For many years, people would ask me if a limited liability company could share equity with employees.
When I asked attorneys if this was doable, the answer was invariably, "Yes, but it is complicated." Fortunately, sharing equity in LLCs is not as arcane and difficult as many suggest it is. There are multiple options, each of which closely parallels their equivalents in non-pass-through entities. This article describes the four most common approaches:
- Capital interests are the closest equivalent to restricted stock in non-pass-through entities.
- Profits interests are very similar to stock options, but differ in that they may also carry some rights to interim earnings, which stock options never do.
- Unit rights are parallel to phantom stock. Neither grants actual ownership rights, but rather the equivalent value of a stated number of units or shares.
- Unit appreciation rights are parallel to stock appreciation rights.
CHOOSING TO BE AN LLC
LLCs are similar to corporations in that they provide owners with liability protection but are taxed as partnerships (unless an election to be taxed as a corporation is made by the LLC). The operating agreement for the LLC should specifically define whether the LLC will be treated as a partnership or as a corporation for tax purposes. If taxed as a corporation, the LLC may be able to issue more traditional kinds of equity, but our focus here will be on the much more common choice to be taxed as a partnership. When taxed as a partnership, LLC ownership is evidenced by membership interests, rather than capital stock. Earnings in the LLC are passed through to holders of membership interests, who pay taxes on them at their personal tax rates. The LLC may make earnings distributions to members to cover tax obligations (or for any other purpose), but unlike S corporations, which are also pass-through entities, LLCs are not required to distribute earnings pro-rata to ownership interests. LLCs are more flexible than S corporations and may offer certain tax advantages to members that S corporations do not.
LLCs have general partners and limited partners. General partners can enter into contracts for the LLC. General partners receive a Schedule K-1, rather than a Form W-2, from the LLC, have their "salary" taxed as a "guaranteed payment," will not have withholding, will not get unemployment benefits, and will have to pay estimated income tax and self-employment tax. In our experience, LLCs seeking to provide equity compensation to employees will treat them as limited partners with more conventional employee tax status, albeit the equity incentives they receive from the LLC may require that they receive a K-1 statement.
All of the awards described here can be, and almost always are, subject to vesting requirements. These can be based on service, the achievement of corporate or personal targets, a liquidity event for the company, or some combination. Time-based vesting can be cliff or gradual, and is usually over three to five years. A "double-trigger" award would not vest the interests until two goals are met. For instance, the employee may have to have both three years of service and the company must have reached a certain revenue target.
All award agreements are contractual matters between the company and the employee or other service provider. There needs to be an overall plan document stating the terms under which the LLC can issue equity awards and individual grant agreements for each tranche of grants awarded to each employee. It is critical that these documents be read and signed by both parties to avoid litigation risk. The agreements are covered by state law and only in the most unusual circumstances could they be construed to be a retirement plan governed by the Employee Retirement Income Security Act.
When choosing an award type, LLCs need to be aware that vested awards may require the employee to receive a K-1 statement -- and that they will want some distribution to pay the taxes. Decisions also must be made about whether the LLC wants the employee to receive interim distributions of earnings. Companies also need to plan for how the equity will become liquid.
If the only liquidity event will be a sale of the company or an investment by an outside interest, vested awards may mean employees have a tax event but no chance to realize any benefits from the award.
For any awards, the Internal Revenue Service requires that there be a reasonable means of assessing the value. Ideally, this is an outside appraisal. We strongly recommend these appraisals in any event. Companies should not give away what may be a substantial amount of equity based on a guess. Lacking an appraisal, companies need to show that they have a defensible method for showing what the equivalent fair market value for the interests would be based on a willing-buyer, willing-seller model or a liquidation value (generally only appropriate for companies that do not have substantial goodwill that cannot easily be valued in a model). The models might be based on recent investment rounds or formulas commonly used in the industry.
PROFITS INTERESTS AND CAPITAL INTERESTS
Capital interests are the closest parallel to restricted stock in C and S corporations. They provide the employee with a share of the proceeds of the sale of the assets of the LLC. They may be able to redeem that right for cash if the company provides for an interim purchase of the capital interests prior to its sale.
