LLC Equity Compensation

Before the advent of LLC statutes, the only way to combine the benefits of limited liability with pass-through taxation was with an S corporation. Entrepreneurs were told that if they dreamed of a major exit or liquidity event, going public through a C corporation was the way to go. Today, all 50 states have well-developed LLC statutes; the IRS has enacted “check the box” regulations making it easier to elect pass-through status; and the growth of private equity combined with increasing regulation of the public markets have made going public less attractive for many. As a result, LLCs now represent the most common form of business organization for emerging companies.

At some point during the life cycle of an LLC, it likely will become important to reward extraordinary effort – whether a co-owner contributing “sweat equity,” a key manager who wants some ownership or rank-and-file staff. Flexibility is a hallmark of LLCs, and there are several possibilities for structuring rewards. The conversation often turns to equity compensation. However, without appropriate consideration of the implications, the result could be frustration and an unexpected tax bill.

To better understand some of the tax implications, one must recognize the basic distinction between capital interests and profits interests in an LLC taxed as a partnership. A capital interest represents immediate ownership in the assets of the LLC. If the LLC liquidated immediately after an employee’s receipt of a capital interest, the employee would be entitled to a share of the liquidated assets. After an employee’s receipt of a profits interest, however, if the LLC immediately liquidated the employee would not be entitled to any portion of the LLC’s assets. A profits interest only grants a share of future appreciation and distributions from the LLC.

The most straightforward way to acquire a capital interest in an LLC is by purchase, but that is not what is usually intended by either the issuing company or the employee. Instead, the LLC typically grants an employee a capital interest without requiring payment in return. The employee owes tax on the fair market value of the capital interest, and the LLC receives a corresponding deduction. If the capital interest is restricted and does not immediately vest, then the employee may consider making a Section 83(b) election, which provides for the employee to be taxed on the restricted interest on the date the equity was granted rather than on the date of vesting.

Because the value of a profits interest is mostly speculative, receipt of a profits interest should not be taxable, as there is no fair market value to report. In Revenue Procedure 93-27, the IRS issued guidance that receipt of a vested profits interest should generally not be taxable. The IRS expanded that guidance in Revenue Procedure 2001-43, which provides a safe harbor for receipt of an unvested profits interest, and treats that grant as if a Section 83(b) election were made, as long as certain qualifying conditions are met.

Equity compensation can be an ideal way to align an employee’s interest with the LLC, but the details carry important tax and non-tax consequences.

Rett Peaden is a partner in SGR’s Corporate Practice, where he helps clients navigate the complicated process of mergers and acquisitions. He also provides general counsel to business clients, advising on ongoing transactional matters and succession planning.