Taxing equity incentives Featured

9:55am EDT July 22, 2002

Limited liability companies (LLCs) are rapidly becoming the favored vehicle through which many entrepreneurial companies choose to carry on their businesses. While an LLC has many corporate characteristics, most are taxed as partnerships.

This creates significant benefits, but also significant challenges — particularly in the area of equity compensation.

The use of equity compensation often plays a significant role in compensating and retaining key personnel. However, traditional forms of corporate equity compensation, such as incentive, or nonqualified, stock options, are not available to an LLC. Nevertheless, an LLC does have several tools in its arsenal through which it may provide incentive compensation, including:

  • a profits interest;

  • a capital interest; and

  • an option to acquire a capital interest.

While various tax and nontax considerations must be addressed in selecting the appropriate form of incentive compensation, consider the following important tax consequences and unresolved issues associated with such arrangements.

A “profits interest” generally entitles the recipient to share in the future earnings and appreciation in the value of the LLC at a certain point after the date of grant. If certain requirements are satisfied, including that the service provider not dispose of the profits interest for two years, then the transfer of a profits interest will not result in income recognition to the service provider. Correspondingly, the LLC will not be entitled to a tax deduction. A profits interest is generally desirable when the goal is to avoid immediate income recognition.

A “capital interest” generally entitles the recipient to an immediate interest in the underlying assets of the LLC as well as the ability to share in future profits. But the recipient of the capital interest will generally be taxed on that interest (an amount determined as equal to the excess of the value of the interest received over the price paid, if any).

The LLC, meanwhile, will be entitled to a deduction equal to the amount of compensation recognized by the service provider. The grant of a capital interest may be 100 percent vested or, alternatively, subject to a vesting schedule (similar to restricted stock).

As an alternative to granting an outright capital interest, an LLC may also grant a right, or option, to acquire an interest in the underlying assets of the LLC. Upon exercising the option, the recipient will have an immediate interest in the underlying assets and future revenue of the LLC.

In this situation, the recipient’s interest option will not be recognized as income upon the receipt of the option. Instead, the recipient’s option will be recognized as income only when the option is exercised (as an amount equal to the excess of the fair market value of the LLC interest received over the exercise price, if any). And then, the LLC will be entitled to a corresponding deduction.

While the tax consequences flowing from the above arrangements appear relatively straightforward, consider these issues. One significant drawback to the issuance of a capital interest is that the LLC may recognize gain on the transfer equal to the excess of the fair market value of the transferred LLC interest over the LLC’s basis in its underlying assets.

Therefore, unlike a corporation, an LLC may have its compensation deduction offset by a gain on a deemed transfer of its assets. Of greater concern is the Internal Revenue Service’s position that an LLC member cannot also serve as an employee of the LLC in which he or she is a member (i.e., a partner). This position can have unanticipated employment tax and benefit consequences.

A member also may be subject to self-employment taxes on his wages (at a rate of 15.3 percent), whereas an employee’s share of FICA is only 7.65 percent. It’s imperative that the LLC address this concern with its employees up front to avoid unanticipated tax consequences from the employee’s perspective. Some form of gross-up payment may be required to place the employee on equal footing with his corporate counterpart.

Likewise, an LLC must also address whether the distributions it makes to its members are subject to self-employment tax. While LLC members may be considered limited partners and therefore not subject to self-employment tax on their share of the partnership distributions, they better make sure they address this and many similar issues in advance to avoid any unexpected surprises.

John E. McGrady III is an attorney with the tax group of Pittsburgh-based law firm Buchanan Ingersoll, P.C.