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FAST Act Includes Changes to Securities Laws

By Avital Perlman

President Obama signed the Fixing America’s Surface Transportation Act, or FAST Act, into law on December 4, 2015.  The FAST Act, which is aimed at improving the country’s surface transportation infrastructure, also contains several sections that amend securities laws to ease regulatory burdens for smaller companies.

Improving Access to Capital for Emerging Growth Companies, or EGCs continue reading >>

International Tax Planning II — Inbound

In our last blog post covering international tax planning, we focused on the unique tax traps related to international acquisitions. In our final installment, we discuss the tax considerations for foreign businesses looking to acquire companies in the U.S.


 

The U.S. is still the big apple for most foreign businesses, but deciding how to get a bite of it requires careful tax planning.

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Why Go Public?

This blog post is the first installment of our "Going Public" blog series; a collection of blog articles dedicated to educating readers on the legal and financial considerations companies need to have when and if they decide to go public. Next week, we'll be covering the different ways a company can go public so please stay tuned. 

Why Go Public?

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23 States Legalized Marijuana – Bankruptcy Courts Remind Us That It’s Legal in None of Them

“There was a time a few years ago when the United States was spoken of in the plural number.
Men said ‘the United States are’ — ‘the United States have’ — ‘the United States were.’ But the war changed all that.”   The Washington Post, April 24, 1887.   The phrase “United States” became a singular noun after the Civil War. continue reading >>

Rule 144 : How Officers, Directors and Large Shareholders Can Navigate Affiliate Sale Requirements

Introduction

The resolution of tension between two desires of a subset of powerful investors—to sell, and to govern well—is the impetus behind the affiliate sale provisions as drafted in the amended Rule 144.

Rule 144 is the main avenue open to affiliates to sell un-registered securities in the public market. An “affiliate” of an issuer is defined as a “person” who directly or indirectly controls the issuer, generally any executive officer, director or shareholder beneficially-owning 10% or more of the issued and outstanding shares.[1] Volume limitations, reporting obligations and manner of sale provisions, as well as a definition of “person” that responds to the concept of “indirect control,” are among the measures incorporated into Rule 144, in view of the SEC’s understanding that, absent limitations, those in control of a company could be liable for significant abuses in sales of un-registered securities.[2]

Affiliates should know who they are, and what their obligations under the rule are in order to plan efficient sales with reduced liability potential. Additional benefits may be gained at the point of negotiating director or officer compensation. Negotiators may better gauge the value of un-registered compensation shares if they understand the workings of the Rule 144 affiliate sale process.

[1] An affiliate of the issuer is a person that directly, or indirectly through one or more intermediaries, controls, or is controlled by, or is under common control with, such issuer. See 17 CFR 230.144(a)(1). Factors the SEC has indicated as relevant to the determination of “control” include an individual’s status as a director, officer, or 10% shareholder. See American Standard, October 11, 1972.
[1] 2007 Proposal, p. 20.

Affiliate Sale Rules

Part I: Who is an “Affiliate”?

The navigation of affiliate sale requirements begins with a substantive analysis: Is a given security-holder an “affiliate” for the purpose of Rule 144? The answer is complicated by the broad definition of “person,” which responds to the possibility of “indirect control” of an issuer.

As stated above, an affiliate is defined as a person who directly or indirectly controls the issuer. “Indirect control” is determined in courts through a facts and circumstances analysis—it is a “know-it-when-we-see-it” idea. A director’s wife, for example, may exert indirect control on a company through influence, though she holds no formal position and may not own many shares. When does an ordinary filial relationship become a control relationship with the issuer? The question becomes more involved when determining when percentage-ownership, perhaps by an otherwise ordinary public investor, translates to having “control” of a company. Courts consider 10% beneficial ownership indicative of a control relationship, but not dispositive.

