In the past few years, I’ve worked on an unusually large number of matters requiring complex tax analysis in high-stakes situations. While I’ve always had a healthy respect for the importance of tax issues, these more recent engagements have left me in absolute awe of the risks associated with the tax code. Seemingly harmless transactions consummated years before can dramatically alter your tax position years after.
The notion I wanted to get across with this post’s hopefully catchy title is that there are always at least two occasions on which tax advice is critical for any transaction or business arrangement: first, at the time of entering into the transaction or arrangement; and second, at the time of exiting the transaction or arrangement.
A corporate and transactional lawyer is, by definition, at least half a tax lawyer — he or she must have enough knowledge and experience to spot issues, and then must have a full tax lawyer nearby. Obviously, tax advice should always be obtained in connection with any venture capital financing or merger & acquisition transaction. But, the tax code is full of other tricks and traps to catch the unwary. Some of the usual suspects in my practice include:
- complex rules regarding limited liability company (LLC) membership interests, including the use of profit interests for purposes of employee or consultant compensation — these issues seem particularly acute when a company wants to superimpose a corporate-style capital structure (e.g., common stock, preferred stock, options and warrants) on an LLC
- complex “change of ownership” rules that can dramatically limit the value of net operating loss (NOL) carryforwards — these rules are specific to ‘C’ corporations (as opposed to pass-through entities such as ‘S’ corporations or LLCs) and can pose problems whenever there are meaningful share issuances or transfers; it is important to keep track of the ‘change of ownership’ test on the occasion of each such issuance or transfer
- complex rules governing the use of equity incentive compensation, such as non-qualified stock options (“NSOs” or “non-quals”), incentive stock options (ISOs), restricted stock, and stock appreciation rights (SARs) — the decisions on this topic impact the tax benefits available to the company and the after-tax income ultimately received by the recipient, and often have unintended or at least under-appreciated tax, accounting and financial consequences for both sides
- Section 409A rules that regulate details that must be included in any deferred compensation arrangement (which is quite broadly defined to include most compensation that is not paid in cash at the time it is earned)
- Section 280G rules that greatly complicate “golden parachutes” (i.e., substantial compensation payments due as a result of a change of control transaction)
- Section 83 rules that provide an optional election (under Section 83(b)) in connection with the receipt of restricted property (such as restricted stock or profit interests) that vests over time (while the election allows the recipient to eliminate the tax that would be due at each vesting date, it can result in a higher tax under some other circumstances)
- and others…
Effective tax planning can create substantial economic benefits for a company (or individual), while a lackadaisical approach can result in real tax costs. Although there is a fairly high upfront cost to good tax planning, in my experience it is a fraction of the cost later incurred in trying to fix a tax problem that otherwise could have been avoided. Unfortunately, since most people have not personally experienced a large unexpected tax bill, the risk of such a tax bill is often underestimated; nevertheless, it is quite distressing if and when it comes. Conversely, tax savings create dollar-for-dollar value that is available to fund working capital, growth or distributions to owners. Accordingly, my strategic advice to companies (and individuals) is to discuss tax issues with their legal counsel early and often, no less than on the ‘entry’ and ‘exit’ of every significant transaction.