NEW 2015 Edition of

Structuring Venture Capital,

Private Equity, and
Entrepreneurial Transactions

e are proud to enclose the 2015 edition of Structuring Venture Capital, Private
Equity, and Entrepreneurial Transactions by co-authors Jack S. Levin and
Donald E. Rocap, senior partners in the international law firm of Kirkland &
Ellis LLP, in conjunction with special editors Russell S. Light of Kirkland & Ellis
LLP and the late Martin D. Ginsburg of Georgetown University Law Center.
Here is a summary, written by the authors, of major developments reflected
in the new edition.

Highlights of the New Edition

l

Federal income tax rates for 2015 and thereafter

n

C corp income tax rates. The top federal C corp income tax rate for 2015 and
thereafter (on both OI and LTCG) continues at 35% (subject to an approximately
3 percentage point reduction on qualified U.S. production business net income).
See discussion at 107(5) and (6).

Individual income tax rates. The top federal individual income tax rates for 2015
and thereafter (which also apply to partnership, LLC, or S corp-level income flowing
through to an individual equity owner) are as follows:

5
5
5
5

On OI and STCG, the top rate continues at 39.6% (subject to an approximately 3

percentage point reduction on qualified U.S. production business net
income).
On normal LTCG, the top rate continues at 20%.
On QDI (qualified dividend income), the top rate continues at 20% (i.e., the same
as LTCG).
On Code 1202 LTCG (on qualified small business stock held more than 5
years), the top rate is:

1
Copyright 2015 CCH Incorporated. All Rights Reserved.

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 14% for such stock acquired after 12/31/14 (unless Congress again retroactively

extends [to stock acquired in 2015 and perhaps thereafter] the 0% rate
described immediately below, as the Obama administration budget
recommends),
 0% for such stock acquired between 9/28/10 and 12/31/14,
 7% for stock acquired between 2/18/09 and 9/27/10, and
 14% for stock acquired between 8/11/93 and 2/17/09. See discussion at 107(1)

through (3) and (6).

n

Individual income-based Medicare taxes in addition to regular income tax:

On passive income from investments and businesses as to which

individual is not active, the rate continues at 3.8%, to the extent the individuals
AGI exceeds a threshold amount ($250,000 for a joint-return individual). See
discussion at 107(4)(a) through (c).

Individual itemized deduction and personal exemption phase-outs also affect

individual federal income taxes:

5
5
l

On compensation and self-employment income, the rate continues at 3.8%,

with (a) 2.9% imposed partly on an employer and partly on an employee and
100% on a self-employed person plus (b) an additional 0.9% on such income in
excess of a threshold amount ($250,000 for a joint-return individual) imposed
100% on an employee or self-employed person.

An itemized deduction phase-out by 3% of AGI in excess of a threshold

amount (approximately $300,000 for a joint-return individual), with a maximum
phase-out equal to 80% of itemized deductions.
A personal exemptions phase-out as AGI increases (from approximately
$300,000 to $425,000 for a joint-return individual). See discussion at 107(4)(d)
and (e).

Securities law changes

n

Newco public sale of stock with abbreviated SEC Reg. A registration. If an

offering of Portfolio Company securities does not qualify for 1933 Act exemption
e.g., as a Reg. D private placement to investors or a Rule 701 private placement to
service providersPortfolio Company can nevertheless sell securities while avoiding a
full-blown SEC 1933 Act registration by utilizing newly revised SEC Reg. A, in
which case Portfolio Company is exempt from 1933 Act registration but is required
to file a Reg. A offering statement with SEC.
SEC Reg. A amendments effective 6/19/15 substantially increase the amount of
securities Newco can sell publicly under Reg. A and change many of the pre-existing
Reg. A rules:

(1) The maximum amount of equity (and/or debt) securities Portfolio Company can
sell in one or more Reg. A offerings during any 12-month period is (a) $20 million if
Portfolio Company elects to utilize Reg. As Tier 1 rules or (b) $50 million if Portfolio
Company elects to utilize Reg. As Tier 2 rules. For an offering no greater than $20
million, Portfolio Company can elect either Tier 1 or 2, while an offering greater than
$20 million can be made only under Tier 2.
(2) As compared to a full-blown 1933 Act registration statement, a Reg. A offering
statement is generally far shorter and less complex, does not require Newco to respond
to SEC comments, and is generally less expensive and time consuming. However, a
Tier 2 Reg. A offering requires a more extensive offering statement than does a Tier 1
offering.
(3) Portfolio Company can use Reg. A only if Portfolio Company was created under
the laws of, and has its principal place of business in, the U.S. or Canada. In addition,
Portfolio Company cannot use Reg. A if it is a 1934 Act reporting company, a
blank check company, an investment company required to register under the ICA, or a
BDC. Nor can Portfolio Company use Reg. A if it is a PE/VC fund exempt from
ICA registration under ICA 3(c)(1) or 3(c)(7), since a Reg. A offering constitutes a
public offering which would destroy such ICA exemption.
(4) While Portfolio Company can sell securities in a Tier 1 offering to anyone, it can
sell securities in a Tier 2 offering only to (a) an accredited investor without limitation as
to amount or (b) a non-accredited investor in a limited amount (except that such
limitation on amount does not apply if the securities will be listed on a national
securities exchange). The limited amount (i) for a non-accredited individual investor is
not more than 10% of the greater of such individuals annual income or net worth
(calculated in the same manner as for making an accredited investor determination) and
(ii) for a non-accredited entity investor is not more than 10% of the greater of such
entitys annual revenue or net assets.
(5) A Reg. A offering is a public offering (not a Reg. D private offering). Hence,
(a) except for the limitation on the amount of Tier 2 securities that can be sold to a
non-accredited investor in a Tier 2 offering as described in (4) above, there is no limit
on the type of distribution, the number of offerees or purchasers, or the offerees/
purchasers sophistication, income, net worth, or other characteristic and (b) securities
purchased in a Reg. A offering are not restricted securities, so that they can generally
be freely resold.
(6) SECs normal factually based subjective integration doctrine applies in
determining whether an offering exceeds the Reg. A limits, except that:
(a) an offer or sale of Portfolio Company securities prior to the Reg. A offering
is not integrated with the Reg. A offering, and

