A joint venture (JV) need not—and often should not—be structured as a separate jointly owned entity (see my April 3 blog), but if it is, the tax reasons to use a limited liability company (LLC) rather than a corporation as the jointly owned entity are compelling.
Tax Advantages of JV LLCs
Most entities formed to conduct strategic joint ventures in the U.S. are formed as LLCs. LLCs pass their taxable income through to their owners, thereby reducing the effective maximum federal tax rate on JV income from 41.8% to 35% (taking into account the dividends received deduction). JV LLCs pass losses through to the JV members currently, while JV corporations can only offset other income of the JV with net operating loss carry forwards.
More importantly, if the JV is designed with the possibility of a sale or IPO in mind, a JV LLC generates greater after-tax proceeds of a sale or IPO. Sale proceeds are greater because a buyer will pay more for assets and accompanying amortization tax shield than it will for corporate stock. Even if the exit is an IPO, the JV members will have increased their tax basis in the ultimate public company stock by undistributed operating earnings during the time the JV was an LLC. Recent IPOs have also used tax-sharing agreements to capture for sellers into an IPO the tax benefits of the amortization tax shield that exists if the business was operated in LLC form prior to the IPO.
If the JV is not so successful, the JV LLC can often be unwound by splitting up the business, while a tax-free split-up is difficult or impossible for a JV corporation. Also, ultimate losses on disposition or shutdown of a JV corporation are capital losses that can be effectively unusable, while losses in a JV LLC are normally ordinary.
Tax Issues in JV LLCs
When the members contribute business assets, including intangibles, to a JV LLC, the depreciation allocation method is a material deal term that should be negotiated at the term sheet stage. LLC agreements usually allow transfers of LLC interests to affiliates, but even tax-free transfers of more than 50% in 12 months restart and delay depreciation for both partners, so the agreement should require the non-transferring partner’s consent or provide an adjustment to compensate the non-transferring partner. Provisions to resolve disagreements relating to tax filing positions or handling of tax audits are negotiated and can be difficult. Transactions between the members and the JV LLC are subject to arm’s length transfer price standards, as are the provisions for allocation of JV LLC profits between the members.
The tax advantages of adopting the LLC form for a JV entity make resolving LLC tax issues and dealing with the complexities of partnership tax worthwhile, so that LLCs are likely to remain the entity of choice for strategic JVs.