Equity Options for LLCs

By

Limited liability companies (“LLCs”) are a popular entity choice for small business owners and even startups in some circumstances. Issuing equity in LLCs can be complicated and lead to additional compliance and reporting obligations, and great care should be taken when determining the right equity structure. This blog is meant to serve as a brief introduction to four common ways of issuing equity in an LLC to compensate key service providers or employees.

There are four common methods of granting equity or equity incentives in an LLC: (1) outright membership interest or membership unit grants, (2) LLC Incentive Units (aka “profit interests”), (3) LLC equity appreciation rights, and (4) options to acquire LLC capital interests. Note that any of the below may be granted in a manner that vests over time.

Awarding Membership Interests/Units

The most basic compensation structure on this list is simply awarding a service provider equity in the business. While this is straightforward and carries the benefits of price of ownership, this option comes with several key considerations, including:

  1. LLC equity owners, or “members” of the LLC, have certain rights including basic information (i.e. ownership percentages and access to financial records) and may have voting rights. Thus, be sure that you intend for the recipient to have these rights.
  2. All equity owners in an LLC are “partners” for tax purposes, and thus (i) must be given a K-1 at the end of each year and (ii) cannot be W-2 employees and instead must file and pay quarterly self-employment taxes.
  3. The service provider will be taxed on the value of the equity grant immediately. This is not an issue for a brand-new company that has no value, but if the company is established and has some value, then this could lead to unintended tax obligations. For example, if the business is worth $1,000,000 and a 10% grant is made, then the recipient will need to report income of $100,000, and pay taxes on that. The company, however, does get to take a corresponding tax deduction for this amount.

LLC Incentive Units

A prevalent compensation mechanism increasingly used by startups and small businesses is the granting of LLC profits interests, also called “Incentive Units.” Recognize that an LLC membership interest has two components – the capital interest, or the present value of the interest, and the “profit Interest.” The capital interest has value right now and is subject to the tax consideration laid out above. An employee or service provider who is granted an LLC profits interest receives a right both to the future profits of the LLC and the appreciation in value of the assets of the LLC. At the time of the grant, the profits interest holder is not entitled to share in the value of the enterprise up to that point in time and therefore the grant will not result in taxable income to the recipient. Unlike an equity grant, however, the LLC does not receive a compensation deduction for the grant of a profits interest.

Generally, when a profits interest is granted, it holds no value. The profits interest holder does not recognize income until the interest vests. Over time, the LLC hopefully increases in value. Therefore, the profits interest will likely be more valuable in the future than at the time of the grant. Because there was an appreciation in value since the time of the grant, the recipient would be subject to ordinary income tax on this appreciated value. To avoid this treatment, recipients can make an election under Internal Revenue Code 83(b), which allows the employee or service provider to recognize as income the value of the profits interest as it was on the grant date as opposed to the date at which it vested. In other words, if the profits interest holder files a timely 83(b) election, she will not pay any taxes upon vesting of the profits interest and will only pay long-term capital gains tax as a result of future taxable events.[1] A potential downside for employees receiving a profits interest, however, is, as discussed above, that they are no longer able to be considered employees for tax purposes and must receive a Schedule K-1 tax form instead of a Form W-2. Beneficially for the LLC, Incentive Units may be structured to be non-voting (financial only) units, leaving control of the company in the hands of the original owners.

Options

Like a stock option, an option to acquire LLC capital interests (“LLC option”) is a contract that allows an employee or service provider to purchase LLC capital interests at a fixed price. Similar to any other option, an LLC option typically has an expiration date at which time the contract can no longer be exercised and expires.

A significant advantage of LLC options is tax treatment: typically, there is no taxable event until the option is exercised so long as the option does not have a readily ascertainable fair market value at the time of grant. On the date of the exercise of the option, the service provider will be subject to ordinary income tax on the difference between the fair market value of the membership interest purchased and the exercise price in the option. If a service provider exercises a stock option and then holds the membership units for more than one year, she may be eligible for capital gains treatment in the event of an eventual sale.

LLC Phantom/Synthetic Equity

An LLC may choose to implement a phantom “LLC unit” plan and grant “parallel” or “phantom” units. Importantly, phantom units are not actual membership units (ownership) in an LLC. They are merely based on the value of the membership units of an LLC (they are sometimes also known as “synthetic equity”). If properly structured, phantom units are not taxable to the recipient at the time of the grant; the phantom units will be taxable to the recipient when a trigger event (e.g., change of control, death, or disability) occurs. The company cannot deduct the value of phantom units granted, but may deduct payments made to the service provider when a “trigger event” occurs.

We know this is a lot to digest and equity compensation can be complicated. That is why it is critical to consult with an attorney who is comfortable doing these types of transactions to be sure you get them right. Hopefully this post will help you understand the equity compensation types and provide a starting point for granting equity to service providers or employees.

[1] There are additional tax law provisions that provide a safe harbor under which the IRS will not treat the receipt (or vesting) of a profits interest as a taxable event. See IRS Revenue Procedure 93-27 and 2001-43. Notably, IRS Revenue Procedure 2001-43 states that taxpayers do not need to file an 83(b) election when a restricted profits interest is issued so long as certain conditions are met. However, this is beyond the scope of this post and many profits interest holders continue to make protective section 83(b) elections despite this provision.

About the Author
Candace Groth

Candace Groth is a senior attorney at Vela Wood. She focuses her practice in the areas of mergers and acquisitions, venture capital, and private equity.

Learn More