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(b) an offer or sale of Portfolio Company securities subsequent to the Reg. A

offering is not integrated with the Reg. A offering where such subsequent
sale is:
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made more than 6 months after completion of the Reg. A offering, or

registered under the 1933 Act, or

pursuant to Rule 701, or

solely to persons not resident in the U.S. in compliance with SEC Reg. S
in an offshore transaction with no directed selling efforts into the
U.S. market with respect to such securities and the securities are
restricted from resale to a U.S. resident for a specified period (one year
for Portfolio Company equity securities and 40 days for Portfolio
Company debt securities), or

pursuant to 1933 Act 4(a)(6) crowdfunding rules.

(7) After making a Tier 2 offering Portfolio Company is generally not required
to become a 1934 Act reporting company, but is required to file periodic SEC Reg.
A reports (e.g., disclosing its financial results), although not as many or as extensive
as the filings required for a 1934 Act reporting company.
(8) If Portfolio Company were selling securities in a full-blown 1933 Act registered
public offering, Portfolio Company could generally not (because of the SEC gunjumping rules) communicate with potential purchasers regarding the offering until
filing its full-blown registration statement with SEC. However, where Portfolio
Company is planning a Reg. A offering, Portfolio Company can test the waters
before preparing the Reg. A offering circular. By filing a simple statement with SEC,
Portfolio Company can communicate with potential purchasersorally, in writing, or
by advertising (in newspapers, on radio or TV, or by mail)to determine whether
they have any interest in purchasing Portfolio Company securities. If there is not
sufficient interest, Portfolio Company can drop the idea of a Reg. A offering
without incurring the expense of preparing and filing a Reg. A offering statement.
(9) Reg. A preempts state securities law registration and qualification requirements.
See discussion at 207.6.
l

Purchase or sale of a business, including leveraged buyout (LBO)

n

Two-step acquisition of publicly traded Targetavoiding Target shareholder

vote. Where BuyerCo (possibly financed by PE/VC fund) is acquiring publicly traded
Target by (1) first purchasing a portion of Targets stockeither in a tender offer or in
one or more negotiated purchasesand (2) then squeezing out Targets remaining

(minority) shareholders by a merger (between Target and either BuyerCo or its

subsidiary), BuyerCo generally prefers to avoid a vote of Targets shareholders, e.g.,
because Target, as a 1934 Act reporting company, would be required to comply with
SECs proxy rules which generally would result in substantial delay before completing
the merger.
There are two circumstances, however, where a vote of Targets shareholders can be
avoided:
First, under a long-standing exemption (Delaware General Corporation Law 253)
where BuyerCo (organized as a corporation, partnership, or LLC) owns 90% or more of
Target (organized as a corporation)whether acquired by BuyerCo in a tender offer for
Targets stock or otherwiseand both BuyerCo and Target are formed in Delaware (or
in another state permitting a similar short-form merger), Target need not secure a
shareholder vote on the squeeze-out merger and hence (where Target is a 1934 Act
reporting company) no proxy statement is necessary for Targets shareholders.
In addition, where the BuyerCo-Target acquisition is friendly and Target has
adequate authorized but unissued stock, Target might grant BuyerCo a top-up option
before BuyerCo commences its tender offer for Targets stock, giving BuyerCo the onetime right (and perhaps the obligation) to purchase from Target (typically for a note)
that number of new Target shares which, when combined with the Target shares
acquired by BuyerCo in the tender offer or the negotiated purchases, will be sufficient to
meet the state law threshold for a short-form merger (e.g., 90% in Delaware).
Second, under a 2013 addition to Delaware law (as further amended in 2014)
Delaware General Corporation Law 251(h)a vote of Targets shareholders (and
hence a 1934 Act proxy statement) on a forward or reverse merger of Target and
BuyerCo (or a BuyerCo subsidiary), can be avoided where:
(a) Target (organized as a corporation) has more than 2,000 shareholders or is
exchange traded immediately prior to executing the merger agreement,
(b) BuyerCo or its subsidiary (organized as a corporation) (AcquiringCorp)
makes a first-step tender or exchange offer for any and all Target stock,
(c) after such first step, AcquiringCorp owns sufficient Target stock to approve the
second-step squeeze-out merger (under Delaware law and Targets charter),
generally more than 50%,
(d) all non-tendering Target shareholders receive in the merger the same
consideration as the tendering Target shareholders received in the tender offer,
i.e., cash where the tender offer consideration was cash,
(e) Target is incorporated in Delaware, and

