For many years, the most common advice on sharing equity with employees in a limited liability company (LLC) has been "switch to S corporation status instead." The argument was that it was too complicated to share equity in an LLC. Yet many LLC leaders want to share equity with employees and have very good reasons for retaining their company's status as an LLC. When we at the NCEO asked experts in employee ownership law if it were possible to share equity in an LLC, the usual response was "yes, but it is complicated." No one seemed to want to go into too much detail about just what these complications were, however.
This book finally makes detailed material available on equity compensation in LLCs. It not only explains all the issues around LLC equity compensation but also includes a chapter on considerations in drafting a plan.
In the third edition, the book has been substantially revised and expanded. The main chapter, on equity interests in LLCs (chapter 3), was replaced by a new chapter from a team of experienced attorneys. Another new chapter (chapter 4) discusses how to allow LLC equity interest holders to be treated as employees. The plan documents in previous editions have been replaced by a new chapter that discusses drafting considerations for LLC equity plans. Finally, the existing chapters on LLCs, designing equity incentives, accounting, sharing equity with employees, and communicating have been updated.
Table of Contents
1. A Primer on Limited Liability Companies
2. Designing an Equity Incentive Plan
3. Equity Compensation in Limited Liability Companies
4. Allowing Holders of LLC Equity Interests to Be Treated As Employees
5. Accounting for Equity Compensation in an LLC
6. A Primer on Sharing Equity with Employees in Non-LLC Companies
7. Communicating with Employees About Equity
8. Drafting Considerations for LLC Equity Compensation Plans
About the Authors
About the NCEO
From Chapter 3, "Equity Interests in Limited Liability Companies" (footnotes omitted)
One of the potential complexities of granting equity compensation to employees of an LLC classified as a partnership for tax purposes is that the IRS takes the position that a member cannot also be an employee of the LLC. Instead, once an employee owns an equity interest in an LLC, the individual is treated as a partner, and (1) the member should receive only a Schedule K-1, and not a Form W-2; (2) the member’s salary will likely be treated as a partnership “guaranteed payment”; (3) the LLC should not withhold income taxes or make employment tax payments attributable to member payments; (4) the member must pay estimated taxes quarterly; (5) the member cannot participate in certain tax-advantaged benefit plans; (6) the member must pay self-employment taxes on its share of LLC income as self-employment income; and (7) the member likely will be required to file tax returns in all jurisdictions in which the LLC files tax returns.
This means that an LLC member, such as a recipient of a capital interest or a profits interest, will be subject to self-employment taxes on its share of income generated by the LLC’s activities. The tax partner status of the recipient also limits the recipient’s tax advantages with respect to employee benefits, health insurance, and other fringe benefits. For example, being a partner affects the recipient’s ability to exclude from income the health insurance premiums paid by the LLC on the recipient’s behalf. As a member, the recipient also cannot participate in “cafeteria plans” (a reimbursement plan governed by Section 125, which allows employees to contribute a certain amount of their gross income to designated accounts before taxes are calculated).
In 2016, the IRS reinforced its historical position on this issue by issuing temporary regulations addressing tax partnership/disregarded entity tiered structures. These temporary regulations clarify that an individual may not be a partner in one entity and an employee in another entity in a structure in which a partnership owns a disregarded entity. Therefore, for an LLC classified as a partnership that has one or more wholly owned subsidiaries that are disregarded entities, partners in the LLC cannot be treated as employees of the subsidiaries and vice versa.
In general, once a member of an LLC, the member’s tax filings and other compliance responsibilities may become more complicated and costly, which should be considered seriously by both the LLC and the potential member before an LLC grants a capital interest or profits interest to an employee. Many employees, particularly those who are not in senior management, do not want to be subjected to the additional complexities that come along with being a member of an LLC. For these reasons, options, which can be structured to allow the employee and the employer to control the timing of whether and when the employee becomes a member of an LLC, or phantom unit plans, which have no prospect for the employee to become a member, may be preferable, albeit at the “cost” of not being able to treat any portion of their income or gain in an exit or liquidity event as capital gains.
There are some potential organizational structures that can be put into place to allow recipients of LLC interests to remain W-2 employees, which is beyond the scope of this chapter. Please see chapter 4 for a brief discussion of some of these structures.
From Chapter 5, "Accounting for Equity Compensation in an LLC"
Once the amount of compensation expense has been determined under equity accounting, the aggregate expense must be amortized over the employee’s service period. This is usually the same as the vesting period. If the vesting occurs all at the end of the service period, the total expense is amortized on a level (straight-line) basis so that the same amount of expense is recognized each year during the service period.
If the employee gradually vests each year during the service period, the employer may choose either straight-line or multiple-option amortization. By using the multiple-option approach, the amount of the expense to be recognized each year is treated as a separate award and amortized accordingly. For example an award that vests ratably over three years is treated as a grant of three separate awards: an award vesting in one year, an award vesting in two years, and an award vesting in three years. Each year’s award is expensed over its appropriate vesting period. The net result is an expense in the first year consisting of 100% of the first year’s award, plus 50% of the second year’s award, plus 33% of the third year’s award. The second year expense is equal to 50% of the second year’s award plus 33% of the third year’s award. The third year expense would consist of only the remaining portion of the third year’s award (i.e., 33%). Because of the front-loading effect of multiple-option amortization as well as its complexity, most companies use straight-line amortization.
From Chapter 8, "Drafting Considerations for LLC Equity Compensation Plans"
The schedule by which options become vested and exercisable (e.g., 25% each anniversary of the grant date for four years, cliff vesting at 100% after two years, or vesting upon the achievement of specific financial performance goals) may be set forth in the plan, but, more commonly, LLCs will reserve the determination of vesting terms for individual award agreements.
Generally, options may be exercised at any time after they become vested. However, in order to ease the burden and costs associated with the booking up of capital accounts that will occur on exercise, LLCs may wish to limit the exercise of options to specific dates, e.g., December 31 of each year.
If desired, the plan may permit the LLC to grant options with terms that permit the early exercise of an option (before vesting) and receipt of restricted capital units that will vest over the same schedule as was applicable under the terms of the option.
The plan should include a provision in order to comply with the Fair Labor Standards Act requirement that options granted to nonexempt employees should not be exercisable for a period of at least six months from the date of grant (except in the event of the employee’s death, disability, or retirement, a change of control, or other circumstances permitted by regulations).
The plan should describe the method by which options may be exercised. Typically, the option price may be paid in cash, by delivering units already owned by the grantee, or by any other method permitted by the administrator.