Calculating Beneficial Ownership: Applying the Corporate Capital Rule
In some prior posts (Beneficial Ownership Under the Corporate Transparent Act: The Capital Calculation Rules and Calculating Beneficial Ownership: Applying the Partnership Capital Rule), I described how FinCEN’s Reporting Rule for preparing BOI reports required the reporting company to determine whether it was subject to the Partnership Capital Rule or the Corporate Capital Rule.
This post describes how to apply the Corporate Capital Rule.
Beneficial Ownership Under the Corporate Transparency Act: The Capital Calculation Rules
The CTA will require more than 35 million businesses to file a beneficial ownership information (BOI) report with FinCEN. The BOI report will need to provide specific items of personally identifiable information (PII) about each beneficial owner of the company.
Calculating Beneficial Ownership under the Corporate Capital Rule
FinCEN’s Reporting Rule distinguishes between the test for calculating ownership percentages (1) for reporting companies “that issue capital or profit interests (including entities treated as partnerships for federal income tax purposes)” and (2) those that are “treated as corporations for federal income tax purposes, and other reporting companies that issues shares of stock.” See 31 CFR 1010.380(d)(2)(iii), subsections (B) though (C) (emphasis added).
This is a confusing distinction. As I wrote earlier, it tries to distinguish between (1) entities taxed as a partnership as well as other (non-partnership) entities that issue capital or profit interests, and (2) those taxed as a corporation, including those that issue shares of stock.
Reporting Companies Subject to the Corporate Capital Rule
If a reporting company falls into the first category (i.e., subsection (C) of 31 CFR 1010.380(d)(2)(iii)), the reporting company must follow the “Corporate Capital Rule” in subsection (C). The Corporate Capital Rule provides that an individual’s ownership percentage is equal to the greater of:
- the total combined voting power of all classes of ownership interests of the individual as a percentage of total outstanding voting power of all classes of ownership interests entitled to vote, or
- the total combined value of the ownership interests of the individual as a percentage of the total outstanding value of all classes of ownership interests; and
Consequently, the reporting company needs to perform two calculations for each potential beneficial owner and take the higher of the two resulting percentages.
The first calculation asks to determine the potential beneficial owner’s combined voting power.
The second calculation asks to determine the total “combined value” of the potential beneficial owner’s ownership interests as a percentage of the total outstanding value of all classes of ownership interests. In the same way that this approach led to ambiguity when it was part of the Partnership Capital Rule, it also leads to ambiguity here.
The calculation is ambiguous if the total combined value of all the classes of ownership interests is unknown or a matter of speculation. This will be the case for any reporting company that owns any assets not easily liquidated into cash. When the total value of the reporting company is not determinable, the percentage of the total value held by any potential beneficial owner will also not be determinable.
When the Calculation is Not Reasonably Determinable
Subsection (D) of 31 CFR 1010.380(d)(2)(iii)) provides that “if the facts and circumstances do not permit the calculations described in [the Corporate Capital Rule, subsection (C)] to be performed with reasonable certainty, any individual who owns or controls 25 percent or more of any class or type of ownership interest of a reporting company shall be deemed to own or control 25 percent or more of the ownership interests of the reporting company (emphasis added).”
Subsection (D) creates a “failsafe rule” that tells the reporting company to identify as a beneficial owner any “individual who owns or controls 25 percent or more of any class or type of ownership interest of [the] reporting company.”
Examples that Apply the Corporate Capital Rule
Example #1. Alpha Corporation is a corporation. Alpha Corporation has five stockholders: A, B, C, D and E, each of whom holds an equal number of voting common shares of the corporation.
In Example #1, because each of the five stockholders holds (1) a 20% voting interest, and (2) a 20% share of the total value of the corporation, none of them has 25% or more under the Corporate Capital Rule. In Example #1, the Corporate Capital Rule produces a reasonably certain outcome (because the percentages never change regardless of the liquidation value of the corporation), so there is no need to apply the failsafe rule in subsection (D).
Example #2. If the facts are the same as Example #1, except that A and B each hold 1,000,000 shares of voting common stock, while C, D and E hold 100,000 shares of non-voting common stock.
In Example #2, the voting power is split equally (50% each) between A and B. As a result, each of A and B is a beneficial owner. Looking at percentage of total value, C, D and E each have 100,000 shares out of a total of 2,300,000 shares, or 4.3% each. As a result, none of C, D or E is a beneficial owner.
Example #3: If A and B each own 1,000,000 shares of voting common stock, and C, D and E each own 100,000 shares of non-voting preferred stock, where the preferred stock is entitled to a preferential return of $1 per share before any cash is distributed to the common stockholders, the result changes.
In Example #3, A and B are each beneficial owners because they split equally (50% each) all voting power. But, when you apply the percentage of total value rule, the calculus changes.
Because of the preferred return held by C, D and E, we cannot calculate their percentage of total value without knowing the liquidation value of the corporation. (For example, if the liquidation value was $300,000, then C, D and E would each get 33.3%. But, if the liquidation value were much greater, their percentages would be reduced as A and B began to participate.) Without knowing the total liquidation value of the corporation, we cannot calculate the ultimate percentage of any individual shareholder.
As a result, in Example #3, we need to apply the failsafe rule. Under the failsafe rule, A and B and beneficial owners because each of them holds more than 25% of the corporation’s voting common stock. Shareholders C, D and E are also beneficial owners because each of them owns more than 25% of the corporations non-voting preferred stock.
Conclusion
Reporting companies that must apply the Corporate Capital Rule will need to coordinate their analysis with counsel. Small changes in the terms of the company’s stock, including its voting provisions and provisions for a preferred return, can have an enormous impact on the calculation of beneficial ownership.
