The structures for granting equity incentives to employees and other service providers of corporations are tried and true. The income tax consequences to a grantee upon his receipt of restricted stock and stock options and to the issuing corporations are well settled. Over the last 20 years, however, as LLCs taxed as partnerships have become a more popular vehicle for operating businesses, LLC managers have sought to create equity incentives for their employees and other service providers, with the goal of achieving, to the extent possible, tax consequences similar to those achieved by corporate equity incentives: deferral of the obligation to pay a purchase price, deferral of tax liability, and maximization of income taxable as capital gains on an exit or later sale. The tax consequences of a grant of equity in an LLC that has elected to be taxed as a corporation is equivalent to the grant of equity in an entity formed and taxed as a corporation.
LLCs can issue two types of equity interests, capital interests with essentially the same tax treatment upon grant to the grantee as the issuance of stock of a corporation. LLCs may also issue profits interests, the equivalent of which does not exist in the corporate context. As discussed in greater detail below, profits interests—which entitle the grantee to a share of future (rather than existing) income and appreciation of the LLC—are a popular and tax-efficient way to get equity into the hands of LLC employees and service providers without triggering current tax to them. Nonqualified options (but not incentive stock options, which may be granted only by corporations) are technically available in the LLC context as well, but the current tax rules surrounding the issuance of LLC options is unsettled. Also like a corporation, an LLC may issue contractual rights to participate in bonus compensation arrangements, which may pay out based on the value or appreciation in LLC equity.
The discussion and below and the accompanying exhibit outline the tax impact of LLC equity and equity-based compensation structures to both the grantee and the issuing LLC (and ultimately the existing LLC owners on a pass-through basis).
LLC Capital Interests
An LLC may grant a capital interest, a type of equity that entitles the holder to a slice of the LLC’s existing capital at the time of grant. For example, the grant of a 5% capital interest membership interests or "units" in a company valued at $1 million on the date of grant would be worth $70,000. This is akin to granting a service provider 5% of the stock of a corporation. (This example assumes the LLC and the corporation have only one class of equity outstanding with equal rights to liquidation proceeds.)
As is the case with the grant of corporate stock, the tax consequences to the grantee and the LLC depend on whether the capital interest is "restricted" or "substantially non-vested" upon its grant—that is, it is subject to a substantial risk of forfeiture and non-transferrable. (Equity that may be repurchased by the issuing entity for a price that is less than fair market value if the grantee stops performing substantial services or fails to meet a condition related to the purpose of the transfer, such as the achievement of a performance target, is subject to a substantial risk of forfeiture. Equity is non-transferrable as long as it cannot be transferred free of a substantial risk of forfeiture.)
If the capital interest is restricted or substantially non-vested, the tax consequences depend on whether the service provider makes an election under IRC section 83(b) (i.e., an "83(b) election") upon the grant of the interest. Note that capital interests, whether restricted or unrestricted, constitute “property” for the purposes of IRC section 83(b), which provides, in general, that when there is a transfer of property for services, the value of the property less the amount paid, if any, is taxable to the service provider upon grant or, if later, as the property vests. If an IRC section 83(b) election is made (it must be filed with the IRS within 30 days of grant of the property), the value of the property less the amount paid will be taxable to the service provider upon grant.
Taxation of a Vested Capital Interest
Consequences to the grantee
A grantee who receives a vested capital interest is taxable upon receipt, in an amount equal to the difference between the interest’s fair market value and the amount paid. This difference, if any, is ordinary compensation income to the grantee. The grantee becomes a partner for tax purposes upon receipt of the vested capital interest and is no longer treated as an employee. As a result, the grantee will—share in profits and losses in accordance with the economic deal among the members,
- receive Forms K-1,
- be responsible for paying self-employment taxes rather than having the LLC withhold employment taxes, and
- pay estimated income taxes rather than have income taxes withheld by the Company.
Because the grantee is no longer an employee, she will not be eligible for tax favorable benefits available to employees with respect to her service to the LLC.
