The Equity Compensation Report
Each issue features brief news updates; discuss ideas on plan design, operation, and structure; share insights from experts; and have tips on communicating equity compensation to employees. The Equity Compensation Report covers the full range of equity compensation plans, such as stock options, stock appreciation rights (SARs), phantom stock, stock purchase plans, direct share ownership, restricted stock, and restricted stock units. It does not cover employee stock ownership plans (ESOPs).
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If you are not yet a member, you can read a sample issue (September 2012) and the sample article below from the most recent issue.
Sample Article from the March 2013 Issue:
Tax Consequences of Granting a Capital Interest in an LLCDavid R. Johanson, Rachel J. Markun, and Samuel W. Krause, Jackson Lewis LLP
Capital interests give an employee or other recipient the right to share in the value of limited liability company (LLC) assets through the receipt of a share of the proceeds upon sale of the interest, often, but not always, on the sale of the company. Capital interests are the closest parallel to restricted stock in an S or C corporation.
An employee who receives an equity capital interest that is freely transferrable or without a substantial risk of forfeiture (that is, a vested capital interest) in an LLC recognizes ordinary compensation income in an amount equal to the fair market value of the equity capital interest (less the amount, if any, paid for the interest). The fair market value of the interest received as compensation for personal services must generally be included in the recipient's gross income in the first tax year in which the member may transfer the equity capital interest or the interest is not subject to a substantial risk of forfeiture.
The fair market value of this interest, for purposes of computing the employee's income and the LLC's deduction, may be determined in one of several ways: (1) by reference to the fair market value of the personal services rendered to the fair market value of the LLC's assets; (2) by determining the value of the capital that was shifted from existing LLC members to the new grantee; (3) by determining the fair market value according to what a willing buyer and willing seller would agree upon as a purchase price in an arm's-length sale; or (4) by determining the amount that the employee would receive upon a liquidation of the LLC at the time the interest is issued. Regardless of the method used to determine fair market value, income and employment tax withholding will be required.
If the interest is subject to a substantial risk of forfeiture and is nontransferable, then the taxable event can be delayed until the restriction lapses unless the employee makes a Code Section 83(b) election. A Code Section 83(b) election must be made by the employee within 30 days of the grant's award. The election states that the employee agrees to be taxed immediately upon receipt of the capital interest at ordinary income rates, with any subsequent appreciation in the interest taxed at capital gain rates upon disposition. A Code Section 83(b) election may be made where there is no bargain element in the equity purchase or grant and no gain (for example, where an interest in an LLC worth $100 is purchased for $100 as well as where there is taxable gain to report). An employee who receives a restricted capital interest will not be treated as a partner for tax purposes until the restrictions lapse, unless the Code Section 83(b) election is made. Furthermore, if a Code Section 83(b) election is made, and the employee later forfeits all or part of the award, the employee is not entitled to a refund with respect to the income taxes that he or she already paid.
If a Code Section 83(b) election is not made, then ordinary income tax is paid on the fair market value of the award at the time it vests (the equity is freely transferrable or no longer subject to a substantial risk of forfeiture). This is not the same as when the employee actually sells the capital interest, which may be later. Any difference between the price at vesting and the price at sale would be subject to long- or short-term capital gains taxes, depending on how long the LLC employee holds the capital interest.
The LLC is entitled to a deduction for the fair market value of the capital interest that the employee reported as income at vesting or upon the employee making the Code Section 83(b) election, and the LLC has the obligation to withhold income and employment taxes, as with any employee compensation. Despite the fact that the capital interest is being exchanged for the employee's services, there is a risk that the LLC may still be required to recognize gain for a "deemed sale" consisting of the sale of an interest in its assets for cash, payment of the cash to the employee who rendered services to the LLC, and a subsequent contribution of the cash by the employee back to the LLC in exchange for the capital interest. Any gain resulting from the deemed sale would be taxable to the other LLC members but offset in part by a deduction for compensation paid to the employee.
This article is adapted from a chapter by the authors in our forthcoming book Equity Compensation for Limited Liability Companies, 2nd ed. This is the second part of a two-part article. In the February issue, the authors discussed profits interests.