By Jeff Wolfe

jeff2At the Forrest Firm, we work with a variety of legal entities, including corporations, non-profit corporations, partnerships, and limited liability companies (LLCs). LLCs are an increasingly popular entity choice for business owners for a couple of key reasons: first, LLCs are pass-through tax entities by default (meaning profits and losses flow through to the individual return of the owners); and second, LLCs are more flexible from a paperwork perspective when compared to the legal requirements and formalities of a corporation.

One drawback to an LLC, however, arises when the owners want to implement an equity compensation plan to incentivize employees. Although sometimes the differences are only in the terminology, there are some key distinctions between equity compensation alternatives and features that are available for an LLC compared to a corporation. For instance, since an LLC ownership interest is not “stock,” an LLC cannot adopt a “stock option plan.” Instead, an LLC can award profits interests or capital interests as we discuss below.

Profits Interests

In a profits interest plan, the incentive is an economic interest, represented as a percentage of future profits. The interest has no value at grant, is not taxable at grant, and results an initial capital account balance of $0 for the recipient. As the LLC generates profits, the recipient’s capital account increases by the recipient’s percentage of profits, reduced by (a) the recipient’s percentage of losses and (b) the value of actual profit distributions to the recipient in cash or property. Profit allocations are taxable to the recipient according to the character of the underlying assets (capital gain or ordinary income).

Capital Interests

Under a capital interest plan, the incentive is an ownership interest, represented as a percentage of ownership. The main difference with a capital interest compared to a profits interest is that a capital interest includes a right to the underlying capital of the LLC, as well the increase in value and profits and losses of the LLC going forward. A capital interest may be granted as an outright award, an interest that vests over time, or an option to purchase a capital interest (which may also include a vesting schedule).

In the non-option context, the recipient would pay ordinary income taxes on the fair market value of the interest as it vests (or make a special Section 83(b) election to pay taxes on the entire award up front). In the option context, the option is not taxable at grant, but when exercised, the difference between the exercise price and the value of the interest is recognized and taxable as ordinary income. Because of their potentially high exercise prices and the corresponding tax liability, options ordinarily would not be exercised until a liquidity event.

Tax and Other Considerations

There are several other accounting and tax considerations (e.g., whether the LLC has elected to be taxed as an S corporation), as well as practical considerations (e.g., will employees understand the value of such awards), when deciding whether to award profits interests or capital interests. Sometimes these considerations will lean an LLC away from equity compensation and towards bonuses or phantom equity plans that do not impact the capital accounts or ownership of the LLC. In other situations, an LLC may ultimately decide to convert to a corporation and then adopt a traditional equity incentive plan that would allow it to grant stock options to employees.

For these reasons, decisions regarding how to structure and implement your equity and other incentive compensation plans should be made in close consultation with your legal and tax professionals. Please reach out to the attorneys at the Forrest Firm if you need assistance with incentivizing your employees in any legal entity, including limited liability companies.