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.

Profits Interests

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, provided certain basic safe harbor rules are met (the employee can also affirmatively make the election). This 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 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. The rules require that 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 in a redemption of the award 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, 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. It is unclear whether a profits-interest holder would be treated as an employee if there are no vested interests, but the IRS regulations refer only to the grant of the interest, so the answer is presumably no. Companies also have tried various work-arounds, such as layering entities so that one LLC holds the membership interest and another is the employer. The IRS has ruled against at least one of these approaches, so readers should consult with an attorney on this issue. If an 83(b) election is not made, or deemed to have been made, then the employee would probably not be subject to partnership tax treatment, but the employee would have to pay taxes on gains at vesting as ordinary income rather than only capital gains tax and then only on sale. Because of that, almost everyone who gets these interests chooses 83(b) treatment. (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. Section 409A deferred compensation rules require that, at the very 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.

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 happens, 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 and 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.

ERISA Issues

Any kind of deferred compensation that pays out benefits in ways similar to retirement plans may be subject to Employee Retirement Income Security Act (ERISA) rules, the same rules that govern pension and other retirement plans. That can create multiple issues for companies, with complex compliance requirements and no offsetting benefits of actually having the plan be qualified for tax benefits. There are no clear regulations on this, just a handful of relevant court cases almost always initiated by an employee. If plans are "top-hat" (just available to key employees, usually defined as 15% or less), the plans will not be subject to ERISA. If plans pay out periodically, such as every three to five years on vesting of awards, they will also not be subject to ERISA. If plans do not pay out until termination of employment, they probably will be. Less certain is if you can condition vesting on a change of control or other liquidity event. Arguably, if such events are anticipated in the reasonably near term, the plan should not be seen as a retirement plan, but some attorneys are more cautious. Also see our book Equity Compensation for Limited Liability Companies (LLCs).