It is not unusual for owners of limited liability companies to reward employees with some form of equity, but their advisors often say it’s too complicated to do in an LLC structure. In fact, LLCs can share equity interests in much the same way S or C corporations do. These interests have close parallels to stock options, restricted stock, stock appreciation rights and phantom stock in LLCs, though in some cases their tax treatment can be somewhat different.
This article will look at these alternative ways to share equity and help you decide who should get how much and under what rules.
Note that LLCs do not have stock—they have “membership interests” that can increase or decrease in value. Companies can choose whatever vesting schedules they want for each grant to an employee (different grants can have different rules). These interests may vest when an employee has served a certain amount of time or reached certain performance goals, when the company is sold, or some combination of these approaches. We assume that employees are treated as limited partners of the LLC, not general partners making decisions about the assets of the company.
The Profits Interest
A profits interest is the closest parallel to incentive stock options in C or S corporations. A “profits interest” entitles those who hold interest in a company to both its capital appreciation and, if the LLC chooses, the interim profits of the business. They should be granted at the company’s current fair market value, set by an appraiser or the board to avoid any possible tax complications. Most of the LLCs we have talked with do not distribute profits, except for the money employees will need to pay their taxes on their LLC’s earnings.
While profits interests are similar to incentive stock options in an S or C corporation, they are not exactly the same. Stock option holders, for instance, have no right to company earnings (nor tax obligations for them). Moreover, a profits interest in an LLC is generally held until the company is sold, while a stock option might be exercised beforehand.
In the typical arrangement, employees receive an award and make an “83(b) election” on their taxes. This fixes the ordinary income tax obligation at the time of grant, which is zero if the grant is made at fair market value and if the award gives the employee no guaranteed right to a stream of future income, such as a share of the profits. If a profits interest is held for at least one year after it vests, the amount received is treated as a long-term capital gain; otherwise, it is a short-term gain.
There is some dispute about whether the employee actually needs to make the 83(b) election or if the IRS will automatically note it (the general view is the latter). If profits interest holders make the election, they are treated as if they had an actual equity stake in the company. That means they will receive a K-1 statement for their share of ownership and have to pay taxes on it. Distributions can be made by the LLC for this purpose. The money LLCs pay to employees for their limited partner status is not subject to employment taxes. But the employees are subject to self-employment taxes (FICA and FUTA) on their salaries. Some companies “gross up” employee pay to cover these additional taxes.
Companies can distribute earnings to the holders of these interests, but it need not be in proportion to the employees’ equity stakes. There are no statutory rules for how a profits interest must be structured. The distributions of earnings would normally be based on vested units, but they could also be based on allocated units.
For example, say an employee, “Roy,” is granted profits interests on 500 LLC membership interest units in 2013 at their fair market value of $500 each. In 2017, one year after the shares have become fully vested, the profits interest is cashed out at $800 per unit. Roy pays capital gains taxes on the gain of $15,000 (500 units x $300). In the interim, Roy gets a K-1 statement each year for his share of the company’s earnings, and the company distributes sufficient earnings for him to pay taxes.
Capital interests are the closest thing to restricted stock. While profits interests give the holder the right only to an increase in company value (and sometimes, interim profits beyond what is needed to pay taxes), capital interests give employees the right to the full value. Unlike profits interests, they do not carry any claim on current corporate earnings and they do not require the employee to pay taxes on a share of the company’s earnings.
Capital interests that are freely transferrable (they can be sold without restrictions) or that are fully vested (for example, they don’t depend on some future performance target) are recognized as ordinary compensation for their fair market value—minus anything the employee pays for them. In the more common cases, the capital interest is nontransferable and subject to a “substantial risk of forfeiture” (an IRS description for assets whose transfer is based on performance and that are not yet vested). In this case, the taxable event can be delayed until the restriction lapses. Ordinary income tax would be due on the value of the award when it becomes fully vested—whether it is sold or not. The employee would make an 83(b) election, however, to get capital gains treatment on part of the value. The election must be made within 30 days of the grant. The employee would pay ordinary income tax on the value of the award minus anything paid for the award. No further taxes would be paid until the capital interest is sold, at which time the taxable amount would be treated as a capital gain.
An employee who receives a restricted capital interest (that is, one that is subject to vesting) will not be treated as a partner for tax purposes until the restrictions lapse, unless the 83(b) election is made. If the employee makes the election and later forfeits all or part of the award, he or she is not entitled to a refund for the income taxes already paid.
For example, say an employee named “Sheila” gets a capital interest grant in 2013 equal to 500 units of an LLC valued at $500 apiece. She decides to make an 83(b) election and pays taxes on $25,000 (500 x $500) and the company gets a corresponding deduction. The award vests in 2016. Five years later, in 2018, she sells the units for $800 per unit, or $40,000, and pays capital gains tax on $15,000. The company gets no deduction for that amount.