If an employee is issued a capital interest with no substantial risk of forfeiture at grant (that is, there is no vesting requirement), then the employee must pay ordinary income tax at grant on the value of the award. The company gets a corresponding deduction. In the much more common scenario where there are vesting requirements, then there is no tax due on the grant. Instead, when the award vests (whether or not it can be made liquid), the value at the time of vesting is subject to ordinary income tax treatment. The employee could, however, choose to make a Section 83(b) election to pay taxes on the value at grant and no further taxes until the interest is later sold. The company would get a deduction at that point. When the equity interest is sold, the employee pays capital gains on the increase in value. The employer does not get a deduction. Section 83(b) elections must be made within 30 days of the receipt of the award.
Although the capital interest is being exchanged for the employee's services, there is a risk that the LLC may still be required to recognize gain for a "deemed sale" consisting of the sale of an interest in its assets for cash, payment of the cash to the employee who rendered services to the LLC, and a subsequent contribution of the cash by the employee back to the LLC in exchange for the capital interest. Any gain resulting from the deemed sale would be taxable to the other LLC members but offset in part by a deduction for compensation paid to the employee.
Because they have no claim on the profits of the company, holders of capital interest do not receive a K-1 statement even if their interests are fully vested.
Profits interests are more akin to stock options, although with significant differences. Profits interests grant the employee the right to the increase in the value of the LLC over their duration as well as a claim on interim profits. 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, as would be the case with a 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. 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. The employee can make a Section 83(b) election at grant to fix the tax basis of the award at zero.
For grants meeting these terms, the company does not get a deduction for the grant of a profits interest to the employee and withholds no taxes. The employee gets capital gains treatment for the increase in value at sale. Because it is not certain what the tax treatment for the employee and the employer would be if these safe harbor requirements are not met, profits interests are almost always set up to meet them.
A plan could be drafted so that unvested holders of equity interests are not eligible for distributions of income. Unvested profits interests are not considered ownership of an LLC that require the holder to receive a K-1 statement for a share of the earnings unless the employee has made an 83(b) election or is deemed to have made one. In practice, employees almost invariably make the 83(b) election or, under IRS proposed regulations beyond the scope of this discussion, are treated as if they had anyway. Profits interest holders who are deemed to be owners must receive a Schedule K-1 statement attributing their respective share of ownership to them, and pay estimated income taxes on all income from the LLC (as well as self-employment taxes on their salary from the LLC).
That means they will have a tax responsibility for the current income or gains of the LLC even if vesting rules for the award of LLC distribution policies may not entitle them to any distributions with which to pay these taxes. Companies need to design their plans so that the employees can pay these taxes, or the profits interest becomes more punishment than reward.
UNIT RIGHTS AND UNIT APPRECIATION RIGHTS
The major advantage of profits interests and capital interests for employees is that they can turn some or all of the gain into capital gains. For many LLCs, however, the complexities of these awards, and, for profits interests, the need to pay out interim distributions to their holders, leaves them seeking a simpler solution even if it means all the benefits of the awards are taxed as ordinary income.
Unit rights and unit appreciation rights provide a way to do this. Unit rights are parallel to phantom stock, and unit appreciation rights to stock appreciation rights. With unit rights, the employee receives the value of a stated number of membership interest units; with unit appreciation rights, the employees receive only the increase in value. When the rights vest, the LLC pays the employee the cash value of the right. That payment is treated as ordinary income for the employee and is deductible to the employer.
The employees are not considered owners of the LLC and have no claim on its earnings, nor do they receive K-1 statements. In effect, these plans are bonuses paid out over time based on the value of the company, as opposed to, for instance, profits or meeting certain performance targets.
This article only outlines the major issues in creating an equity incentive plan for employees in LLCs. LLCs should seek the advice of an advisor with substantial actual (not just claimed!) experience in this area.
Corey Rosen is the founder and senior staff member of the National Center for Employee Ownership, as well as the co-author of Equity Compensation in Limited Liability Corporations.
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