By a fairly wide margin, LLCs are now the most common type of entity for both emerging and established businesses.FN1 The dominance of LLCs is a testament to their ownership, management and tax flexibility, as well as the fact that all 50 states now have well-developed LLC statutes.
The Benefits of Equity Compensation
Whether a particular LLC is still a startup or is further along, its owners and operators may want to provide equity compensation to key employees and other service providers (like consultants and advisors). Equity compensation provides the following benefits to the company:
It helps to align the interests of key employees and other service providers with those of the company by providing incentives to those recipients to perform at a higher level and to facilitate the growth and profitability of the company.
It helps create loyalty with recipients by providing them with either actual equity in the company or something similar which increases in value as the company does.
It provides an alternative to cash compensation, which can be very valuable for startups and other cash-tight businesses.
However, an LLC taxed as a partnershipFN2 cannot issue stock options, restricted stock, and other common forms of equity compensation available to corporations. As a result, LLC owners and operators are often unsure how to provide equity compensation to service providers. This article provides a brief overview of the most common types of equity compensation available to LLC -- as well as related equity incentive plans.
A capital interest is probably what one generally thinks of when thinking about the equity of a company since it represents ownership of the company such that one would be immediately entitled to a share of the company’s assets upon liquidation, sale, or a similar event.
Given the flexibility of LLCs, it is perhaps not surprising that equity awards can be structured in a variety of different ways – including capital interests (whether structured as units, membership interests, economic interests, or otherwise), profits interests, phantom equity, or options to purchase equity. However, before issuing any equity compensation, it is important to understand the economic and tax implications of these various options. (These options also raise securities law concerns that are discussed in the Equity Incentive Plan section at the end of this article.)
Capital Interests
A capital interest is probably what one generally thinks of when thinking about the equity of a company since it represents ownership of the company such that one would be immediately entitled to a share of the company’s assets upon liquidation, sale, or a similar event. (A capital interest in an LLC is more or less equivalent to stock in a corporation – and in an LLC a capital interest may be referred to variously as a unit, share, membership interest, or economic interest.)
As a result, a capital interest in an LLC has a present value, because if the company were to dissolve right after the interest was acquired, its holder would be able to share in any assets of the company. For example, if a recipient receives a 10% capital interest in an LLC that is valued at $1 million, then the recipient’s capital interest has a present value of $100,000 (assuming the LLC’s owners have an equal right to liquidation proceeds).
Furthermore, the holder of a vested capital interest in an LLC is a “partner” for tax purposes and, under IRS rules, is ineligible to be treated as a W-2 employee. This means that the holder of a vested capital interest will receive a K-1 instead of a W-2 from the LLC, will be subject to self-employment taxes, and will be responsible for making estimated tax payments – which is generally less than desirable from the perspective of the recipient.
Additionally, since the acquisition of a capital interest is the receipt of property with a present value, its grant is a taxable event – the consequences of which depends on whether or not the interest is “restricted” and, if it’s restricted, whether or not an Internal Revenue Code (“IRC”) § 83(b) election has been made.
A capital interest is restricted if it is “non-transferable” and “subject to a substantial risk of forfeiture” within the meaning of the IRC. Generally, a capital interest is restricted if it is subject to vesting or if it is subject to forfeiture or repurchase at less than fair market value if the recipient stops performing services to the company. And, briefly, an IRC § 83(b) election permits the recipient of a capital interest to be taxed at the time of grant as if the interest was fully vested.
Where a recipient receives an unrestricted capital interest, such person owes taxes as ordinary income on the difference between the fair market value of the capital interest and the amount paid for it, if any. But if the capital interest is restricted and subject to vesting, the taxation will depend on whether the recipient timely makes an IRC § 83(b) election. If no 83(b) election is made, or if it is untimely, then the capital interest will be taxed as ordinary income as it vests at the then current value of the interest less any amount paid for the interest. But if an 83(b) election is timely made, then the capital interest will be treated for tax purposes as if it was fully vested and thus taxed like an unrestricted capital interest, i.e. taxed as ordinary income on the difference between its fair market value and any amount paid.
Unlike a vested capital interest that generally has present value upon receipt, a profits interest only entitles its holder to a share of the future earnings of the company (i.e. future profits)
Because equity compensation is generally not purchased, the fact that the recipient of a capital interest owes taxes on the fair market value of the interest (either upon its grant or its vesting) generally makes issuing capital interests to service providers – unless done so in the early days of the company’s life cycle – less desirable than the next sort of equity compensation to be discussed: a profits interest.
Profits Interests
Unlike a vested capital interest that generally has present value upon receipt, a profits interest only entitles its holder to a share of the future earnings of the company (i.e. future profits). As a result, a profits interest has no present value upon receipt, and only entitles the recipient to share in the company’s appreciation in value after the interest has been acquired. (In this way, a profits interest is similar to a stock appreciation right, or SAR, in a corporation – but with the potential for capital gains tax treatment.) Accordingly, receipt of a profits interest is generally not a taxable event for its recipient provided that certain conditions are met, including that the interest is held for at least two years.FN3
The fact that receipt of a profits interest is generally tax free makes them a desirable and popular form of equity compensation, especially where the goal is to avoid immediate income recognition for the recipient. However, as with capital interests, the holder of a vested profits interest is a partner for tax purposes and ineligible to be treated as an employee of the LLC.
