Options for Issuing Employee Equity in LLCs

Choosing the best type of entity for a company can be a challenge.  C corporations are the norm for most emerging growth businesses, particularly those raising money from investors.  However, LLCs are becoming more widespread, even for operating businesses.  Founders may want to have the tax benefits of LLCs, which are not subject to a company-level tax (as is the case with C corporations) and may enable more tax deductions. 

This potential for tax savings does not, however, come without a cost.  LLCs tend to be more complicated and expensive to setup and manage, particularly for operating businesses.  LLCs can become even more tricky for businesses that want to issue equity to incentivize employees or other service providers.  This article addresses some of the ways LLCs can use equity to incentivize service providers, and the implications of each option (pardon the pun).

Profits Interests Subject to Vesting

LLCs are able to grant ‘equity’ to their service providers by issuing profits interests that entitle the recipient to a percentage of future appreciation of the business (after the date of such issuance, based on the valuation on the date of grant).  Profits interest in an LLC can be a best-case-scenario for companies granting equity as they can have tax advantages over incentive stock options, but they are more complicated to setup and may not be right for every business based on future needs.

General Comparison to Corporate Stock Options.  As a result of Code Section 409A, corporations will almost universally grant stock options with exercise prices at or above market value on the date of grant.  The issuance of profits interests in an LLC is very similar in many ways to stock options having an exercise price equal to the fair market value of common stock as of the date of grant.  Economically, the incentives are very similar - the interests do not generate economic benefit for the service provider if the company does not increase in value after the grant date.  For securities purposes, the issuances are both securities issuances, requiring satisfaction of securities law filings (including based on a 701 exemption). Administratively, profits interests and stock options generally are both granted pursuant to a plan and agreement/notice that sets forth the particular terms of the interests; however, the ‘plan’ provisions also may be set forth in the LLC agreement and the LLC agreement may need to be restated in order to accomodate profits interests (and differentiate those interests from other existing membership interests).  As with corporate stock options, profits interests may be subject to repurchase rights if the service provider is no longer providing services to the company and/or rights of first refusal on behalf of the company and/or its members should the service provider attempt to transfer the interest.

Unlike stock options, the holder of a profits interest is the owner of that interest (subject to vesting restrictions), similar to shareholders of a corporation that hold their shares subject to ‘reverse vesting’ requiring them to forfeit the interest if the vesting restrictions are not satisfied. Alternatively, LLCs can give service providers an option to receive a profits interest, discussed below. Where profits interests have been issued subject to vesting, the LLC agreement typically will provide that distributions with respect to unvested profits interests generally will either (i) not be distributed to the profits interest member but instead held by the LLC on behalf of the service provider pending vesting (i.e., held in escrow by the company), or (ii) be distributed subject to contractual obligations of the service provider to repay excess distributions (i.e., a 'clawback').

Tax and Administrative Implications of Profits Interests.  As discussed in the introduction, LLCs are usually taxed as partnerships to avail their members of certain tax benefits, including the avoidance of company level taxation (often referred to as the “double-layer” of tax). As a partnership for tax purposes, the LLC itself does not – for tax purposes – have a separate legal existence from its members. Instead, the LLC’s tax obligation is determined under Subchapter K’s aggregate theory of taxation, where each member of the company is treated as the owner of a direct and undivided interest in the LLC’s assets, liabilities and operations. The LLC files a tax return but is not itself a taxpaying entity; instead, the LLC’s members are subject to tax on the LLC’s operations and individually report their respective shares of the LLC’s “pass-through” separately stated items of income, loss and deduction.

Each service provider that receives a profits interest will be a member of the LLC as to that profits interest and will receive their allocable share of any pass-through items of income, loss and deductions from the company on an annual basis. As a result, the LLC must issue each of them a Form K-1 setting forth these allocations, which will complicate their personal tax return filings. Each profits interest holder, as a member of the LLC, also may be treated as self-employed, subject to self-employment tax and not be eligible for certain employee benefits.