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(f) the merger agreement expressly permits this procedure and states that the
short-form merger shall be effected as soon as practicable after the tender offer
closes.
Where BuyerCo is a newly formed entity (perhaps formed by PE/VC fund to acquire
Target in an LBO), BuyerCo may offer Targets executives an opportunity to exchange
their (low tax basis) Target shares for BuyerCo shares tax free (with carryover low
tax basis), as part of BuyerCos Code 351 formation and its buyout of Target,
without recognizing the CG inherent in their Target shares.
However, if BuyerCo is using Delaware 251(h) (discussed in Second above)rather
than Delaware 253 and similar provisions in other states (discussed in First above)to
squeeze out Targets non-tendering shareholders, BuyerCo will not be able to offer
Targets key executives this tax-free rollover opportunity because:
(i) the federal tender offer rules (x) require BuyerCo to offer each Target
shareholder the highest consideration [BuyerCo] pay[s] to any other security
holder for [Target] securities tendered in the tender offer and (y) prohibit
BuyerCo from purchasing (or agreeing to purchase) Target shares outside the
tender offer once the tender offer has commenced and prior to its expiration and
(ii) after the tender offers expiration Delaware 251(h) requires all non-tendering
Target shareholders (here Targets key executives) to receive the same merger
consideration as the tendering Target shareholders received in the mergerhere
cash where the tender offer consideration was cash.
The solution would be to avoid a Target shareholder vote on the second-step merger
by invoking the long-standing Delaware 90% exemption (or comparable exemption
in many other states) discussed in First above, supplemented by a top-up option
(should the tender offer alone not achieve Delaware 253s 90% threshold) and
forsaking use of Delaware 251(h). See discussion at 503.3.2.7.
n

Target boards fiduciary duty. Under state corporate law, business judgments reached
by Target corporations directors are generally accorded deference if the board acted
on an informed basis, in good faith, and in the honest belief that the action was taken in
the best interests of the corporation and its shareholders. In order for the board to
claim the benefit of this judicial business judgment rule, the board must be able to
demonstrate that it acted with due care after thorough study and conscientious
deliberation.1
However, when Target corps board is considering a transaction in which Targets
shareholders give up controli.e., (1) a cash sale of Target (generally the case where a

While Delaware law is clear on the boards fiduciary duty and some other states laws are less clear,
all states are likely to agree on the principles enunciated in text.

PE/VC fund sponsors BuyerCos LBO acquisition of Target) or (2) a combination of

Target and BuyerCo, with Targets shareholders receiving BuyerCo stock but with the
combined BuyerCo-Target enterprise controlled by one or a group of BuyerCo
shareholders acting in concertTargets directors have an enhanced duty to protect
the interests of Targets shareholders and obtain the highest price for their shares
reasonably attainable (the so-called Revlon duty), and courts typically subject the
directors conduct to enhanced scrutiny to ensure that they have acted reasonably to
achieve these goals.
As protection against a Target shareholders breach of fiduciary duty claim
(seeking an injunction against the acquisition or damages after the acquisitions
consummation2), Targets board, especially where Target is a public corporation,
may utilize some or all of the following measures:
(1) appoint an independent board committee whose members have no interest (e.g.,
stock ownership or anticipated favorable employment) in BuyerCo, which
committee in turn selects independent legal counsel and an independent
investment banker to represent and advise the committee,
(2) empower the independent committee to engage in an auction process, soliciting
other bidders for Target, or at least performing a more limited market check,
(3) authorize the independent committee to obtain an investment banker fairness
opinion, and/or
(4) permit or require the independent committee to seek a majority vote of Targets
disinterested directors and/or a majority vote of Targets disinterested shareholders.
In a transaction involving related parties (e.g., directors or controlling shareholders
sitting on both sides of the transaction), an entire fairness standard applies, under
which Targets board must demonstrate that it (1) achieved a fair price for Targets
shareholders and (2) engaged in a fair process.
Thus, when some board members have an interest in the transaction different from
the interest of Targets shareholders generallye.g., in an LBO where BuyerCo or its
PE/VC fund sponsor offers Targets management the opportunity to continue as
post-acquisition BuyerCo/Target executives, perhaps with increased compensation,
and/or to invest in BuyerCo by buying, or receiving options to buy, BuyerCo common
stockthere is a conflict between such Target directors/managements (1) duty to
obtain the highest price for Targets public shareholders and (2) natural desire for

A corporation incorporated in Delaware or some other states can eliminate director monetary
liability for certain types of fiduciary duty breaches through a charter provision.

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BuyerCo (which will be partly owned by, and/or pay enhanced compensation to,
such Target directors/management) to purchase Target at the lowest possible price.
In such case, it is advisable to form a committee of Target independent directors
(composed of Target directors with no interest in BuyerCo) to foster an arms length
negotiation between BuyerCo and Target. Targets independent committee must be
fully informed and must have freedom to negotiate with BuyerCo at arms length.
Targets independent committee typically selects its own independent investment
banker and independent legal counsel and generally has authority to seek other buyers
for Target. Such an independent committee acts as both a procedural and a substantive
measure to ensure a fair process.
In addition, if Target subjects the transaction to a non-waivable condition that a
majority of disinterested shareholders approve the acquisition, this provides further
evidence that the transaction was entirely fair to Targets public shareholders. In fact, if
a transaction involving related parties has the benefit of both an empowered,
disinterested Target board committee and a non-waivable majority of the minority
shareholder approval condition, then in Delaware the entire fairness standard does not
apply and Targets board can regain the benefit of the business judgment rule.
An investment banker fairness opinion and/or some form of (pre- or post-agreement)
auction or market check helps to demonstrate that Targets board (or independent
committee) acted in an informed and reasonable manner. However, courts look
carefully at investment banker fairness opinions, particularly when competing bids are
being considered. See discussion at 503.3.3.
n

