Troubled Waters: Navigating the Tax Issues of Llcs With Bridge Debt

• Publication year: 2014
• Author: William Skinner, Esq.

Troubled Waters: Navigating the Tax Issues of LLCs with Bridge Debt

William Skinner, Esq.¹

William R. Skinner, Esq. is a tax associate with Fenwick & West LLP, in Mountain View, CA. He practices in the areas of international taxation, corporate/M&A tax, taxation of financial instruments and tax controversy. He has significant experience in international tax planning, tax controversies involving sophisticated international and domestic tax issues, and in the taxation of corporate transactions, such as mergers, acquisitions, financings, debt and equity offerings, and entity formations.

Introduction

It is an all-too-common occurrence in the venture capital community to extend bridge loans to portfolio companies in order to help them to reach the next round of equity financing or attempt a sale. Often these loans are convertible into equity at the holder's election or automatically upon the next preferred stock financing that meets a defined set of criteria. Sometimes these loans are secured by the assets of the borrower.

While such bridge loans do not pose significant tax issues for corporate borrowers, corporate tax concepts often do not translate to limited liability companies ("LLCs") taxed as partnerships. This article explores one such lesser-known, but potentially serious, tax trap: using convertible notes or other "bridge" debt to finance an operating company taxed as a partnership. These notes can create serious problems, such as phantom income (i.e., income recognized for tax purposes by the members without any distribution of cash) resulting from a company's insolvency/failure.

LLCs may be taxed as partnerships or corporations. Absent an election to be taxed as a corporation, an LLC is taxed as a partnership, so that the members are taxed on their shares of the LLC's income or loss. This article assumes that the LLC is taxed as a partnership and its unit-holders taxed as partners.

After discussing the basic tax problem, this article outlines certain approaches that may help remediate the problem of phantom income from notes in certain cases. However, the best way to avoid these tax issues is not to create such debt in the first place, and instead fund the LLC with a comparable preferred unit or an instrument that, while styled "debt," constitutes equity for tax purposes.

Outline of the Basic Fact Pattern and Tax Issues

For illustration, let's consider a simplified fact pattern of a Company organized as an LLC taxed as a partnership with only two members, A and B, each of whom contributes an equal amount of equity capital and holds 50% of the common units. The Company needs additional capital, and finds a third party, C, who lends the company $100 on a note convertible into the company's preferred equity on a qualified financing round. In addition, A advances $100 to the Company on the same terms as C.

In the LLC's post-borrowing operations, if everything goes well, A and C will convert their notes into additional units or, alternatively, into preferred stock after conversion of the Company to a subchapter C corporation. Such conversions of debt to preferred stock raise their own issues, such as taxation of units/shares received for accrued but unpaid interest.² However, here we will focus on the potential issues that would arise if the LLC loses the $200 of loaned funds and fails.

Under the partnership tax rules, each of the Company's members is allocated a portion of the tax deductions (i.e., net operating losses) attributable to the Company spending the $200 advanced with respect to the notes. The manner in which these deductions are allocated should track the way the partners are treated as responsible for debts. In the case of the loan by C, the loan is not recourse to either A or B, and so A and B are viewed for tax purposes as sharing this loan ratably in proportion to their interests in the Company's profits (i.e., 50%-50%).³ In the case of the loan by A, the full liability ($100) is allocated to A, as the partner/lender effectively has put his own money at risk in the Company.⁴ In total, A will bear $150 of the liability of the notes, and B will bear $50. The losses corresponding to these sums will flow through to A and B, and, subject to certain limitations,⁵may be deducted by A and B on their personal income tax returns against other sources of income outside the Company.

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Thus far, A has advanced $100 of cash and potentially deducted the $100 of losses corresponding to these sums. A and B have each also potentially deducted $50 of losses attributable to their share of the Company's note borrowed from C. C, as creditor of the Company, has not been allocated any of the Company's losses.

There is no free lunch for A and B for having deducted tax losses funded with borrowed money. If the Company were profitable, it would generate taxable income that is allocable to A and B, even though the cash is used to repay the Company's loans. If the Company converted the notes to equity, this note conversion would relieve A and B of partnership liabilities and trigger a deemed distribution of cash that reduces their respective bases in their Company interests and gives rise to capital gain to the extent it exceeds their respective bases in the Company.⁶ Finally, if the Company wound up and the notes were simply cancelled, A and B would generally be taxable on ordinary income from the cancellation of indebtedness ("COD income").⁷

The tax consequences to A are particularly tangled if the Company fails. Recall that A wears two hats: a member of the Company, which has borrowed cash, and a lender to the Company. In his capacity as a member, A has taken $150 of ordinary deductions and now will be required to recapture that tax benefit on satisfaction of the debt. At the same time, in A's capacity as creditor, if the Company has truly failed, A has a genuine economic loss of $100. Although this transaction, economically, is a loss by A of his $100, the character and timing of the different parts of the transaction may not match, causing A to effectively lose his tax deductions.

Moreover, the example discussed here is simplified for purposes of illustration by assuming that the Company has only two members, A and B, and two creditors. In practice, the Company more commonly could have many more than two members, all of whom could be adversely affected by the COD income of the Company. Each of these members may be required to be...