Consequences to the LLC
The grant of a vested capital interest is treated, to the extent of any difference between the value of the capital interest and under current law5 the amount paid for the capital interest, as a deemed taxable transfer of a proportionate share of the LLC's property to the grantee, followed by a nontaxable contribution of the deemed transferred property back to the LLC by the grantee. (Proposed Treasury Regulations would provide that the deemed transfer is of cash and not property. This approach would eliminate the gain, loss, and deduction on a proportionate share of the LLC’s assets.) The deemed transfer of assets to the grantee will trigger gain, loss, and deduction in the LLC, which will flow through to the other LLC owners. The transfer of the vested capital interest will also generate a compensation deduction if the payment for the grantee's services is a deductible expenditure.
Taxation of a Restricted Capital Interest: No IRC Section 83(b) Election
Consequences to the grantee
If the grantee does not make an IRC section 83(b) election, the grantee will have taxable income as the capital interest vests, in an amount equal to the difference between the then-value of the vested portion of the capital interest, less the amount paid for that vesting portion. The grantee becomes a partner with respect to the vested portion of the capital interest as it vests and will only receive tax allocations with respect to the vested portion of the capital interest. Consequences to the LLC
If the grantee does not make an IRC section 83(b) election, each time a portion of the capital interest vests, the LLC will be treated as transferring a proportionate share of its property to the grantee, followed by a nontaxable contribution by the grantee of the property back to the LLC. The deemed transfer of property to the LLC will generate taxable gain, loss, and deduction that will pass through to the LLC owners as it vests. The vesting of the capital interest will generate a compensation deduction if the payment for the grantee's services is a deductible expenditure. The LLC will be as treated owning the unvested capital interest until it vests.
Taxation of a Restricted Capital Interest: IRC Section 83(b) Election Is Made
Consequences to the grantee
If the grantee makes a timely IRC section 83(b) election7, he will be treated for tax purposes as if he received a fully vested capital interest. (A grantee may choose to make the election if the capital interest was granted at a low value and she anticipates further appreciation, or she may be required to make one by the LLC, so she is treated as a tax partner from the outset.) Note, however, that an IRC section 83(b) election applies only for tax purposes. For business purposes, the capital interest is still restricted; thus it’s subject to forfeiture and is non-transferrable.
Consequences to the LLC
When an IRC section 83(b) election is made by the grantee, the LLC is treated for tax purposes as if it transferred a fully vested capital interest.
LLC Profits Interests
While an LLC capital interest entitles the holder to a share of the company’s existing capital upon a hypothetical liquidation of the LLC immediately after grant and a share of future income and gain, a profits interest does not participate in existing capital, only future income and gain. Thus, the IRS treats the value of a profits interest upon grant as zero (Revenue Procedure 93-27). There is no equivalent to profits interest in the corporate context, though its economics could be compared to a fair market value option.
Taxation of a Vested Profits Interest
The IRS takes the position that the receipt of a vested profits interest to the grantee in consideration for services provided is not a taxable event, as long as the profits interest is not transferred by the grantee within two years of receipt, the profits interest is not issued by an LLC holding property producing a certain and predictable stream of income, and it is not a publicly traded partnership. The grantee becomes a partner for tax purposes upon receipt of the profits interest and is allocated future income, gain, or loss per the LLC Agreement.
There is no gain, loss, or deduction to the LLC or the existing partners upon the grant of a vested profits interest.
Taxation of a Restricted Profits Interest
Consequences to the grantee
In general, neither the receipt of a profits interest by the grantee for services to the LLC nor the later vesting of the profits interest is taxable to the grantee as long as the grantee is treated as owning the profits interest from the date of grant (including for the purposes of making allocations of income, gain, or loss).
While a capital interest is treated as property for purposes of IRC section 83, a profits interest is generally viewed as something other than property. Thus, IRC section 83 does not apply, and an IRC section 83(b) election is not necessary. Despite this, many practitioners recommend making a protective IRC section 83(b) election in case the profits interest is later determined to be a capital interest. Upon forfeiture of the profits interest, the grantee will be entitled to a loss equal to her basis in the profits interest (as adjusted for income and gain allocated).
Consequences to the LLC
Neither the LLC nor the existing LLC members will recognize gain, loss, or deduction upon the grant and later vesting of a profits interest. Upon forfeiture of a profits interest, the remaining LLC members will receive allocations related to the forfeiture. Note that holders of equity interests in LLCs are not treated as employees for tax purposes. This means that they are not issued a Form W-2 and are not subject to withholding. Payments for services may be guaranteed payments reported on Schedule K-1 and the tax treatment of fringe benefits is different. Terms to consider for LLC equity grants
It’s important to keep in mind the following terms:
- Capital versus profits interests: While the value of a capital interest is greater than a profits interest, because the receipt of a capital interest is taxable and the receipt of a profits interest is not, most service providers prefer to receive a profits interest rather than have to pay taxes up front on an illiquid asset.