LBO fraudulent conveyance risk. Where BuyerCo acquires Target in an LBO, the
transaction is frequently structured so that Targets pre-acquisition creditors are
prejudicedgenerally because the proceeds from the acquisition debt are paid out to
Targets old shareholders while the acquisition lenders acquire a claim against Targets
old assets which (if such claim is secured by Targets assets) is superior to Targets old
unsecured creditors or (if not so secured) is pari passu with Targets old unsecured
creditors.
If the BuyerCo-Target LBO is so structured and the BuyerCo-Target enterprise goes
bankrupt reasonably soon after the LBO, Targets old creditors (and in some
circumstances Targets new trade and general creditors) may have a fraudulent
conveyance claim against (a) the acquisition lenders, (b) Targets old shareholders who
received the LBO proceeds, and (c) the LBOs private equity sponsors. Such a claim
would be based on the collapse (or step-transaction) doctrine employed by courts in
numerous fraudulent conveyance cases, under which the loans from the acquisition
lenders, the acquisition of Targets assets and liabilities, and the payments to Targets
old shareholders can be treated by a court as a single transaction. In this case, BuyerCo

would be viewed for fraudulent conveyance purposes as not having received adequate
consideration from the acquisition lenders in exchange for issuing them debt
instruments (and possibly security interests), because the amount borrowed from the
acquisition lenders was promptly paid out to Targets shareholders (rather than used to
pay Targets creditors or to acquire additional assets for Target).
Thus the LBO may be held to violate the fraudulent conveyance laws where
BuyerCo/Target violates any one of three financial tests immediately after the LBO
solvency (asset FV greater than liabilities), adequate capital, and ability to pay
obligations as they mature in the ordinary course of business.
Traditional sources of law dealing with such fraudulent conveyance issues include the
Uniform Fraudulent Transfer Act (UFTA) adopted by most states, the Uniform
Fraudulent Conveyance Act (UFCA) adopted by a few states, and the Bankruptcy
Code applicable throughout the U.S.
In 7/14 the Uniform Law Commission approved a number of amendments to the
UFTA, including renaming the new act the Uniform Voidable Transactions Act
(UVTA). The retitling of the Act is an attempt to eliminate the confusion
surrounding the use of the word fraud throughout the UFTA, i.e., when a transfer is
subject to avoidance based upon actual fraud and when a transfer is voidable
based upon constructive fraud. The UVTA also includes amendments relating to
choice of law, burden of proof allocation, and the good faith defense.
Currently, seven states (Georgia, Idaho, Kentucky, Minnesota, New Mexico, North
Carolina, and North Dakota) have adopted the UVTA, and it has been introduced
in several other state legislatures. Ultimately, the UVTA may be adopted by all states
that have adopted the original UFTA. See discussion at 501.4.3.8.
n

BuyerCo responsibility for Target liabilities not explicitly assumed in an asset

purchase. In an acquisition structured as an asset purchase, under various versions of
the bulk sales act adopted by various states, a buyer of Targets assets in bulk generally
becomes liable for Targets liabilities (up to the FV of the Target inventory and
equipment purchased) unless the buyer has given notice to all of Targets creditors at
least a specified period before the asset sale and has followed other specified procedures.
Although most states at one time enacted a bulk sales act, in recent years all but
two states (Maryland and California) have repealed their bulk sales statutory provisions.
Nevertheless, some courts have held the buyer of a business responsible for some
Target liabilities (especially tort liabilities for defective products, underfunded pension
liabilities, and environmental liabilities) under the vague common law doctrines of de
facto merger and successor liability when Targets business is transferred to buyer as
a going concern and Target goes out of existence, especially (but not exclusively) where

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Targets owners receive a substantial equity interest in buyer. See discussion at

501.3.4.3.
n

HSR filing for acquisitionannual inflation adjustment. A Hart-Scott-Rodino filing

with FTC/DOJ is required if the size of BuyerCos purchase price for acquiring Target
(and, in certain cases, the size of the parties to the transaction) exceeds specified tests.
The authors have updated the entire HSR discussion to reflect the 2/15 annual
inflation adjustment of all the HSR tests, thresholds, and filing fees. See discussion at
501.3.3.1.

GAAP accounting for an acquisition, as substantially revised by FASB in 11/14.

Accounting at the BuyerCo level. When BuyerCo acquires Target, the

accounting carrying value of Targets assets on BuyerCos consolidated financial
statements areunder the purchase accounting rulesgenerally written
up to the amount BuyerCo paid (in cash, BuyerCo stock, BuyerCo notes, and
inherited Target liabilities) to acquire Target, regardless of the transaction
form (e.g., stock purchase, asset purchase, or merger).
Such purchase accounting book value write-up for Targets assets on
BuyerCos consolidated financials generally increases BuyerCos post-acquisition
(a) GAAP depreciation/amortization for the old Target assets (both tangible and
intangible) and (b) potential future GAAP impairment write-downs if the
purchased Target goodwill declines in value, thus reducing BuyerCos
post-acquisition accounting net income.3

Accounting at the Target level. For an acquisition before 11/19/14, where

Target continued to exist as a BuyerCo subsidiary, Target was generally required
to apply (i.e., push down in accounting parlance) BuyerCos purchase
accounting on its stand-alone financial statements, such that the accounting
carrying value of Targets assets (on Targets stand-alone financial statements)
was generally written up to the amount BuyerCo paid to acquire Target as
described above.4
However, for an acquisition on or after 11/19/14, the accounting rules have
changed substantially such that Target may generally elect whether to (a) apply

These accounting rules are not the same as the income tax rules and hence the accounting rules
may result in reduced accounting income without any reduction in taxable income.
4
In limited circumstances under the old pre-11/19/14 accounting rules, Target could avoid pushdown
purchase accounting (and thus retain its old accounting carrying values on its stand-alone financial
statements) by structuring the acquisition as a recapitalization where (i) Target survived and (ii) old
(or in some cases new) Target shareholders who were not part of a collaborative group with BuyerCo
owned a significant stake in Targets common equity (generally at least 6% but in some cases at least
20%) after the acquisition. Qualification for this now obsolete recapitalization accounting exception
to pushdown purchase accounting for Target was complex and at times uncertain.

