A common question we receive when working with limited liability companies taxed as partnerships under Subchapter K of the federal income tax law (“LLCs”) is, can the company grant stock options to its employees and independent contractors, even though the company isn’t a state law corporation (and is in fact taxed as a partnership under the federal tax law)? The short answer is, yes, it is possible for an LLC to issue equity-based compensation to employees and independent contractors, but it is not called a stock option and differs from stock options in some important respects. Profit interests have much different complexities to it, and we will give you an overview as you read along.
Overview of Profit Interests:
LLCs do not issue “stock”, but rather, “membership interests”, or “units”. Most LLCs that have multiple members are taxed as partnerships for federal tax purposes, and do not elect to be taxed as a corporation. For LLCs that are taxed as partnerships, the closest equivalent to a stock option in a corporation is called a “profits interest”.
If you grant an individual a profits interest in an LLC, that individual is receiving an interest in both the future profits of the LLC, and the appreciation of the assets of the LLC. Because the recipient of the profits interest is only receiving an interest in the future profits of the LLC and the appreciation of the assets of the LLC, the grant of the profits interest, if done correctly, should not result in any taxable income to the receipt at the time of the grant.
For example: If you are granted a profits interest in an LLC equal to 5% of the LLC’s outstanding equity, you have a right to 5% of the LLC’s profits after the date on which you received the profits interest. Additionally, let’s say the LLC was valued at $1 million on the date you received the profits interest. A year later, a buyer comes along and purchases the LLC’s assets for $2 million. Because the LLC’s assets appreciated in value by $1 million, your profits interests at the time of the sale would be equal to 5% of that appreciation, which is $50,000. You would not be entitled to any value of the $1 million allocated to the other members prior to the grant of your profits interest.
Typically, to create and issue profits interests, an LLC will have to amend its operating agreement to create a new class of membership interests or units that will take the form of profits interests. The current members hold capital interests in the LLC (which we would typically call the “Class A Units”), and the recipients of the profit interests would likely receive “Class B Units”, which will need to be clearly labeled and set forth in the LLC operating agreement as profits interests. The class of profits interest units can either be voting or non-voting units.
Major Similarities and Differences Between Profit Interests and Stock Options:
Like stock options, a grant of profits interests should not result in a taxable event for the recipient at the time of the grant. Unlike stock options, the recipient of a profits interest does not have to pay an exercise price to obtain the equity interest represented by the profits interest. Upon receipt of the profits interest, the recipient is a member of the LLC (an option holder only holds an option to purchase shares, and is not a shareholder until they exercise their option and pay the exercise price).
Like stock options, a grant of profits interests can also be subject to a vesting schedule. Vesting can be either time based or performance based, so that the recipient vests in the equity as they continue to provide services to the LLC, or they meet certain performance goals set by management of the LLC.
A recipient of a profits interest can no longer be considered an employee of the LLC for federal income tax purposes. Instead, once the recipient receives the profits interest, they have to be treated as a “partner”. This means that instead of having income and employment taxes withheld from their paychecks and receiving a Form W-2, they will instead have to make quarterly tax deposits themselves as a self-employed person, pay self-employment taxes, and receive a Form K-1 from the LLC. A recipient of a stock option, on the other hand, continues to retain employee status and receive a W-2 reporting their salary/withholding information.
If you want to give employees an equity incentive, but you don’t want them to cease being employees for federal income tax purposes, you could issue the equity out of a separate company set up for this purpose. This is expensive and more administratively burdensome, but employees typically prefer to have taxes withheld from their paychecks on their behalf.
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Conclusion
While the concept of granting a profits interest in your LLC may seem straightforward, there are additional tax law requirements not discussed above that must be met in order to ensure recipients are eligible to receive profits interests (the dreaded so-called “capital account book up”, for example) (see IRS Rev. Proc. 93-27 and 2001-43).
We would be happy to discuss these complexities with you if you think profit interests may be a good option for you and your LLC. Please contact me at haveman@carneylaw.com if you have any questions.
Disclaimer: this post is for informational/educational purposes only. It is not intended to provide any legal advice.
By: Zach Haveman