An employee's ownership of equity interests in his or her employer is a commonplace practice in businesses of all sizes, both public and private. Closely held businesses that want to attract and retain quality employees must consider offering those employees some form of equity participation in the business, and since the early 1990s, limited liability companies have become the structure of choice.
LLCs offer flexibility in governance and tax treatment not available to corporations. Yet issuing ownership interests to LLC employees presents its own set of problems.
First, many forms of equity compensation (such as incentive stock options and employee stock ownership plans), can only be offered by corporations. Second, the way the IRS treats an employee's membership interest in an LLC is not as clear as the agency's treatment of stock issued to corporate employees. Finally, when employees do receive a membership interest in an LLC, this may change their tax status from employee to partner, and subject them to self-employment tax and a tax on fringe benefits that corporate employees don't face.
Let's briefly discuss these last two items, both of which involve unsettled questions of law. There are two sets of proposed Treasury regulations that address many of the issues, but the regulations have not been finalized and cannot currently be relied on if your LLC is issuing membership interests. This creates a state of limbo in an area that should be straightforward and predictable, a state in which the unwary face uncertainty and tax traps.
Any business that issues compensatory equity to its employees must consider the impact of Section 83 of the Internal Revenue Code. If an employee receives property (such as shares of stock issued by a corporate employer) in exchange for services rendered, Section 83 requires the employee to pay taxes immediately, at ordinary income rates, on the fair market value of the property. If the property is "restricted property" under Section 83 (meaning the property is not transferable and is subject to a substantial risk of forfeiture if employment ends), the employee is not taxed upon receipt; instead, the employee will be taxed when the property first becomes transferable or is no longer subject to the risk of forfeiture.
In either event, the amount of tax is based on the fair market value of the property at the time the employee is first subject to income tax. If the property is restricted property and not taxable upon issuance, the employee can nevertheless elect to be taxed immediately on the fair market value of the property (without any deduction for the risk of forfeiture), rather than waiting until the risk of forfeiture lapses, at which point the tax may be much greater because of the appreciation in the value of the property over time. This is called an "83(b) election," and it clearly involves some risk-taking by the employee.
Under current law, the application of Section 83 to the issuance of LLC membership interests is unclear. The proposed regulations say that Section 83 will govern the issuance of all types of LLC membership interests, and they provide a safe harbor for the valuation of the interests. However, until the regulations become final (and it is uncertain when that will happen), LLCs and their advisors must continue to deal with unanswered questions about how to apply Section 83.
Different Interests
LLCs do not issue "stock." Rather, they issue "membership interests," which are similar to the interest of a partner in a partnership. These membership interests come in two basic forms-a "profits interest" and "capital interest." (Equally complex issues dealing with the issuance of options to purchase such interests are beyond the scope of this article.)
A profits interest gives the employee an opportunity to participate in the appreciation in value of the LLC that occurs after (but not before) the employee receives it. This is similar to the stock appreciation right at corporations. Under the current IRS revenue rulings, the receipt of a profits interest does not trigger income to the employee as long as (1) neither the LLC nor any member of the LLC takes a deduction with respect to the issuance of the profits interest; (2) the employee takes into account his or her share of LLC profits and losses in computing tax liability; and (3) the employee doesn't dispose of the interest for two years. As long as these guidelines are followed, practitioners can feel comfortable that the issuance of a profits interest will not trigger immediate income tax to the employee.
While the revenue rulings help, they do not answer key questions about the application of Section 83 to these profit interests. For example, the rulings do not say that profit interests are subject to Section 83, but they do say that if the requirements are followed, an 83(b) election is not necessary. Under these uncertain circumstances, most practitioners recommend that an 83(b) election be filed in connection with the receipt of a restricted profits interest, even if the requirements are followed. Proposed regulations would make all membership interests subject to Section 83, whether or not they are profit interests or capital interests. Once these regulations are finalized, the confusion about the applicability of Section 83 to LLC membership interests should be resolved.
A "capital interest" is any interest in the LLC that is not a profits interest. An LLC should not issue a capital interest (restricted or unrestricted) as compensation to an employee without careful consultation with tax advisors. While the issuance of an unrestricted capital interest is always immediately taxable to the employee, there can also be tax consequences for the other members of the LLC.
These tax consequences are difficult to predict with certainty, particularly if one or more members have contributed appreciated property (property that has a fair market value higher than the contributing member's tax basis) to the LLC. If the LLC does not plan the issuance with an understanding of the complexities involved (including the necessity of book-ups of LLC assets and the possibility of taxable "capital shifts" among the LLC members resulting from the issuance), the LLC members, along with the employee, could also be taxed under a number of theories that the IRS could employ.