10

pushdown accounting (i.e., apply BuyerCos purchase accounting [as described

above] on Targets stand-alone financial statements) or (b) retain (unchanged)
Targets old accounting carrying values for Targets assets (i.e., not push down
BuyerCos purchase accounting). Consequently, where Target continues to exist
for accounting purposes post-acquisition as a BuyerCo subsidiary and does not
elect to push down BuyerCos purchase accounting, Target continues (on its
separate post-acquisition financials) to use its pre-acquisition asset book values
unchanged such that Targets post-acquisition GAAP depreciation/amortization
and/or goodwill impairment charges do not increase as a result of the buyout (as
they would if pushdown accounting had applied). See discussion at 504.
l

S corp tax issues

n

Avoiding corporate-level income tax on sale of S corp assets. An S corp is a

flow-through entity for tax purposes and hence normally pays no federal income tax at
the entity level, i.e., income of an S corp is subject to only one level of income tax
(imposed at the shareholder level). However, Code 1374 subjects an S corp to a
corporate-level penalty tax on asset-sale gain (so that the S corps asset-sale gain is
subject to double tax) under two circumstances:
(1) where the S corp was formerly a C corp but switched to S corp status or
(2) where the S corp (although always an S corp) acquired assets tax-free with
carryover basis from a C corp.
In either such case Code 1374 has long subjected the S corps asset-sale gain
(which accrued before the S election or the tax-free-carryover-basis asset acquisition)
to double tax if such assets were sold (a) within 10 years after the conversion from
C to S corp or (b) within 10 years after the S corps tax-free acquisition of COB
assets from a C corp.
However, beginning in 2009, legislation reduced this 10-year penalty period first
to 7 years and then to 5 years. For such an S corp asset sale during 2014 the period
was 5 years, but such legislationshortening the 10-year penalty periodexpired
12/31/14. Hence beginning 1/1/15 the penalty period for such an S corp is again 10 years,
unless Congress reduces the 10-year period (retroactively) for such a 2015 S corp
asset sale to 5 years or 7 years. See discussion at 301.2.2.

Avoiding restrictions on S corp shareholders. A corporation can elect to be an

S corp (subject to S corp flow-through tax rules rather than C corp double tax rules)
only if it meets certain arbitrary rules relating to its stock and its shareholders,
including:

all of the corporations outstanding shares of stock are identical from an

economic standpoint (although not necessarily from a voting power standpoint)
and

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each of its shareholders is an individual (or the estate of an individual) who is a

U.S. citizen or resident, i.e., no shareholder can be a corporation, partnership,
LLC, or individual non-U.S. citizen/resident.5

However, one technique for minimizing the impact of these arbitrary rules and
achieving similar economics to (1) a second class of stock (e.g., granting one or more
shareholders a senior equity position or a complex profit sharing ratio or both)
or (2) an entity or a non-U.S. individual shareholderespecially useful where an
existing S corp is raising new money from a PE/VC fundis for:
(a) such S corp to drop its existing business and assets (in a tax-free Code 721
transaction) down to a newly formed partnership or LLC (lower-tier operating
entity) and
(b) PE/VC fund either to make an investment in lower-tier operating entity (rather
than in S corp) or to purchase an interest in lower-tier operating entity from S
corp.
S corps old business is then owned and operated by lower-tier partnership or LLC
entitya form of organization not subject to the S corp arbitrary rules discussed
abovewhich is in turn owned in part by S corp and in part by PE/VC:
U.S.
individuals
100%

PE/VC fund
and/or other
new equity
owners

S corp
Cash

Senior or formula
equity claim

Drop down Junior or formula

equity claim
S corps
assets and
business

New
Partnership or LLC
(lower-tier operating entity)

In situations where an actual transfer of S corp assets to a lower-tier operating

entity (as described above) is not desirable (e.g., because of the need for third-party
consents), the same result can be achieved utilizing the entity conversion mechanism
5

Under limited circumstances a trust for a U.S. individual or a one-member LLC owned by a U.S.
individual or a TEO can also be an S corp shareholder.

12

available under most state laws. Under this alternative, (1) the existing S corp
shareholders contribute all their S corp shares to a new S corp (Holdco S corp),
(2) the old S corp elects under state law to convert into a partnership or LLC, and
(3) the new investors invest in the newly converted partnership/LLC or purchase
a portion of such partnership/LLCs equity from Holdco S corp.
Steps (1) and (2), taken together, are treated, for federal income tax purposes, as a
tax-free F reorganization, which views Holdco S corp as a continuation of old S corp,
while step (2) (old S corps state-law election to become a partnership/LLC) is not
treated for state law purposes as an asset transfer, so that the state law drawbacks of an
actual asset transfer (e.g., retitling of assets and possible need for third-party consents)
can typically be avoided. See discussion at 301.4.1 and 301.4.3.
l

PE/VC fund qualifies as SBICincrease in size standards for SBIC investment in

Portfolio Company. Where PE/VC fund is an SBIC, PE/VC fund can generally invest in
Portfolio Company only if Portfolio Company is a small business, i.e., meets at least one
of the following two size standards:
(a) tangible book net worth not in excess of $19.5 million (recently increased from
$18 million) and average net income for prior 2 complete fiscal years not in
excess of $6.5 million (recently increased from $6 million) or
(b) certain employee or revenue standards published by SBA from time to time
for the industry in which Portfolio Company is principally engaged. See
discussion at 209.1.