What are the tax benefits of a profits interest?  A service provider generally will not have taxable income on its receipt of pure a profits interest in an LLC because the interest will have no value as of the date it is issued (by definition). Profits interests usually are granted subject to vesting, and service providers usually file 'protective' 83(b) elections on such profits interests with a goal of ensuring that any future gains are taxed at capital gains tax rates rather than ordinary income; capital gains treatment should be available assuming the interest is held for at least a year (or, in the context of an asset sale of the LLC, as to assets that the LLC has held for at least a year, regardless of the service provider’s holding period on its profits interest).  As a comparison, incentive stock options trigger capital gain on sale as well but only upon satisfaction of certain holding period requirements and, even if taxed at capital gainst rates, may trigger the alternative minimum tax.  Another benefit of profits interests is that the employee does not need to fund an exercise price (and the company does not need to accomodate the potential complexities of a net exercise).

Administrative Cost.  There is an administrative burden in managing profits interests, which increases exponentially with the number of different times the company wants to make a grant.  Following each date of a grant, the LLC must determine the value of the entity at the time of each grant of a profits interest. This is best done using a third-party valuation firm, as a corporation may do for its 409A valuations. The LLC also usually will need to account for unrealized appreciation in the LLC as of each grant date by adjusting the existing members’ capital accounts or allocation rights to ensure that the recipient of the profits interest does not inadvertently share in any pre-grant value in the LLC; the LLC generally will need to either (i) “book up” the capital accounts of the existing members in the LLC in the amount of the unrealized appreciation as of the date of the grant, or, alternatively, (ii) the company and its members may elect to amend the LLC’s operating agreement to provide for a special allocation of that pre-grant unrealized appreciation among its existing members (“Capital Account Adjustment”). Without these Capital Account Adjustments, the intended economic deal could be frustrated.  For example, upon the LLC’s subsequent realization of unrealized gain lurking within the LLC, such as upon a sale of some of its assets having unrealized appreciation at the time the profits interests were granted.  , could be allocated to the profits interest member, effectively giving that member an interest in the value of the LLC that existed prior to their grant. Such an allocation to the profits interest member would have substantially different tax implications; it would be a capital interest in the existing value of the company rather than a profits interest. Receipt of a capital interest shifts existing value from the existing members to the new member, which is immediately subject to tax as compensation and at ordinary income tax rates.

Due to the above complexity with valuations and capital accounting, LLCs should avoid issuing profits interests on more than a few occasions because tracking the multiple valuation dates and making the necessary Capital Account Adjustments can quickly become an accounting nightmare.

Options to Purchase Profits Interests

An LLC also may issue options to acquire capital interests entitled to a percentage of the company’s value as of the exercise date of the option (I will call this an “Option for Capital Interest”).

An Option for Capital Interest may have a stated acquisition/exercise price to mimic a corporate stock option. For tax purposes, there may be a capital shift on the exercise date of such option (immediately taxable to the service provider at ordinary income rates). The LLC still needs to do a valuation on the date of the grant and then again on the date of exercise in order to determine the future capital shift, if any. In addition, Capital Account Adjustments may need to be made to avoid giving the service provider a capital interest in any pre-grant company value.

The tax treatment of options issued by an LLC is not entirely settled, which can create additional complexity and uncertainty.  Furthermore, granting options rather than outright profits interests probably increases the likelihood of the option holders having multiple exercise dates, which could dramatically increase the administrative burdens associated with managing the different grants (as discussed above). For example, even if an LLC issues all options on a single date, the options ultimately might be exercised by the grantees on multiple dates. These complexities could be mitigated by setting pre-determined allowable exercise dates, but doing so might further reduce the value of the option to the service provider.

Phantom Equity/Management Carve-Out Plan

To avoid the tax, valuation, accounting and other problems created by the use of profits interests or options, LLCs sometimes instead grant phantom equity.  Phantom equity is relatively simple to administer but without the tax benefits of profits interests.  A phantom equity grant essentially gives the service provider the right to receive a cash bonus equivalent to what they would have received if they held a profits interest (i.e., based on the LLC’s valuation as of a future date).  A significant benefit of phantom interests over profits interests is their ease of administration and implementation. Unlike with profits interests, the holder of a phantom equity grant is not a member of the LLC and has no equity interest in perpetuity, regardless of whether the holder has ‘vested’ as to any phantom payments; instead, the phantom interest exists only as long of the holder is providing services (and their economic rights terminate when they stop providing services).  Bonus under a phantom equity plan are compensation taxable at ordinary income rates, which is less favorable for the service provider than a profits interest.

