Equity Incentives for LLCs and Partnerships
I. Introduction Limited Liability Companies and partnerships (both referred to here as "LLCs") can issue 4 basic forms of equity (or equity-type) compensation for past or future services:
1. Capital Interests;
2. Options to purchase capital interests;
3. Phantom equity; and
4. Profits Interests.
II. Capital Interests
A capital interest in an LLC entitles the recipient to share in the LLC's current enterprise value as well as share in any future income and growth in enterprise value. If the LLC were liquidated immediately after the grant of a capital interest, the recipient would receive a share of the proceeds of the liquidation. On the date of grant of a vested capital interest, the recipient is taxed on the difference between the amount paid for the capital interest and the fair market value of the capital interest on the date of grant. If any portion of the capital interest is unvested, the recipient would be taxed at each vesting date on the difference between the amount paid for the portion of the capital interest that becomes vested and the fair market value of such portion on the vesting date. This results in income known as "phantom income" because the recipient is taxed on amounts that aren't actually received so there is no cash to pay such tax. The LLC receives a compensation deduction to the extent of any income realized by the recipient. Capital interests can be quite useful equity incentives at the early stages of an LLC if the fair market value at the time of grant is low, so the recipient either pays the fair market value of the interests or pays tax on that value. If the value of such interests is high on the date of grant, the issuance of capital interests may be problematic as the recipient will not want to pay for them or be taxed on their value.
Since the assumption is that the capital interest will increase in value, the recipient of a capital interest that is subject to vesting may wish to file an 83(b) election and elect to be taxed on the difference between the price paid for the entire capital interest and the fair market value of such capital interest on the date of grant, notwithstanding the fact that the interest is not fully vested.
III. Options to Purchase Capital Interests
An option to purchase a capital interest is taxed the same as a non-qualified stock option, as LLCs cannot grant incentive stock options. The recipient is not taxed at the date of grant and the LLC does not receive a deduction on such date. On the date of exercise of the option, the recipient is taxed at ordinary income rates on the difference between the exercise price paid and the fair market value of the underlying capital interest on the exercise date. The LLC receives a corresponding compensation deduction on such difference. So long as the recipient holds the capital interest for more than a year after exercise, the recipient would receive long-term capital gains treatment on the difference between the fair market value of the capital interest on the date of exercise and the eventual sale date.
IV. Phantom Equity
Phantom equity gives the recipient the right to receive a bonus equal to the increase in value of capital interests in the LLC. The recipient would not be a member of the LLC as a result of the phantom equity grant, so the Company could continue to treat the recipient as a W-2 employee, rather than a partner (all members must be treated as partners so they cannot be treated as employees). So, no K-1 would need to be issued to the recipient. However, any amounts paid to the recipient would be taxed at ordinary income rates, which is a big disadvantage to the recipient. So, I generally don't recommend the use of phantom equity. Profits interests are much more useful, as described below.
V. Profits Interests
Profits interests are the most useful equity incentives for LLCs. A profits interest entitles the recipient to share only in the income and increase in enterprise value of the LLC after the date of grant. Unlike a capital interest holder, the profits interest holder is not entitled to share in the value of the enterprise on the date of grant. So, if the LLC is liquidated immediately after the grant, the profits interest holder would receive nothing. There is no tax on the recipient on the date of grant and the LLC does not receive a compensation deduction for such grant. Also, in some cases, all appreciation in value can be taxed as capital gain. Profits interests can be granted as fully-vested or subject to vesting.
A. Vested Profits Interests
Currently, vested profits units are not taxable so long as Rev. Proc. 93-27 applies. The grant of a profits interest in exchange for services is not taxable to the recipient if the following conditions are met:
1. the recipient receives the profits interest for the provision of services to or for the benefit of the LLC in his or her capacity as a member or in anticipation of becoming a member;
2. the profits interest does not relate to a substantially certain and predictable stream of income from LLC assets, such as income from high-quality debt securities or a high-quality net lease;
3. if the holder of the profits interest does not dispose of the interest within 2 years of receipt; and
4. the profits interest is not a limited partnership interest in a "publicly traded partnership" within the meaning of section 7704(b) of the Internal Revenue Code.
B. Unvested Profits Interests
Neither the grant nor the vesting of profits interests is treated as a taxable event. The grant of a profits interest is deemed to be a taxable event even if the interest is unvested, but it is deemed to have no value on the date of grant, so no income arises from the grant. Pursuant to Rev. Proc. 2001-43, the following conditions must be satisfied for the recipient to be treated as receiving the interest on the date of grant:
1. the LLC and the recipient must treat the recipient as the owner of the interest from the date of grant and the recipient must take into account the distributive share of partnership income, gain, loss, deduction and credit associated with that interest in computing its income tax liability for the entire period during which the recipient has the interest;
2. upon the grant of the interest or at the time that the interest becomes substantially vested, neither the LLC nor any of the LLC members deducts any amount (as wages, compensation or otherwise) for the fair market value of the interest; and
3. all other conditions of Rev. Proc. 93-27 are satisfied.
If all the conditions are met, no 83(b) Election needs to be made. The LLC and the recipient will be treated as if an 83(b) election was made with a fair market value of $0 placed on the profits interests. Despite this protection, many tax practitioners recommend filing a "protective" 83(b) election upon receipt of a profits interest. If any of the requirements of Rev. Proc. 93-27 are not met (e.g., the profits interest is disposed of within two years), Rev. Proc. 2001-43 would not apply and the tax benefits of that procedure would be lost unless the recipient made a timely 83(b) election.
In general, I recommend LLC and partnership clients use profits interests to provide equity incentives to service providers in most cases, rather than other forms of equity compensation. Under current law, if properly structured, the recipient is not taxed on the grant date or upon vesting and any increase in value of the interest can be capital gain. Depending on the structure of the profits interest, it may make sense to file a "protective" 83(b) election in case the requirements of Rev. Proc. 93-27 are not met in full.