Reduced tax rate for gain on sale of Code 1202 qualified small business stock.
Code 1202 grants a reduced LTCG tax rate (and a reduced Medicare tax rate) for an
individuals gain from sale of a C corps stock which has been held more than 5 years and
meets several other requirements. The extent of the tax rate reduction turns on when the
taxpayer acquired the stock:

Date stock acquired

Reduced
LTCG tax rate

Portion of LTCG subject

to 3.8% Medicare tax

8/11/93 thru 2/17/09

14%

50%

2/18/09 thru 9/27/10

7%

25%

9/28/10 thru 12/31/14

0%

0%

1/1/15 and thereafter

14%
50%
n unless Congress retroactively extends (to 2015 or perhaps thereafter) the 0%
rate as the Obama budget recommends and as Congress has previously done
year by year.

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To be eligible for Code 1202s reduced individual LTCG tax rate, the transaction
must meet all the requirements described in (1) through (8) below, some relating to the
C corp issuer of the stock (Portfolio Company), some relating to the selling shareholder,
and some relating to the nature of the transaction in which the selling shareholder
acquired the stock. The authors have expanded their analysis of Code 1202s applicability
vel non to a number of factual patterns outside the normal sale by an individual of
C corp stock purchased for cash and held more than 5 years before sale.
(1) Gain must be taxable to an individual. To qualify for 1202 treatment the CG must
be taxable to an individual, trust, or estate (hereinafter referred to as an individual), not to a
C corporation.
If the gain is recognized by a flow-through entity such as a PE/VC fund (i.e., a
partnership, LLC, or S corp), the reduced rate is available to an individual equity owner on
his/her share of the flow-through entitys gain, to the extent such equity owners interest in
the entity is not greater than when the entity acquired the Portfolio Company stock and such
equity interest has been held continuously since the entity acquired the Portfolio Company
stock.
Where an S corp distributes to its shareholderseither on the S corps liquidation or
as a dividend, both of which constitute a taxable event to the S corpqualified 1202 stock
in Portfolio Company held by the S corp for more than 5 years before such shareholder
distribution, the appreciation in the qualified stock at the time of its distribution to
shareholders is recognized by the S corp and constitutes 1202 gain allocable (on a
flow-through basis) to the S corps individual shareholders. However, the Portfolio
Company stock ceases to be qualified 1202 stock when received by the S corps
shareholders and thus does not constitute qualified stock when later sold by the
shareholders, because the Portfolio Company stock was not acquired by the S corps
shareholders at original issuance as required by (2) below.
(2) Stock acquired at original issuance and post-8/10/93. The individual reporting
the gain (or the flow-through entity in which the individual reporting the gain holds an
equity interest) must have acquired the stock at its original issue (directly or through an
underwriter). Thus, the shares must be purchased in a primary offering from Portfolio
Company (or from Portfolio Companys underwriter), not from a third party in a secondary
offering. It is not, however, necessary that the shareholder purchase the Portfolio Company
shares when Portfolio Company is first formed and first issues shares.
The Portfolio Company stock must also have been originally issued after 8/10/93, when
Code 1202 was first enacted.
Where an individual receives Portfolio Company stock by gift or at death from an
individual who held the qualified stock, the stock continues to qualify in the transferees

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hands (so long as the transferee is a qualified shareholder or a flow-through entity to the
extent owned by a qualified shareholder).
When a partnership or LLC holding qualified stock distributes such stock to its equity
owners, the stock received by an equity owner who is a qualified shareholder (i.e., an
individual) continues to be qualified stock if the additional requirements described in
(1) above are satisfied.
There is, however, no such favorable carryover treatment for (a) Portfolio Company
stock held by an S corp and distributed by the S corp to its shareholders or (b) Portfolio
Company stock held by an individual and contributed by the individual to a partnership,
LLC, or S corp.
If a qualified shareholder holds qualified stock in corp #1 but exchanges such corp #1
stock for corp #2 stock in a tax-free Code 351 incorporation or 368 reorganization, the
corp #2 stock received in exchange continues to be qualified stock with a tacked holding
period from the corp #1 stock. However, if corp #2 is not a qualified corporation at the
time of the exchange (e.g., because corp #2 has more than $50 million of assets, as described
in (6) below), gain on the qualified shareholders subsequent disposition of the corp #2
stock qualifies for 1202 treatment only to the extent of the built-in appreciation inherent in
the corp #1 stock at the time such stock was exchanged for corp #2 stock.
(3) 5-year holding period. The shareholder must hold the Portfolio Company stock for
more than 5 years.
However, there is tacking for (a) a stock transfer by gift or at death or by partnership or
LLC distribution to its equity owners (to the extent an equity owners interest in the entity is
not greater than when the entity acquired the Portfolio Company stock and such equity
interest has been held continuously since the entity acquired the Portfolio Company stock),
(b) on a conversion of convertible preferred stock (but not convertible debt) into (e.g.)
common stock, (c) on a conversion of non-voting into voting stock, or (d) on a rollover of
old 1202 stock for new 1202 stock (pursuant to a Code 1045 sale of the old 1202 stock
coupled with a purchase of new 1202 stock within 60 days thereafter).
Where Portfolio Company convertible debt is converted into stock, the holding period
starts anew at the time of the debt conversion and the measurement of whether Portfolio
Company qualifies for 1202 (e.g., satisfies the $50 million or less asset test) is made at
the time of the debt conversion. Moreover, the gain which qualifies for 1202 is limited to
appreciation in the stock occurring after the debt conversion. Thus, the 1202 result is
sharply different for convertible debt than for convertible preferred, where the common
stock received on conversion is treated as merely a continuation of the preferred stock.
Where a Portfolio Company warrant is exercised, the transaction is treated as a new
purchase of common stock so (a) the holding period for the stock starts anew at time of exercise

