Web Article
January 18, 2019

Equity Incentives in Limited Liability Companies (LLCs)

Many businesses take steps to align the interests of employees and the company, often by providing variable compensation linked to the value of the company. Others want to offer recruitment or retention bonuses to develop the workforces they need to grow. Corporations use equity compensation plans such as stock options, performance shares, or restricted stock, and LLCs have similar versions of these equity compensation plans.

LLCs and employee ownership provides an overview, and this article covers the specifics of using profits interests, which are the most commonly used form of equity compensation in LLCs, including a description of their tax implications. It also covers capital interests and unit plans.

Profits Interests

The most commonly recommended approach to sharing equity in an LLC is to share "profits interests." Despite its name a profits interest 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. The economic impact when an LLCs uses profits interests is similar to a corporation using stock options or stock appreciation rights.

The terms of the award are flexible, and many companies include vesting requirements.

For example, imagine an LLC valued at $1.3 million awards an employee a profits interest worth the increase in value of 5% of the shares. The award vests if the employee remains at the company for one year, and it is exercisable after three years. If the employee leaves before one year has passed, he or she forfeits the award. If the employee remains and the company value has increased to $1.9 million in 3 years, the employee’s award is worth 5% of the $600,000 increase in value, or $30,000.

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.

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 members 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.

Although any vesting rules the company chooses can be used, 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.

Tax Issues for Profits Interests

The tax treatment of profits interests is not simple. In the typical arrangement in which certain basic safe harbor rules are met, the employee would pay ordinary income tax obligation at the time of grant on the value of any difference between the grant price and any consideration paid, 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. This treatment is similar to  what would happen in a corporation if an employee receiving a stock option made an “83(b) election” (and, in fact, some recipients of profits interest actually do make an 83(b) election).

If profits interests are held for at least one year after the interests vest, and two years after grant, the amount received in a redemption of the award is treated as a long-term capital gain; otherwise, it is a short-term gain.

Proposed (but never finalized) Revenue Ruling 2005-43 stated that profits interests are not taxed at grant if they would have no value if the company were liquidated at the same time and the basic safe harbor rules are met. In other words, profits interests must only apply to the growth of the value of the company following the date on which the award is issued. Awards 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). Profits interests can be tax-free at grant only if provided to employees or other service providers.

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, would not be eligible for unemployment insurance, and could not receive tax-deductible retirement and health-care benefits. Some companies gross up employee pay to cover this additional tax burden.

Capital Interests

Capital interests are the LLC equivalent of restricted stock grants in S or C corporations. Rather than give the employee the right to the increase in the value of membership interests, the employee receives the full value. Rules for vesting and whether the employee is considered a partner or an employee would be similar to a profits interest grant.

The employee can make an 83(b) election at grant and pay tax on any value conveyed at that time as ordinary income (this may be nominal in a start-up). When the interests are sold, the employee would pay capital gains taxes. Otherwise, the employee would pay no tax at grant but ordinary income tax on vesting, even if the interests cannot be sold at that point. Any subsequent gain would be taxed at capital gains rates at sale. Because the tax treatment of profits interests is generally more favorable (the 83(b) election triggers no current tax), they are much more common than capital interest grants, but capital interest grants might make sense in mature LLCs that want to reward employees for existing value, not just growth.

Capital interests are rarely granted in LLCs, however, because the tax consequences to the LLC are uncertain and potentially costly. It is arguably possible that the grant could cause a taxable income or gain event for the LLC and/or pre-existing members.

Unit Plans

A simpler approach that many LLCs find attractive is to issue the equivalent of phantom shares or stock appreciation rights. There is no agreed-upon legal definition for what these would be called in an LLC, but we refer to them as unit rights plans or unit appreciation rights plans.

In a units rights plan the employee is granted a hypothetical number of LLC membership interests that are subject to vesting over time. Typically, when they vest, the value of the awards is paid out in cash. In a unit appreciation rights plan, the same things happen, but only the increase in value is paid out. In either case, the employee is subject to ordinary incomes tax at the time of payout on the amount of the payout. The payment is treated in the same way as a bonus would be. The employee is considered an employee of the company, not a member.

For companies where the tax benefits to employees of profits interests is not critical, unit plans are simpler and provide employees with the often substantial benefits of actually being taxed as an employee. Employees also do not have to file estimated income tax returns or deal with K-1 statements. These benefits can make these approaches compelling in broad-based plans.