- Voting versus non-voting: Current ownership may prefer that the interests held by service providers be non-voting.
- Restricted ownership: Generally, service provider equity is earned over time through vesting. If vesting conditions are not met, the equity will be forfeited.
- Repurchase agreement: When service terminates, the LLC may want the right to repurchase vested interests. The purchase price can be fair market value. It may be something less if the termination is for "cause" (like violation of a non-disclosure, etc.).
- Other restrictions: The LLC can subject the service provider equity to other restrictions that may not apply to interests held by other owners, such as limits on access to certain financial information (like the ownership interests of other members), restrictions on the transfer of the interests, and drag-alongs.
LLC Options
A service provider can be granted an option to purchase a capital interest in an LLC. An LLC option is a contractual right held by the grantee to purchase a capital interest in the LLC at a fixed price in the future. Unlike corporations, LLCs cannot issue "incentive stock options." There is no final guidance from the IRS on how compensatory nonqualified options of an LLC will be treated. For now, it is assumed that the tax treatment will be similar in many respects to a compensatory nonqualified stock option of a corporation: as long as the option is granted with a strike price equal to fair market value at the time of grant and is exempt from, or complies with, the requirements of IRC section 409A, there is no income for the service provider and no deduction for the LLC upon grant. Upon exercise, the service provider will recognize ordinary income equal to the spread between the exercise price of the option and the fair market value of the LLC interest received, and the LLC will have an equivalent deduction (which passes through to the existing members). It is likely that upon exercise, the LLC will be treated as a deemed taxable transfer of a proportionate share of LLC property to the service provider, followed by a contribution of the deemed transferred property.
LLC Equity Appreciation Rights or a Bonus Based on Equity Value
A service provider may be granted the contractual right to receive a share of the profits earned by or appreciation in an LLC. These arrangements are not true equity and the service provider is not treated as a partner for tax purposes. Rather, they are deferred compensation arrangements that are subject to special rules under IRC section 409A. These rules restrict the timing of deferred compensation and impose harsh penalties for noncompliance.
Deferred compensation is ordinary income to the key employee when received and generally deductible by the LLC when paid. For example, an LLC can structure a bonus arrangement through a management bonus plan that allocates a percentage of a pool (of, say, net income from sales or a portion of sales proceeds) to certain employees under certain conditions set forth in such plan, or through a change in control bonus plan where the bonus payment would only be paid in the event of a change in control of the LLC (or a sale of the company's assets). A service provider who is granted an equity appreciation right or a bonus rather than equity can remain an employee (rather than a partner) for tax purposes.
Key Takeaways
If the objective is to issue a service provider real equity, rather than an unsecured contract to pay a bonus in an amount tied to the value of the company, the interest will have to be granted as a capital interest or profits interests. LLC options are available, but as described above, the tax treatment is uncertain and there is risk of unintended tax result. As between a capital interest and a profits interest, the question is largely one of economics and taxes. A capital interest has current value and a profits interest does not. This means that the service provider receiving the capital interest will generally have taxable compensation income upon grant—or later vesting, if an IRC section 83(b) election is not made. Frequently, a key employee would prefer to take a profits interest because it is not currently taxable and does not require payment of consideration to the company. A profits interest is generally viewed as comparable to a nonqualified stock option or a stock appreciation right, but with the potential for capital gains treatment. A bonus plan can give the same economics to the key employee, but all payments will also be treated as ordinary income when paid.
For additional information, please see theexhibit containing LLC equity incentives for service providers.
Robert M. Finkel is the partner-in-charge of Moritt, Hock and Hamroff, LLP’s New York City office where he also serves as co-chair of its tax practice group. Mr. Finkel has been an adjunct professor at Boston University School of Law’s Graduate Tax Program since 1995. He was an adjunct professor at the Radzyner Law School (IDC Herzliya, Israel) where he taught U.S. corporate and tax law (2005-2006).