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and (b) determination whether the Portfolio Company qualifies for 1202 is made at time of
exercise. However, in a cashless warrant exercise (where the warrant is exchanged for stock
with an FV equal to the appreciation in the warrant and the warrant holder makes no cash
payment), the built-in appreciation inherent in the stock at issuance does not qualify for 1202.
Stock received by a service provider in connection with the performance of services is
treated as issued when the resulting compensation income, if any, is included in the service
providers income in accordance with the rules of Code 83 (i.e., (a) at issuance where the stock
is vested at issuance, (b) at issuance where the stock is subject to vesting but the service provider
makes a timely 83(b) election, or (c) at vesting where the stock is subject to vesting and the
service provider does not make a timely 83(b) election).
As described in (2) above, if a qualified shareholder exchanges qualified stock in corp #1 for
stock in corp #2 in a tax-free Code 351 incorporation or 368 reorganization, corp #2s
stock received in the exchange is qualified stock, but if corp #2 is not a qualified corporation
at the time of the exchange (e.g., because corp #2 has more than $50 million of assets, as
described in (6) below), gain on the qualified shareholders subsequent disposition of the corp
#2 stock qualifies for 1202 treatment only to the extent of the built-in appreciation inherent in
the corp #1 stock at the time such corp #1 stock was exchanged for corp #2 stock.
(4) Stock must be acquired for cash or other qualified consideration. The Portfolio
Company stock must have been acquired in exchange for:
(a) cash,
(b) property other than stock, or
(c) services.
However, as discussed in (2) above, if a qualified shareholder exchanges qualified stock in
corp #1 for stock in corp #2 in a tax-free Code 351 incorporation or 368 reorganization,
corp #2s stock received in the exchange is qualified stock, because the corp #1 stock
was issued for qualified consideration (even though the corp #2 stock was not), but if
corp #2 is not a qualified corp at the time of the exchange (e.g., because corp #2 has more
than $50 million of assets), gain on the qualified shareholders subsequent disposition of
the corp #2 stock qualifies for 1202 treatment only to the extent of the built-in appreciation
inherent in the corp #1 stock at the time such corp #1 stock was exchanged for corp
#2 stock.
(5) U.S. C corp issuer. The Portfolio Company stock must have been issued by a
U.S. C corp. Hence, stock in an S corp, stock in a non-U.S. corp, and equity interests
in a partnership or LLC do not qualify (although stock in a U.S. C corp indirectly owned by
a qualified shareholder through a flow-through entity does qualify).

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(6) $50 million maximum assets at issuance.

Gross asset measurement. The aggregate gross assets of [Portfolio Company] (or any
predecessor thereof) (including intangible assets) must not exceed $50 million at any time
on or after 8/10/93 until immediately after the shareholder acquires the stock.6
Portfolio Companys assets are measured by their adjusted tax basis, except that an asset
contributed to Portfolio Company with carryover basis is measured by its FV at
contribution. This $50 million calculation is made after taking into account the amount
received by Portfolio Company in the stock issuance being tested for 1202 qualification.
For purposes of the $50 million test, Portfolio Companys assets generally include 100%
of the assets of any 50%-or-more corporate parent and any 50%-or-more direct or
indirect corporate subsidiary measured by vote or value (ignoring certain non-voting
plain vanilla preferred stock).
Step-transaction doctrine. The statute does not define the term immediately after
the shareholder acquires the stock (which is when Portfolio Companys assets are
measured). Thus, taxpayers may take the position that the term should be interpreted
literally to refer to the state of affairs at the instant immediately following the issuance of
stock, disregarding all subsequent events, including future pre-planned stock issuances.
However, in interpreting other Code provisions IRS and the courts, applying the steptransaction doctrine, have frequently interpreted the term immediately after to
include preplanned future events.
Hence it is unclear whether a first investor or investor group in Portfolio Company
(whose investment does not increase Portfolio Companys gross assets above $50 million)
qualifies for Code 1202 treatment where there is a preconceived plan (ultimately carried
out) to raise additional financing from a different or even the same investor or investor
group that does increase Portfolio Companys gross assets to more than $50 million
shortly thereafter.
However, the legislative history of 1202s enactment can be read as rejecting a 1202
step-transaction doctrine and instead adopting a bright-line end-of-the-day test, by stating
that If a corporation satisfies the gross assets test as of the date of issuance but subsequently
exceeds the $50 million threshold, stock that otherwise constitutes qualified small business
stock would not lose that characterization solely as a result of that subsequent event
(emphasis added).
Application of $50 million test in LBO context. Where Portfolio Company is a new
corporation (Newco) formed for the purpose of acquiring Targets assets (e.g., in an
6

Portfolio Companys liabilities are not relevant to this calculation.

