Entrepreneurs often choose to form a limited liability company (“LLC”) when starting a business for a variety of reasons including its “pass through” tax treatment, the potential personal use of losses, and due to certain qualifying restrictions imposed upon S corporations. LLC’s often want to grant equity interests to key employees or service providers to motivate and reward them to grow the business. Unfortunately, the traditional corporate equity compensation methods (e.g., incentive stock options) are not available to an LLC.
Fortunately, there are several other ways to provide equity compensation in an LLC. The easiest and most tax efficient approach involves the grant of something called a “profits interest.” A profits interest is an interest in the future profits and appreciation of the assets of an LLC. This means that the original members retain the full value of the LLC prior to the grant of the profits interest and the recipient only shares in future profits and appreciation. The grant of the profits interest, if properly structured, should not result in any taxable income to the recipient. A profits interest may be initially granted as a fully vested interest or may vest based on continued service or the achievement of business benchmarks related to the LLC’s operations.
One benefit of the receipt of a profits interest is that the recipient does not have to pay an exercise price to obtain the equity interest represented by the profits interest unlike a stock option since the recipient is already a member. Another benefit is that in certain situations under the current law the recipient may obtain capital gains treatment which may not otherwise be available with a stock option (e.g., a sale of the assets of the LLC). Further, the grant of a profits interest allows the recipient to fully participate in the LLC in a manner similar to other members (or in a lesser role if that is what is decided) while the original members retain their full value of the LLC created prior to the grant of the profits interest.
The tax law provides for very specific requirements for the grant of a profit interest to escape recognition of taxable income by the recipient. The profits interest must be granted to the recipient as a result of providing services to the LLC. The profits interest also must not relate to a substantially certain and predictable stream of income from LLC assets (e.g., income from high-quality debt securities or a high quality net lease) and the profits interest itself must not be disposed of within two years of receipt. If these requirements are satisfied (along with other technical requirements which are beyond the scope of this post), the IRS will not tax the receipt of a profits interest since, in its view, it has no current ascertainable value.
It should also be emphasized that since the recipient of a profits interest is considered a current member of the LLC, the profits interest member will be required to report and pay tax on any income passed through from the LLC (whether the income is attributed to the vested or unvested portion of a profits interest). This negative aspect of the receipt of a profits interest can be overcome by ensuring that the LLC is required to distribute sufficient cash to the profits interest recipient in any year to pay the corresponding tax liability resulting from the passed through income of the LLC. This is important point to take into consideration in negotiating the receipt or structuring the grant of a profits interest.
Finally, it is important to note that once an employee receives a profits interest in an LLC, he or she can no longer be an employee of the LLC for tax purposes. Meaning that any payment for services is subject to self-employment tax and any benefits offered by the LLC to employees may be negatively impacted.
The grant of a profits interest is highly technical from a tax perspective and this post only serves as a basic introduction to the issue. If you are the owner of a LLC and want to grant profits interest to provide an incentive to employees or service providers, we can help.