Another employee, “Sally,” gets the same award, but does not want to pay taxes now. Instead, she pays when the award vests in 2016 when the units are worth $700 each. Sally pays ordinary income tax on $35,000 and the company gets a corresponding deduction. She cannot sell the shares until 2018, when they are worth $40,000. She sells at that time and pays capital gains taxes on the remaining $5,000.
Unit Rights and Unit Appreciation Rights
The advantage of the profits interest and capital interests are primarily that they allow employees to receive capital gains treatment on all or part of the value of an award. In many companies, the extra complexity of these awards is not worth the benefit the employees would receive, particularly now that the rates on capital gains are closer to effective ordinary income tax rates.
In these cases, there’s a much simpler approach with very similar benefits (other than taxes). And that is to use membership interest unit rights or membership interest unit appreciation rights. Unit rights are comparable to phantom stock in an S or C corporation, while unit appreciation rights resemble stock appreciation rights.
A unit right gives an employee the value of a stated number of units; a unit appreciation right gives the employee only the right to a value increase in those units. Both awards are subject to vesting and normally paid out in cash only when it occurs. That amount is taxed as ordinary income to the employee and is deductible to the employer. The employer could also choose to pay the taxes on the award and give the employee the remaining value, not in cash but in membership units. The employee would then get capital gains tax treatment on the sale of the units at some future point when they are sold.
For example, let’s say an employee named “Harrison” gets unit rights equal to 500 units at $500 per share in 2013. They fully vest in 2016 at $700 per unit. Then the company pays Harrison $35,000 and gets a tax deduction for that amount. Harrison pays ordinary income tax on $35,000.
Another employee, “Melissa,” gets unit appreciation rights on 500 units at $500 per share in 2013. They fully vest in 2016 at $700 per unit. The company pays Melissa $10,000 (the $200 per unit increase in value x 500) and gets a tax deduction for that amount. Melissa pays ordinary income tax on $10,000.
Who Gets What, And With What Rules
As important as it is to decide what kind of equity to share, it is even more critical to decide who gets the equity, how much they get, when and with what rules. There are five key things for companies to consider:
• The total pool of equity that will be available
• Who will be eligible
• How the equity will be allocated among those eligible
• What rules apply to the awards
• How the awards become liquid
Determining the pool. A common approach to setting the equity pool is to give out some percentage of the LLC’s total membership interests, most often 10%. Ten percent is not a magic number, though, and 10% of one company may be worth a great deal more or less than another. Employees are not focused on what percentage they own but what it is worth—the company should be too. The goal should be to provide an amount that is enough to attract, retain and motivate people, something that can only be assessed case by case. That amount needs to be higher if the company wants to pay less in fixed wages and more in variable pay.
Companies also tend to give out most or all of the equity they are comfortable with up front, meaning they leave no margin for new employees to get awards. A better approach is more dynamic: Set a target each year for profits, growth and/or some other critical measure of success, then share some percentage of that target, if it’s met, with an equity pool. That gives employees more incentive to hit the target each year and prevents a company from sharing equity when it is not earned.
Eligibility. Companies often want to limit equity to just one or a few “key” people. That’s understandable, but the research on employee ownership shows that broader sharing works better. Most venture firms, for instance, prefer that most or all employees get equity, especially in the early stages of growth. All employees make significant contributions to how a company performs, even though, of course, some may be paid less than others.
Allocation approaches. Most often, the amount given to employees is largely a “seat of the pants” guess. Business owners would likely want to survey the practices of other companies to find a good benchmark, but there are apparently no reliable surveys of equity-granting practices for LLCs.
Companies could set individual performance targets that would, if met, trigger a payout of some percentage of the total equity pool. It is tricky to set really good targets, but this is still better than a guess. Alternatively, a company could use “internal equity” as a guide. In this approach, eligible employees are rated according to their contributions to the company, and this corresponds to how much they are paid. But it may vary, say, if somebody’s pay is based on their future performance or, meanwhile, if somebody could command higher pay elsewhere.
Rules. Most companies’ shares vest over three to five years according to employees’ seniority. The vesting can be gradual or happen all at once. Some companies instead set a performance milestone for themselves or vest only during a liquidity event, such as a company sale. The latter approach can be appealing to people with capital interests who have not made an 83(b) election because they will not pay taxes until money is paid out. But delaying liquidity until some future and uncertain event can severely erode employee confidence in the value of the awards.
Liquidity. We often talk with business owners who think getting equity per se is a good thing, even if there is no clear path to its liquidity. They are confident one day that there will be, but employees usually do not share that confidence. If it’s unclear when people will be able to cash out, the business owners must prove that they can offer some liquidity in the interim.
Equity grants are contractual agreements between employees and their companies. There needs to be careful drafting of the plans themselves, grant agreements and formal board approval. Getting experienced, qualified counsel is a must. With a well-drafted and conceived plan, sharing equity with employees can be a win-win for all involved.
Corey Rosen is the founder of the National Center for Employee Ownership, a private nonprofit information and membership organization in Oakland, Calif., and co-author of NCEO’s book, Equity Compensation in Limited Liability Companies.