Moreover, since a profits interest holder is only entitled to a share of future profits, an LLC has to determine the current value of the company (a “threshold value”) when it issues profits interests to employees and other service providers. This threshold value establishes a baseline above which future profits are earned. While a full discussion of IRC § 409A is beyond the scope of this article, IRC § 409A prescribes strict requirements that apply to the determination of a threshold value for profits interests – which will generally make it advisable for an emerging or existing LLC to hire a business appraiser in order to determine this value – and imposes severe penalties for noncompliance.
A Quick Note about Voting Rights:
The discussion thus far has deliberately avoided any mention of voting rights in connection to capital interests and profits interests. This is because it is possible for either to have – or not have – voting rights, depending on how the company is structured and the terms of its operating agreement. That said, generally holders of capital interests are admitted as members of the LLC and have voting rights, while holders of profits interests are not admitted as members and lack voting rights.
Phantom Equity (Unit Appreciation Rights)
Unlike both capital interests and profits interest, phantom equity – as the name suggests – is not really equity at all. Instead, the holder of phantom equity generally has a contractual right to a cash payment or bonus at a future time – perhaps the achievement of a milestone or maintaining a continuous working relationship with the company for a period of time – and the amount of the payment is tied to the value of – or the increase in the value of – equity in the company. In this way, phantom equity still aligns the interests of key employees and service providers with the company’s performance, but avoids issuing actual equity to its holder.
One of the primary advantages of phantom equity is that its holders can still remain W-2 employees of the LLC, whereas holders of capital interests and profits interests are both considered “partners” for tax purposes and, thus, receive a K-1 instead of a W-2. This can be significant since partners – unlike W-2 employees – are responsible for self-employment taxes and making estimated tax payments, which can increase the tax liability of the holder of capital interests and profits interests and make tax matters correspondingly more complicated.
However, since phantom equity is a form of deferred compensation, it is generally tax free on the grant date, but subject to IRC § 409A. And, as with profits interests, if phantom equity is structured like an appreciation right, the company would generally need to determine a threshold value that establishes a baseline above which the holder of the phantom equity is entitled to share in the appreciated value of the company.
Additionally, since phantom equity is not actual equity, but only a right to receive a cash payment/bonus tied to the value of the company’s equity, it is taxed as ordinary income (like any other cash bonus an employee might receive) and is not eligible to receive capital gains treatment (unlike capital interests and profits interests). But, again, the main advantage of phantom equity is that the recipient is still eligible to remain an employee of the LLC (unlike holders of capital interests and profits interests).
Nonqualified Options to Purchase Capital Interests
Finally, LLCs can also grant – instead of an actual capital interest in the company – a nonqualified option (i.e. a contractual right) to purchase a capital interest in the company. Like the other forms of equity discussed thus far, these options may be subject to vesting, but unlike the other forms of equity awards, options would have to be “exercised” by purchasing the underlying capital interest at a purchase price (generally referred to as an “exercise price”).
Unless and until the option is exercised, its holder is not an actual owner of the company, but only has the right to purchase such ownership (perhaps only at a later date and upon the satisfaction of certain conditions) by paying the exercise price to the company. As a result, the grant of an option generally should not be a taxable event for the recipient.
However, while the tax consequences of receiving compensatory options to purchase a capital interest in an LLC should be similar to how compensatory nonqualified stock options of a corporation are treated, the IRS has not issued final guidance on the tax treatment of these LLC options. This creates undesirable uncertainty around the receipt and exercise of LLC options which could result in surprising and unintended tax consequences.
LLCs can also grant a nonqualified option (i.e. a contractual right) to purchase a capital interest in the company... until the option is exercised, its holder is not an actual owner of the company, but only has the right to purchase such ownership
But if these LLC options are taxed like nonqualified stock options, then as long as the option complies with – or is exempt from – IRC § 409A and is granted with an exercise price equal to its fair market value, then the grant is tax free for the recipient. And upon the exercise of the option, the recipient will be taxed as ordinary income on the difference between the fair market value of the underlying capital interest and the exercise price of the option – and the LLC would be entitled to a corresponding tax deduction (which would pass through to the current owners of the LLC).
Equity Incentive Plans
An equity incentive plan is a written document created for the purpose of establishing terms for a company’s issuance of equity compensation to employees and other service providers (including directors, officers, advisors, and consultants of the company). Generally, an equity incentive plan will have provisions relating to (a) the types of service providers who can receive awards under the plan, (b) the types of awards that are available, i.e. the forms of equity or non-equity that can be granted, (c) the total amount of equity that can be awarded, (d) whether the awards are, at least potentially, subject to vesting, forfeiture, repurchase and the like, and (e) how previously granted awards will be handled in the event of a merger, acquisition, initial public offering, dissolution, and other similar events.
In addition to the benefits of equity compensation discussed above, a company may want an equity incentive plan for the following reasons:
It allows a company’s owners – the members of an LLC – to authorize the issuance of equity compensation, while limiting the amount so authorized and the type of equity, as well as the authority of the plan administrator;
When properly prepared and implemented, it establishes a safe harbor exemption from registration under § 230.701 of the United States Securities Act of 1933 (“Rule 701”);
It can aid in the recruitment of service providers for the company by providing documented terms regarding the equity compensation available; and
It standardizes the equity compensation available to service providers in order to help ensure a fair and consistent application of awards.
While it is generally advisable for a company to have an equity incentive plan in place before issuing any equity compensation to service providers, any such plan should be considered with care – not only for compliance with IRC § 409A and Rule 701, but also its effect on the ownership arrangement, including its potential for the dilution of the current owners share of the company.
This article only provides a general overview of equity compensation and equity incentive plans in the LLC context. If you have questions or would like to discuss anything discussed here, please Reach out, Today!
This article provides only general information and is not intended to be a substitute for legal or tax advice.