Our clients frequently ask us to advise them on how to provide equity-based incentives to employees in their limited liability company (LLC). Knowing that simply answering the question may involve much more than our clients bargained for, our first instinct is to suggest that our clients have their LLCs pay cash bonuses instead. As compared to equity-based incentives, cash bonuses are easier to administer, have clear-cut tax ramifications for the LLC and recipient, and do not involve long-term entanglements (such as fiduciary duties, voting rights, and other rights attendant to equity ownership). Cash bonuses can be tied to LLC events in order to more closely imitate equity, such as achievement of profit targets or liquidity events. Also, unlike most equity-based incentives which carry an uncertain and delayed payout, bonuses could only be more liquid if paid in molten precious metal. (This we do not recommend.)
Being uncommonly intelligent, successful and attractive businesspeople, by the time they ask us this question our clients usually have already considered paying bonuses and have identified good reasons to pursue an equity-based alternative. These reasons typically include all or some of the following: a goal of providing a long-term and potentially significant incentive to key personnel, a desire to avoid or delay taxes payable by employees in connection with those incentives, and a need to preserve cash for other uses. Or sometimes our clients have determined that they will pay a cash bonus, and then allow employees to buy into the LLC.
This is when the real work, and the fun, begins. If there is beauty and elegance to LLCs (which is surely debatable), those attributes derive from the flexibility LLCs provide when it comes to structuring ownership, voting and management rights. This flexibility extends to the equity and quasi-equity incentives that can be offered in LLCs. Selecting the right incentive in each situation can be daunting given the multiple and seemingly complex alternatives available. This article and the included chart provide a brief and selective overview of these alternatives and highlight some of the differences among the typical LLC incentive vehicles.
Descriptions of Common LLC Incentives
LLCs most commonly provide one of three types of equity-based incentives: capital interests, profits interests or phantom units.
“Capital interests” are LLC membership/equity interests which in most cases receive an allocation of LLC profits/losses, share in periodic distributions of LLC profits, and entitle the owner to a percentage of both the current value and future appreciation of the LLC. Holders usually acquire capital interests for additional consideration which is accounted for as a contribution of capital; however, a capital interest can be awarded for past or future services to be performed for the LLC.
“Profits interests” are also membership/equity interests, but they are usually granted in consideration for services without additional cash consideration. Like capital interests, profits interests also receive an allocation of LLC profits/losses and ensure holders receive a percentage share of periodic income distributions. However, upon sale of the company, profits interests only entitle the owner to a percentage of post-grant LLC appreciation. At issuance, profits interests generally carry no value and are not taxed as income to the employee upon receipt.
Here are two simple examples which illustrate some important differences between capital interests and profits interests:
- Assume an employee works in an LLC with a market value of $10 million. If the employee uses after-tax dollars to acquire a capital interest in the LLC, and if the LLC sells all its assets the next day, then absent special circumstances the employee will receive his or her pro rata percentage of the entire purchase price paid by the acquirer. (The payout to the employee/owner from the LLC sale should equal the price paid by the employee for the capital interest the day before; assuming the LLC’s owners valued it properly one day prior, the LLC would not have appreciated and would sell for the same value of $10 million. This example is a bit silly as a result, but it serves to illustrate that capital interests immediately entitle holders to a share of the LLC’s current value.) On the other hand, if an employee receives a grant of profits interests from its employer LLC (remember that profits interests are exchanged for services; the employee does not pay for them), and if the LLC sells its assets the next day, the employee will not receive any payment from the sale. This is because profits interests only entitle their holders to a percentage of future LLC appreciation, and there really could be no material appreciation in the LLC overnight. This also explains why profits interests have no value when granted and are not taxed as income to employee recipients.
- Consider the same two situations – an acquisition by an employee of capital interests using after-tax dollars, versus a grant of profits interests to an employee for no additional consideration. Assume again in each case that the LLC has a market value of $10 million when the interests are issued to the employee. If the employee with capital interests holds them for several years after grant and the LLC appreciates by $10 million during that holding period, then when the LLC is sold for $20 million the employee would be entitled to receive his or her percentage share of the entire $20 million. In contrast, the employee with profits interests (who was never taxed on the profits interests and who never paid additional consideration for the profits interests) would share only in the $10 million of after-grant appreciation.
“Phantom units” may be the most common equity-like incentive granted by LLCs. Unlike capital interests and profits interests, phantom units are not true equity interests at all; rather, they are contract rights which mimic profits interests in several respects, but which carry no ownership or voting rights, do not receive an allocation of profits/losses, and do not share in periodic LLC income distributions. Like profits interests, no tax is paid on a grant of phantom units (although employment taxes are generally due on later vesting of phantom units if vesting applies) and the holder will share in future LLC appreciation only. But phantom unit payouts following a liquidity event are taxed entirely as ordinary income, unlike qualifying capital interest and profits interest payouts which are usually taxed as capital gains (at least in large part) following a liquidity event.
Please see the above chart for a more complete description of these and other key differences among these three alternatives.
While our chart focuses only on the three most common LLC incentives, others may be considered such as options or warrants, equity appreciation rights, and other vehicles which combine elements of some or all of those discussed herein. Options and warrants both embody rights to acquire capital interests in the future at specified times and at specified prices, and the information in the attached chart under the “Capital Interests” heading would apply after the options or warrants were exercised. Equity appreciation rights are contract rights similar to phantom units which allow recipients to share in future LLC appreciation.
Employment Status Considerations
Generally speaking, the Internal Revenue Code treats LLCs as partnerships for federal tax purposes. This means that the LLC annually files a Form 1065 (Return of Partnership Income), and the LLC members receive a Form K-1 reporting to them their allocated share of the LLC’s annual profit or loss.
The federal tax rules also treat an individual’s status as an employee as being inconsistent with his or her status as an LLC owner. As such, if an LLC grants profits interests or capital interests to employees who own the interests individually, the IRS will treat them as self-employed owners of the LLC for certain tax purposes. While an owner can receive a fixed “salary” (which is called a “guaranteed payment” when paid to LLC owners in exchange for services), this different tax treatment means that the LLC cannot withhold employment taxes on the guaranteed payments; the owner must pay both the “employer portion” and “employee portion” of employment taxes, and the owner assumes individual responsibility for paying quarterly estimated taxes on the guaranteed payments (including both income and self-employment taxes).
Additionally, an LLC owner cannot participate in any cafeteria plans established by the LLC for its employees.
Because phantom units are not true equity interests, grants of phantom units do not implicate these same issues. Phantom units are so popular largely as a result, despite the fact that phantom unit payouts are taxed at ordinary income rates (as described above).
Structural Issues with Equity Grants
With any grant of incentives, care must be taken to delineate whether the interests are subject to vesting over time; whether and when profit distributions must be returned (these returns are ominously called “clawbacks”); how the incentives are impacted by termination with cause, termination without cause, and employee resignation; and what transfer restrictions apply to equity interests in the event of termination or resignation, death, divorce, attempted voluntary transfers, etc. Addressing these issues also requires strategy and planning, and may necessitate amendments to an LLC’s Operating Agreement or other constituent documents, inclusion of special provisions in the incentive grant or plan documents, or both.
LLCs provide great flexibility in structuring ownership and incentives. This post only scratches the surface of what LLC owners need to consider when making incentive grants, and LLC principals could pursue virtually countless permutations to the typical incentive vehicles described in this post. Accordingly, those principals are well-served to focus on the goals they hope to achieve with the incentive chosen, and to work backwards from there with the involvement of legal and tax advisors to select the incentive method which best achieves those goals.