Rule 144 gets in front of these questions by counting a range of people, entities and donees related to an individual security-holder as one “person.” Individuals or entities that constitute one affiliated “person” are individually subject to the affiliate sale rules, and their sales will be considered cumulatively as if they were one seller. An analysis of affiliate status can be done on a case-by-case basis where circumstances are vague or there are countervailing factors weighing against otherwise suspicious relationships. For this reason, determining whether one is an affiliate can be a rigorous point of investigation, and it must be done before sales can be planned.

Part II: Affiliate Sale Requirements

Rule 144 permits sales where an affiliate did not acquire shares with the intent to profit by distributing them, possibly at the expense of the issuer or the investing public. Volume limitations, manner of sale provisions and an obligation to report sales of a certain size, are factors the SEC believes demonstrate an affiliate assumed the economic risk of investment. Assumption of economic risk cleanses an affiliate’s intent in the eyes of the authorities.[3]

Volume limitations control the rate at which securities may be sold. Quarterly sales of shares in an exchange-listed issuer are limited to the greater of 1% of the issued and outstanding shares of the same class being sold, or the average weekly trading volume during the preceding four weeks. An affiliate in a non-exchange listed issuer (such as an OTC Bulletin Board or OTC Markets company) must use the 1% measurement. Volume limitations present a significant, though straightforward, control on affiliate sales, and affiliates should consider them when planning sales on a timeline.

Manner of sale provisions prescribe the appropriate relationship between an affiliate and a broker. They prevent sales from taking on the semblance of distributions, through commission structures or otherwise. Affiliates must sell equity securities in unsolicited broker’s transactions directly with a market maker, or in riskless principal transactions. A broker must do no more than execute an order to sell the securities as agent for the affiliate, and may receive no more than customary commission. Solicitation for buy orders is generally inappropriate. The SEC has cited the “gatekeeper” role of the broker to ensure compliance with Rule 144. By turn, affiliates should select brokers with care and construct healthy sale relationships with them in view of the manner of sale provisions.

Finally, the SEC requests to be made aware of significant public securities transfers by affiliates. Affiliates must file Form 144 with the SEC in advance of sales of more than 5,000 shares or $50,000 aggregate dollar value. The sale must take place within three months of filing the form.

Conclusion

Officers, directors or large shareholders of an issuer should have a firm grasp of the affiliate sale rules under Rule 144, so they may plan sales efficiently, effectively and properly. This begins with knowing whether one is an affiliate, and how to count shares using the definition of “person” described above. Once affiliate status is determined, the obligation runs to sell in compliance with volume limitations, manner of sale provisions and Form 144 reporting. At the time of sale, this insulates affiliates from liability, and allows them to cultivate reputations as responsible controlling investors. At the time of employment contract negotiation, knowledge of the affiliate sale process can help an officer or director better gauge the value of compensation shares. Most importantly, being in compliance with Rule 144 enables an affiliate perform its duties to the issuer and the investing public, while participating actively in the market.

[1] An affiliate of the issuer is a person that directly, or indirectly through one or more intermediaries, controls, or is controlled by, or is under common control with, such issuer. See 17 CFR 230.144(a)(1). Factors the SEC has indicated as relevant to the determination of “control” include an individual’s status as a director, officer, or 10% shareholder. See American Standard, October 11, 1972.
[2] 2007 Proposal, p. 20.
[3] Barring other proof of a scheme to evade securities laws.

 

The information in this blog post is for general, educational purposes only and should not be taken as specific legal advice.


Written by Jennifer R. Rodriguez, Esq.

JenniferRodriguez

Selling Your LLC for Stock – The Tax Problem

Entrepreneurs often choose limited liability companies to incubate their businesses. An LLC offers a simple entity structure, it lets the members claim start-up losses on their own tax returns, and it eliminates the double tax imposed on a corporate structure once the venture turns profitable.