Phantom equity plans can also be structured to trigger payments only upon a change of control transaction, similar to a management carve-out plan in the corporate settings.

Stock Option Grants from a Corporate Member

Yet another option for issuing equity in an LLC, although not the least complicated, is to setup a C or S corporation and to grant that newly-formed corporation a profits interest in the LLC in the amount of all future profits interests being contemplated (i.e., grant the total size of the pool to the corporation at one time). This triggers the profits interest issuance issues discussed above in Section 1, but only on a single occasion since there is only one grant date. Thereafter, the corporate entity may issue stock or options directly to the LLC’s service providers. Having only one grant date mitigates the problems with multiple valuation dates and Capital Account Adjustments discussed above in Section 1.  This option, however, is relatively complex to implement for other reasons. For example, it obviously requires the formation of a separate corporate entity and stock option plan, potentially mitigating the tax benefits of an LLC as to the profits interest granted to the corporate member (since the corporate member would pay corporate tax on allocations from the LLC before flowing through to the option holders).  In addition, the stock option plan for the corporate entity needs to be drafted very carefully to ensure that the option holders do not have their interests accrete or dilute based on changes in the company’s capitalization; the corporate member will have a fixed profit interest in the LLC while its option holders may come and go over time, so the option plan will differ from a typical corporate plan in that it should tie back to the LLC such that any ungranted interests or interests that are forfeited/unexercised revert to the LLC (and add to the relative interests of all members, rather than solely the corporate member). Finally, the issuance of option grants from the plan of a corporate member will need to rely on an applicable exemption for securities exemption, but Rule 701, which is the exemption typically used for stock option grants by companies to their employees, may not be available because the issuer of the grants (the corporate member) usually would be a minority owner of the LLC. The exemption under Rule 701 generally is available to issuers only where the issuances are to service providers who provide services to a majority-owned subsidiary. For this reason, it may be necessary to explore having the corporation be a subsidiary of the LLC or to obtain an exemption for securities issuances under the corporations’ plan under Rule 504, Rule 506 or Reg D, which depend on the facts presented at the time of the subsequent issuance(s) (e.g., size of the offering, sophistication/accreditation of the service provider, etc.).

Conclusion

LLCs are flexible entities that provide tax efficiencies not available in corporations; however, tend to be more expensive to form and administer than corporations, particularly when used for operating businesses.  Whether it makes sense for an operating company to issue equity to service providers but remain a pass-through entity (such as an LLC) for tax purposes generally is a balancing act that weighs (x) the amount of tax savings projected from the use of the pass-through structure and the projected timing of those savings, against (y) the significant added time and expense in the administration of the company’s projected equity grants.  I generally advise against the use of an LLC for operating companies that plan to actively grant employee incentives, except in rare circumstances where the exit path is clear and the potential tax savings is sufficient to justify the added cost and complexity.  Even in situations where the tax savings offered by a pass-through entity are projected to be significant, LLCs should be careful to (a) consider a plan with a much smaller scope than in a typical corporate setting  (for example, giving only a few grants to key employees and on a few occasions, in order to mitigate the administrative and accounting issues created by these grants), or (b) implement a phantom equity plan that incentivizes employees for so long as they continue to provide services for the company, understanding that such a phantom equity plan would have the benefit of simplicity at the cost of less favorable tax treatment. 

DISCLAIMER: The tax rules in this area are extremely complex. This post is intended as practical guidance with a mere introduction to the tax and accounting issues that may be implicated, in an effort to allow readers to better understand some of this complexities. Make sure to speak with an attorney capable of addressing these issues before trying to implement any of these approaches.  If you have any questions, feel free to contact me.

Topics:  C-Corporation, LLC, Profits Interests, Stock Options, Stocks, Tax Deductions, Vesting

Published In: Business Organization Updates, General Business Updates, Labor & Employment Updates, Securities Updates, Tax Updates

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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