Start-up companies seeking to incentivize founders and retain key employees often present such individuals with equity in their companies as part of the individuals’ overall compensation packages. Equity-based compensation is intended to align the interests of the employees with the interests of the company’s members and investors. Simply speaking, the better the company does overall in the long term, the better the employee does overall in terms of compensation received in the long term.
The implementation of equity-based compensation by companies can be complex and uniquely challenging, taking into consideration countless laws and requirements ranging from securities law considerations, tax law considerations, corporate law considerations as well as practical business considerations.
Historically, corporations (C corps) have been the most common business entity selected by newly created companies, especially those seeking to raise money from external investors. However, limited liability companies (LLCs) have become an increasingly popular choice in business entity types being selected by newly created companies. Limited liability companies enable companies the flexibility of defining their company’s management structure as well as designating their company’s tax status. While this flexibility can initially be enticing to founders, it can often become problematic and expensive for companies wishing to issue equity to incentivize their employees or other service providers.
This discussion focuses on limited liability companies and the common types of equity compensation offered to incentivize and retain respective employees from limited liability companies as well as the overall tax considerations and practical implications of the receipt of these types of equity-based compensation.
TAX DESIGNATIONS
Limited liability companies have the flexibility in designating their federal tax status. A limited liability company can potentially designate itself to be taxed as a corporation, partnership, disregarded for tax purposes, or a trust.
Generally, most limited liability companies select the designation to be taxed as a partnership for federal tax purposes in order to provide their members with certain tax benefits. These tax benefits range from the avoidance of a company level tax (as is the case with corporations) as well as the flow through of certain company level tax deductions onto the members personal tax return filings.
EQUITY-BASED COMPENSATION
Another key difference between limited liability companies and corporations is that limited liability companies do not issue stock. Rather, limited liability companies issue capital interest “units” as equity.
If a limited liability company has “checked the box” to be taxed as a corporation for federal tax purposes, it generally can sponsor the equivalent of an employee stock ownership plan and can issue the equivalent of incentive stock options.
Because limited liability companies generally are not taxed as corporations, but rather select to be taxed as partnerships (if they have more than one member), these limited liability companies may not offer stock ownership plans or incentive stock options to incentivize and retain key individuals. Instead, limited liability companies have different mechanisms for offering up equity-based compensation to individuals, which are briefly described below.
Limited liability companies can grant two forms of equity interests to individuals in the form of either “profits interest” or “capital interest.” Profits interest entitle the grantee ownership interest in the future growth or appreciation of a limited liability company from the date of grant. Capital interests, which can be viewed as being equivalent to a restricted stock grants, enable the grantee to the right to the existing and future value of the limited liability company.
Profits Interest
The issuance of profits interest is in many ways equivalent to the issuance of stock options in the sense that both equity mechanisms do not generate economic benefits for the grantee if the company does not appreciate in value after the grant date. Additionally, profits interest and stock options are both granted pursuant to a plan that sets forth, among other things, the particular terms of the grant such as repurchase rights, rights of first refusal, and total number of profits interest available for issuance by the company.
Generally, the receipt of a profits interest by a grantee for services provided to a company will not cause the grantee to recognize income because the profits interest has no value as of the date it is issued. It is generally recommended that the grantee file a protective 83(b) election on the receipt of any profits interest which are subject to vesting in order to ensure that any future gains generated from the future sale of the limited liability company will qualify as capital gains treatment versus ordinary income treatment.
The vesting and actual receipt of profits interest by the grantee will make the individual recipient an actual member of the limited liability company and can lead to some additional administrative complications that most parties do not originally foresee. Each profits interest holder becomes a member of the limited liability company and as such will receive their proportionate share of any pass-through items of income, loss and deductions from the company in the form of Form K-1. As a holder of profits interest the grantee will no longer be considered as an employee for federal employment tax purposes and therefore may become ineligible to participate in certain company benefits offered to employees. Instead of receiving wages for services performed on behalf of the company, any wages made to profits interest holders will be characterized as guaranteed payments and as such the profits interest holders must self-withhold on certain self-employment taxes and make estimated tax payments on any income that is allocated to them by the company.