But an LLC has a tax defect that its owners frequently don’t understand until it’s too late: because it is not a corporation an LLC cannot participate in a tax-free corporate reorganization. So when the owners sell their LLC interests to another company for stock, the transaction is a taxable event to them but they don’t get cash to pay the tax on any gain.

If the stock trades publicly the owners can sell some of it to raise cash for the taxes. But they may not want to do that, and there may be SEC- or deal-driven lockups that prohibit them from selling before the tax is due. If the stock doesn’t trade publicly, they may need to find cash somewhere else.

The buyer may have a number of reasons for wanting to acquire membership interests of an LLC using its stock as currency: it may not have the cash itself, or want to use it, or it may want the sellers to continue to have an equity interest in the company and be motivated to help it succeed. The buyer may propose a stock-for-stock exchange, a stock-for-assets exchange, or a merger. All of these transactions could be tax-free to the sellers who own the target – but only if the target is a corporation.

There are solutions to this problem, but each solution carries tax risks. The sellers can incorporate their LLC (or elect to have it treated as a corporation for tax purposes) before the acquisition and then exchange their stock in the new corporation for stock in the buyer. But this approach will usually generate a so-called “step-transaction” analysis: if the IRS decides that the conversion of the LLC into a “C” corporation and the subsequent stock exchange were all part of the same transaction, and that there was no non-tax reason for the conversion, it will disregard the first step – the conversion – and treat the transaction as a taxable sale of the LLC interests. The closer the conversion occurs to the acquisition, the more likely the step-transaction doctrine will be applied.

Another solution is to structure the exchange as a tax-free “Section 351 transfer”. Section 351 transfers can involve property (as opposed to just stock). In a section 351 transfer the seller contributes his LLC interests (or the LLC’s assets) to a new corporation, and the buyer contributes stock (or other property) to the new corporation, and if together the seller and the buyer control more than 80% of the new corporation, then the transfer is tax-free.

But this solution has its drawbacks, as well. For one thing the stock that the seller now owns is not stock in the buyer but in a corporation that is a subsidiary of the buyer. That stock probably won’t be sellable. After a decent interval (which could be as long as a year) the parties could liquidate the subsidiary into the buyer and distribute stock in the buyer, but if they do that too soon then — you guessed it — the step-transaction analysis is applied once again. And if the buyer uses treasury stock to capitalize the subsidiary, there is an unsettled legal question as to whether the transfer is still tax free to the seller. In any event, the section 351 transfer forces the buyer to hold the target’s business in a subsidiary company, something it may not wish to do.

There are also non-tax solutions: the deal might require the buyer to provide enough cash consideration for the seller to pay the tax, but then the amount of cash becomes a negotiating point and chances are the seller gives up something in return for it.

The best solution to the LLC problem is to plan ahead. Way ahead. Do you need an LLC in the first place – will the tax benefits of the losses justify the potential tax problem on a sale for stock? Would an S corporation serve as an alternative to an LLC? (It’s not an alternative if there are foreign, corporate or (in some cases) trust owners, more than 100 owners, or more than one class of equity.) If you plan to sell the business before it turns a profit (and then there would be no benefit to the tax flow-through) should you just start with a corporation in the first place? There are no boiler-plate answers to these questions; the alternatives need to be analyzed in the context of the business and the exit strategy.

If you already have an LLC and plan to sell, the best solution is still to plan ahead. If today you foresee a sale of your company in a year or so, now may be the time to convert it to a corporation. The further in advance of the sale that you do so, the more likely you are to avoid the step-transaction doctrine. (LLCs can usually be converted to corporations tax-free.) Again, there is no one-solution-fits-all, but you will have more options if you address the problem well in advance of the sale.

The corporate tax-free exchange rules of the tax laws are among the most complicated in the Internal Revenue Code, but people have been dealing with them for decades and a solution is often available, as long as you leave yourself enough time and flexibility to find it.


Written by Michael Savage, Esq.

The information in this article is for general, educational purposes only and should not be taken as specific legal advice.