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LBO), the $50 million limitation for Newco (a) would apparently be violated where
the aggregate amount received by Newco from debt and equity financing exceeds
$50 million and (b) might be violated (if the step-transaction doctrine applies) even
where the aggregate amount Newco received from debt and equity financing was below
$50 million but Newcos post-acquisition tax basis in its own assets plus the assets acquired
from Target (including basis created when Newco inherits Target liabilities as part of the
asset acquisition) exceeds $50 million.
Where Newco is formed to acquire Targets stock, it is unclear whether the $50 million
limitation is applied (a) by reference to the aggregate debt and equity financing raised by
Newco or (b) by reference to Newcos and Targets post-acquisition assets (if the steptransaction doctrine applies) by disregarding Newcos basis in Targets stock and instead
taking cognizance of Targets post-acquisition tax basis in its assets.
(7) Active business. The Portfolio Company must meet a complex active business
requirement during substantially all of the shareholders holding period for its stock.
(8) No redemptions. Newly issued Portfolio Company stock is not eligible for the
Code 1202 reduced tax rate if Portfolio Company has made certain types of stock
redemptions.
(9) Calculating amount of gain qualifying for 1202 reduced tax rate. The maximum
amount of an individuals LTCG from stock of a single corporation eligible for the
reduced tax rate is the greater of (a) $10 million (taking into account his or her gain during
the year of the sale and all prior years) and (b) 10 times the taxpayers aggregate basis
in such stock disposed of by the taxpayer during the year of the sale.
Where a qualified shareholder acquires qualified Portfolio Company stock in exchange
for appreciated property transferred to Portfolio Company (e.g., under Code 351), the
amount of such shareholders gain on the ultimate sale of such Portfolio Company
stock which qualifies for 1202s reduced tax rate is reduced by the appreciation in the
property at the time the shareholder transferred the property to Portfolio Company in
exchange for the qualified stock. See discussion at 906.1.
l

Volcker Rule developments regarding a BHC groups investments (e.g., in PE/VC

funds) and activities. In addition to restricting proprietary trading and the sponsorship of
PE/VC funds by a BHC group (i.e., a bank holding company and its subsidiaries and
affiliates), the Volcker Ruleenacted in 2010, but not fully effective until 7/15prohibits
investments in a covered fund (primarily a PE/VC fund exempt from ICA registration
by 3(c)(1) or 3(c)(7)), unless qualifying for an exclusion or exemption.
n

2/15 Fed publication clarifies that the solely outside the U.S. (or the
SOTUS) exemption allows a non-U.S. BHC to invest in a PE/VC fund offered

18

and sold in the U.S. by the PE/VC funds sponsor. The Volcker Rules SOTUS
exemption allows a non-U.S. BHC (i.e., a banking institution organized in a non-U.S.
jurisdiction that is treated as a U.S. bank holding company under the BHCA by
virtue of its U.S. banking nexus) to invest in a PE/VC fund (or a co-investment
entity) if:
(a) More than half the non-U.S. BHC groups business (on a consolidated basis) is
from outside the U.S.,
(b) The PE/VC fund has been offered for sale and sold pursuant to an offering that
does not target U.S. residents (as defined in SEC Reg. S), referred to as the
SOTUS marketing restriction, and
(c) The non-U.S. BHC groups investment in the PE/VC fund is made outside the
U.S. (i.e., the BHC groups decision to invest in the PE/VC fund is made by
non-U.S. personnel, the BHC groups investment is not accounted for by any
U.S. branch or affiliate, and the BHC groups investment is funded from a
non-U.S. source).
Before 2/15, the SOTUS marketing restriction (discussed in (b) above) was widely
interpreted to mean that no party (including the PE/VC sponsor) could offer or sell to a
U.S. resident interests in the PE/VC fund intended to qualify for investment by a
non-U.S. BHC under the SOTUS exemption. Consequently, in order to facilitate a
non-U.S. BHCs investment, the PE/VC sponsor had to form the SOTUS
investment entity (in which no U.S. resident could invest) as one of multiple parallel
investment entities (i.e., two or more parallel entities formed at approximately the
same time by the same GP/management company/sponsor to invest pro rata in the
same portfolio companies and denominated collectively as the same PE/VC fund).
In 2/15, however, the Fed published FAQ 13 clarifying that the SOTUS marketing
restriction prohibiting sales to a U.S. resident applies only to a non-U.S. BHCs (and
not a PE/VC sponsors) offer and sale of interests in the entity in which the non-U.S.
BHC is investing in reliance on the SOTUS exemption. With this guidance, a non-U.S.
BHC can meet the SOTUS exemption requirements discussed above (including the
SOTUS marketing restriction) and invest in a PE/VC fund without the need for any
special accommodation (i.e., there is no need to form a separate entity in which the
non-U.S. BHC invests but in which no U.S. resident invests).
n

Volcker Rule effective date. The Volcker Rule 12/13 final implementing regulations
and subsequent Fed releases extend the Volcker Rule conformance period:

from 7/21/14 to 7/21/15 for all Volcker Rule activities and investments, with two
1-year extensions in the Feds discretion and an additional extension of up to 5
years in the Feds discretion for an illiquid fund investment with respect to
which the BHC group had a contractual obligation as of 5/1/10, and

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from 7/21/15 to 7/21/16 for investments in and relationships with a covered fund
entered into prior to 12/13, with one 1-year extension in the Feds discretion and
an additional extension of up to 5 years in the Feds discretion for an illiquid
fund investment with respect to which the BHC group had a contractual
obligation as of 5/1/10.

However, the Feds regulations state that the Fed expects a BHC group to engage
in good faith efforts resulting in conformance of its activities to the Volcker Rule by the
applicable deadline and a BHC group can make PE/VC fund investments or engage
in new sponsorship activities only to the extent such investments and activities
qualify for a Volcker Rule exclusion or exemption or otherwise can be brought into
conformance with the Volcker Rule by the end of the applicable conformance
period. See discussion at 1014.3.2 and 1014.5.
l

. . . and much, much more.

This publication is designed to provide accurate and authoritative information in regard to the subject
matter covered. It is sold with the understanding that the publisher and the author(s) are not engaged in
rendering legal, accounting, or other professional services. If legal advice or other professional assistance is
required, the services of a competent professional should be sought.
From a Declaration of Principles jointly adopted by a Committee of the American Bar Association
and a Committee of Publishers and Associations

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