements of Parties III. Understanding Economic Arrangements of Parties A. Initially, apportion amount to be distributed among investors B. Identify whether there is a Back-Ended/"European" Waterfall or "Deal-By-Deal" Waterfall C. Back-Ended/"European" Waterfall vs. Deal-By–Deal Waterfall 1. Will Investors receive 100% of their capital contributions first or just a portion of their capital contributions? 2. If deal-by-deal, then investors recoup the cost of deals disposed of, plus allocable expenses 3. Write-offs and permanent write-downs are deemed dispositions D. Priority Returns 1. Once investors receive their capital distribution, they may be entitled to a priority return (or "preferred return"). Some investors prefer that the preferred return be paid before capital contributions are returned (similar to interest first on debt). 2. A private equity fund preferred return is typically 8% per annum, compounded annually 3. Credit funds have lower preferred return rates – 6% 4. Venture funds do not typically pay a preferred return 5. Real estate funds may use multiple “IRR” hurdles as the preferred return measurement. IRR hurdles are difficult to draft than more commonly understood preferred return hurdles. STRUCTURING WATERFALL PROVISIONS | 15 IN LLC AND PARTNERSHIP AGREEMENTS III. Understanding Economic Arrangements of Parties, Continued