Tax and Private Client Blog

Taxation of LLC Equity Compensation

By Aman Badyal

A common issue confronting business owners is how to give their workers "a piece of the pie" to align employee incentives with business owners' goals. Below is a short summary of certain methods to grant employees equity or "equity-like" compensation.

1. LLC Membership Interests

There are two primary forms of LLC membership interests from a tax perspective: Capital Interests and Profits Interests.

A "capital interest" is any membership interest that would give the holder a share of the proceeds if, on the grant date, the LLC sold all of its assets for fair market value and distributed the proceeds to all of its owners in liquidation.

A "profits interest" is any membership interest that has no liquidation value on the date of grant. A zero dollar liquidation value on the grant date is the only requirement to qualify as a profits interest. A profits interest can be structured to provide its holder to full voting rights, limited voting rights, or no voting rights (depending on the relevant state LLC Act), or to provide its holder the right to share in operating distributions or not.

A. Taxation of Capital Interests

Pursuant to Section 83 of the Internal Revenue Code, capital interests are taxable to the service provider. The service provider's taxable income is equal to the difference between the fair market value of the interest and the purchase price, if any. If the capital interest is not subject to a substantial risk of forfeiture (i.e., it is fully vested), the service provider recognizes income on the grant date. If the capital interest is subject to a substantial risk of forfeiture (i.e., it is subject to vesting conditions), then the default rule is that the taxable event occurs as and when the membership interest vests. However, the service provider is allowed to make a special tax election (an "83(b) Election") that requires the service provider to recognize income on the grant date. Though it may seem counterintuitive at first glance, this election is advisable if the service provider expects the value of the interest to increase over time. This is because if an 83(b) Election is not made, the service provider must recognize income based upon the value of the interest as and when it vests.

Additionally, service providers who purchase an unvested capital interest for full fair market value should also make an 83(b) Election to avoid taxable income upon vesting.

B. Taxation of Profits Interests

Pursuant to a safe harbor provided by the Internal Revenue Service, a profits interest received in exchange for services is not taxable if, among other requirements, the:

  • profits interest does not relate to a substantially certain and predictable stream of income;
  • recipient holds the profits interest for more than two years;
  • profits interest is not a limited partnership interest in a publicly traded partnership; and
  • parties treat the service provider as the owner of the partnership interest from the date of its grant and the service provider takes into account the distributive share of partnership income, gain, loss, deduction, and credit associated with that interest.

To reiterate, under the foregoing circumstances, a service provider is not required to recognize income upon the receipt or vesting of a profits interest. Additionally, the safe harbor does not require that the service provider make an 83(b) Election for unvested profits interests; however, we recommend that any person receiving an unvested profits interest make a protective 83(b) Election.

C. Partner Status

In the case of both capital interests and profits interests, the recipient service provider becomes a partner for tax purposes. Many service providers are not accustomed to the additional tax obligations required of partners. For example, partners must report their income from the LLC as self-employment income rather than wages. Additionally, partners may not be eligible for certain fringe benefits that are available to employees.

2. Phantom Equity

Phantom equity plans are essentially bonus plans that are intended to incentivize employees as if they are equity owners. A significant tax disadvantage of phantom equity is that the full amount of compensation received under a phantom equity plan is treated as ordinary income to the service provider. However, the LLC will receive a deduction for the full amount of the payment. Additionally, the service provider can remain an employee for tax purposes (rather than being taxable as a partner).

There are various ways to structure a phantom equity plan. For example, an employee could be granted the right to participate in the future growth of the LLC over and above its current fair market value by receiving cash equal to a percentage of such growth upon a liquidity event. A plan could also provide the service provider with annual benefits equivalent to operating distributions. However, taxpayers should be mindful of the significant complexities arising under section 409A of the Internal Revenue Code when creating a phantom equity plan. 

OUR VIEW

Well advised businesses are presented with a myriad of options to compensate their employees and ensure all parties' interests are aligned. Taxpayers should keep in mind that granting membership interests and creating phantom equity plans each involve significant business, tax and legal risks. Business owners (and service providers) should consult with their tax and legal advisors before entering into such an arrangement.