A previous article for Live Free and Start entitled Startups and Stock Options—Watch Out for The Tax Issues, addressed the ways in which startups formed as corporations can benefit from the use of stock options. However, many startups begin life as a partnership or limited liability company taxed as a partnership (referred to herein as an “LLC” or “LLCs”). This article looks at the forms of equity compensation that LLCs can use to attract and retain employees.
It is not uncommon to find LLC equity compensation plans that appear to be corporate plans with references to “stock” and “corporation” simply replaced with “membership interest” and “LLC.” Much mischief can come from this approach as LLCs and their members and corporations and their shareholders are taxed quite differently. Care must be taken to account for the impact of the tediously complex partnership tax rules on LLC equity compensation plans.
For the most part, the motivations that support providing equity compensation to employees of startups that were discussed in the previous article also apply to LLCs. LLCs can issue four basic forms of equity compensation for services: (i) capital interests; (ii) options to purchase capital interests; (iii) virtual equity interests; and (iv) profits interests.
A capital interest in an LLC entitles the recipient to share in both the LLC’s value at the date of issuance and its future income or loss and appreciation or decline in value. A recipient of a capital interest that vests at grant is taxed on the difference between the amount paid for the capital interest and the fair market value of the capital interest on that date. A recipient of an unvested capital interest 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.
The recipient of a capital interest, whether vested at grant or not, may have phantom income—income on which the recipient owes tax but with respect to which the LLC distributes no cash for the recipient to use to pay the tax. The LLC can take a compensation deduction to the extent of any income realized by the recipient.
Early stage startups can make good use of capital interests from a tax perspective because the recipient of a capital interest granted when its value is low can either pay the fair market value of the interest or the tax on that value. In the case of an unvested capital interest in an early stage LLC, the recipient may decide to file an election under Section 83(b) to be taxed on the difference between the price paid for the capital interest and the fair market value of such capital interest on the date of grant, even though the interest is not then fully vested. Again, it is the low value of the capital interest at the date of grant that makes this attractive. The recipient pays little or no tax on the low-value capital interest and any appreciation in the interest thereafter is taxed at capital gain rates. Once a startup begins to increase in value, the issuance of capital interests can become problematic because recipients may not want or be able to pay for them or be taxed on their value.
Options to Purchase Capital Interests
An option to purchase an LLC capital interest that is issued in exchange for services is taxed the same as a non-qualified stock option (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 that date. When the option is exercised, the recipient is taxed at ordinary income tax 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 can take a corresponding compensation deduction. The recipient’s holding period for the capital interest begins on the exercise date and, therefore, the capital interest will not be treated as long-term capital gain property until a year and a day after exercise. The gain is equal to the difference between the fair market value of the capital interest on the date of exercise and on the eventual sale date.
Virtual Equity Interests
Virtual equity interests in an LLC are like phantom stock or stock appreciation rights in a corporation. They can be useful for later stage startups, where the company has sufficient value to make the issuance of capital interests infeasible, and for early stage startups that don’t want to issue actual equity interests. They give a recipient the right to receive a bonus equal to the increase in value of capital interests in the LLC without actually owning the interests. A holder of phantom equity rights in an LLC is entitled to a bonus equal to the value of the capital interest at the time the bonus becomes payable. A holder of equity appreciation rights is entitled to a bonus equal to the amount by which the value of the capital interest exceeds the value assigned to the rights at the date of grant. Phantom equity rights, like phantom stock rights, are generally subject to the Section 409A deferred compensation rules. Virtual equity appreciation rights can avoid Section 409A, provided the value assigned to the right at grant can never be less than the fair market value at the date of grant.
Because a holder of virtual equity rights is not a member of the LLC, he or she can continue to be treated as an employee, rather than a member. However, amounts paid to the holder are taxed at ordinary income rates rather than capital gains.
Many tax professionals believe that profits interests are the most useful equity incentives for LLCs. A recipient of a profits interest shares only in the income and increase in enterprise value of the LLC after the date of grant, but recognizes no income at the date of grant and recognizes capital gain on the appreciation in the interest from the date of grant. However, the LLC does not receive a compensation deduction for such grant as it would with a grant of a capital interest.
Profits interests can be granted as fully-vested or subject to vesting.