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Equity Incentives in Limited Liability Companies (LLCs)

Limited liability companies (LLCs) are a relatively recent form of business organization, but one that has become increasingly popular. LLCs are similar in many ways to S corporations, but ownership is evidenced by membership interests rather than stock. As a result, LLCs cannot have employee stock ownership plans (ESOPs), give out stock options, or provide restricted stock, or otherwise give employees actual shares or rights to shares. But many LLCs want to reward employees with an equity stake in the company. This article explores how this can be achieved.

The most commonly recommended approach to sharing equity in an LLC is to share "profits interests." A profits interest is analogous to a stock appreciation right. It is not literally a profit share, but rather a share of the increase in the value of the LLC over a stated period of time. Vesting requirements can be attached to this interest.

In the typical arrangement, an employee would receive an award and would be treated as if an 83(b) election had been made. An 83(b) election fixes the ordinary income tax obligation at the time of grant. The employee would pay taxes on the value of any difference between the grant price and any consideration paid at ordinary income tax rates, then pay no further taxes until paying capital gains tax on subsequent appreciation at sale. If there is no value at grant, then, the tax is zero, and taxes would only be paid when the interest is sold, at which time capital gains tax rates would apply.

Proposed (but never finalized) Revenue Ruling 2005-43 stated that profits interests would not be taxed at grant if they would have no value if the company were liquidated at the same time. In other words, profits interests must only apply to the growth of the value of the company. Employees must also hold the interests for at least two years after grant. They also cannot be pegged to a certain stream of income, such as would be the case with a more conventional profit sharing plan. LLCs must enter into binding agreements to comply with these requirements. Grant agreements should also specify terms for the transferability of the interests, if any (generally, they would not be transferable). Profit interests can be tax-free at grant only if provided to employees or other service providers. If profit interests are held for at least one year after the interests vest, the amount received is treated as a long-term capital gain; otherwise, it is a short-term gain.

In addition, if profits interest holders make an 83(b) election, they must be treated as if they had an actual equity stake in the company. That means that they would receive a K-1 statement attributing their respective share of ownership to them and would have to pay taxes on that. Distributions can be made by the LLC for this purpose. Income attributed to their limited partner status is not subject to employment taxes. If the employee forfeits the profits interest (because they never become vested, for instance), a special allocation must be made to reverse the effects of any gains or losses attributable to the employee. Employees would also be subject to self-employment taxes (FICA and FUTA) on their salaries. Some companies gross up employee pay to cover this additional tax.

If an 83(b) election is not made, then the employee would not be subject to this tax treatment, but the employee would have to pay taxes on gains at vesting as ordinary income. (There is some dispute about whether an 83(b) election is really needed under the rules, but that is beyond this article).

While there is no statutory requirement to do so, having an outside professional valuation of the profits interest at the time of grant is advisable. That establishes a defensible value on which to base the future benefits subject to taxation. Granting the interests at less than fair market value could also give rise to taxation on the bargain element at grant. Deferred compensation rules require that, at the least, the company find a way to estimate current fair market value in accordance to standards the regulations set out. Having the board simply pick a number based on some formula or back-of-the-envelope calculation would not meet these requirements.

Distributions of earnings can be made to holders of the profits interests, but need not be in proportion to their equity stake. For instance, if the partners had contributed all the capitalization, they might not allow any allocation of distributions until a target return had been met. There are no statutory rules for how profits interests must be structured. Distributions of earnings normally would just be based on vested units, but could be based on allocated units. Any vesting rules the company chooses can be used, although performance vesting would require variable accounting (adjusting the charge to earnings each year based on changes in value and the vested amounts). Otherwise, the charge must be taken at grant based on a formula (such as Black-Scholes) that calculates the present value of the award.

Also see our book Equity Compensation for Limited Liability Companies (LLCs).

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