Capital Interest
The receipt of capital interest in a limited liability company entitles the grantee a right to the company’s existing capital as well as any future income of the company as well. As such the receipt of capital interest in a limited liability company is deemed to be equivalent to the receipt of stock grants in corporations. The tax consequences to the grantee upon the grant of capital interest are wholly dependent upon whether the capital interest is restricted or unvested. Upon the receipt of vested capital interest, the grantee shall recognize ordinary compensation income and shall be subject to tax in an amount equal to the difference between the fair market value of the capital interest and any amount paid for the capital interest. In the event that the receipt of the capital interest is restricted or unvested, then it is recommended that an 83(b) election is made upon the grant of the capital interest. If the grantee does not make an 83(b) election with respect to restricted capital interest, then the grantee will recognize ordinary income on the vested capital interest in an amount equal to the difference between the fair market value of the capital interest and any amount paid for the capital interest. On the other hand, if the grantee does make an 83(b) election, then for tax purposes, the grantee will have received and paid for all of the capital interest upon the grant date. The 83(b) election only applies for tax purposes, however, and as such the capital interest may still be restricted and subject to forfeiture until the grantee becomes eligible to vest in the capital interest.
Similar to that of profits interest, the recipient of vested capital interest shall become a member of the limited liability company and will receive their proportionate share of any pass-through items of income, loss and deductions from the company in the form of Form K-1. As a holder of capital interest, the grantee will no longer be considered as an employee for federal employment tax purposes and therefore may become ineligible to participate in certain company benefits offered to employees. Instead of receiving wages for services performed on behalf of the company, any wages made to capital interest holders will be characterized as guaranteed payments and as such the profits interest holders must self-withhold on certain self-employment taxes and make estimated tax payments on any income that is allocated to them by the company.
Limited liability companies, like corporations, may offer grantees options to purchase capital interests in the company. The capital interest option is a right to purchase capital interests in the future at a fixed price and is typically subject to the satisfaction of different vesting conditions such as continued employment with a company or the achievement of certain performance-based metrics, before the recipient can exercise the options. Unlike corporations, limited liability companies may not issue “incentive stock options”. There is no final guidance from the IRS as to how nonqualified options to acquire capital interests in limited liability companies will be treated, however, it is assumed that the tax treatment will be similar to the treatment afforded to nonqualified stock options. Therefore, the grantee will be required to recognize compensation income upon the exercise of a capital interest option in the amount equal to the spread between the fair market value of the option on the exercise date and the option’s exercise price. If the exercise price and the fair market value are equal then the grantee will recognize no income and the company will not be allowed an off-setting compensation deduction for income paid to grantee.
Limited liability companies may also grant phantom equity or the promise to pay a cash bonus equal to the value of a unit of capital interest in the company at a future point in time. Similar to restricted stock units (for corporations), phantom equity recipients are awarded the full value of the capital interests on the date of delivery. Because phantom equity does not grant the recipient an actual capital interest in the company, this form of deferred compensation is much easier to administrate on the limited liability company’s behalf. Limited liability companies do not have to jump through certain administrative hurdles such as the issuance of Form K-1s to phantom equity holders or additional accounting complexities of maintaining different capital accounts of the company’s members. Lastly, the granting of phantom equity is not considered a taxable event at the time of the grant; however, the payment of any phantom equity will be treated as ordinary income to the grantee and provide for an off-setting compensation deduction for income paid on behalf of the company.
Limited liability companies have become an increasingly popular choice in business entity types being selected by newly created companies. Founders seeking to incentivize and retain key employees should be well versed in not only the practical implications of awarding of the different types of equity-based compensation available to key employees but also the tax implications of offering such equity-based compensation mechanisms as well. Often times the awarding of equity-based incentive compensation such as profits interest or capital interest or the granting of equity options in limited liability companies can lead to additional administrative complications that neither party originally foresaw. Should you or your company need assistance navigating through complex and uniquely challenging issues surrounding the implementation of equity-based compensation in limited liability companies please do not hesitate to reach out to our attorneys at Founders Legal.
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