Candace Groth

by Candace Groth

Limited liability companies (“LLCs”) are a popular entity choice for many business owners. Unlike c-corporations with their familiar Equity Incentive Plans (a/k/a “stock options”) many attorneys and business owners alike do not understand the different options for issuing equity in LLCs, and the additional compliance and reporting obligations that could result. Come along with me for a brief introduction to granting equity in LLCs.

INTRODUCTION TO LLC TERMINOLOGY

Before we get into the different equity options themselves, a very brief primer to LLC terminology is needed.

An “LLC” or “limited liability company” is an entity type created under state law in the state in which it is organized. As the name suggests, limited liability companies are meant to, among other things, help shield the owner(s) from certain liabilities of the business. However, unlike c-corporations, LLCs have a lot more flexibility in tax structuring. Specifically, LLCs can be taxed as (a) a disregarded entity (single owner only, default); (b) partnership (multi-member LLC, default); (c) s-corporation (single member or multi-member, must file a tax election); or (d) c-corporation (single member or multi-member, must file a tax election).[1]

When we talk about LLCs in this article, we will primarily be discussing LLCs taxed as partnerships.[2] Owners of equity in an LLC are called “members.” Equity in an LLC is called a “membership interest” or “membership unit” depending on the state in which the LLC is organized. Much like a c-corporation, the officers of the LLC make the day-to-day decisions. Additionally, the LLC will be either “manager managed,” and managed by one or more managers (somewhat like a board of directors), or “member managed,” where all the members manage the company (again, somewhat like a board of directors). Most LLCs are manager managed. When we talk about service providers in this article, we reference employees, independent contractors, advisors, and board members, all of whom might provide services and advice to an LLC.

AWARDING MEMBERSHIP INTERESTS/UNITS

There are four common methods of granting equity or equity-like incentives in an LLC taxed as a partnership: (1) outright membership interest or membership unit grants, (2) LLC incentive units (a/k/a “profit interests”), (3) a phantom or parallel unit plan (a/k/a synthetic equity), and (4) contractual options. We will explore each one in turn.

Outright Membership Interest Grants

The most basic structure on this list is simply awarding a service provider equity in the business. While this is straightforward and carries the benefits of ownership, this option comes with several key considerations, including:

  1. LLC equity owners, or “members” of the LLC, have certain rights including basic information (e., ownership percentages and access to financial records) and may have voting rights. Thus, be sure that you intend for the recipient to have these rights, and be specific about what rights the members have.
  2. All equity owners in an LLC are “partners” for tax purposes, and thus (i) must be given a K-1 at the end of each year and (ii) cannot be W-2 employees and instead must file and pay quarterly self-employment taxes.
  3. The service provider will be taxed on the value of the equity grant immediately. This is not an issue for a brand-new company that has no value, but if the company is established and has some value, then this could lead to unintended tax obligations. For example, if the business is worth $1,000,000 and a 10% grant is made, then the recipient will need to report income of $100,000, and pay taxes on that. The company, however, does get to take a corresponding tax deduction for this amount.

Careful structuring of the membership unit/interest grant and company structure can help avoid or limit the effect of the above referenced items or other concerns a client may have about the LLC’s pass-through structure.

LLC Incentive Units or Profits Interests

A prevalent compensation structure increasingly used by startups and small businesses is the granting of LLC profits interests, also called “Incentive Units.” An employee or service provider who is granted an LLC profits interest receives a right both to the future profits of the LLC and the appreciation in value of the assets of the LLC. At the time of the grant, the profits interest holder is not entitled to share in the value of the company up to that point in time (called the Hurdle or Threshold in the Plan) and therefore the grant will not typically result in taxable income to the recipient. Unlike an equity grant, however, the LLC does not receive a compensation deduction for the grant of a profits interest.

Beneficially for the LLC and its owners, Incentive Units may be structured to be non-voting (financial only) units, leaving control of the company in the hands of the original owners. However, unlike a grant of Membership Interests/Units, a member receiving Incentive Units typically will also not be allowed to participate in distributions from the company until distributions in an amount equal to the Hurdle have been distributed, which could be a long time, even sometimes until a sale or exit. It’s important to note also that Incentive Units, like full membership unit/interest grants, have some of the same drawbacks, including having information rights and being considered partners, not employees. Likewise, Incentive Units also have some of the same benefits as full membership unit/interest grants, including possible capital gains treatment for the service provider if held for more than one year.

Phantom Stock/Synthetic Equity

Finally, an LLC may choose not to issue equity or contractual options at all, but rather to issue phantom equity. Phantom stock, parallel units, or synthetic equity are not actual membership units/interests (ownership) in an LLC. The Plan, and the resulting units are merely based on the value of the membership units/interests of an LLC. If properly structured, parallel units are not taxable to the recipient at the time of the grant; the parallel units will be taxable to the recipient when a trigger event (e.g., change of control, death, termination of service, or disability) occurs. The company cannot deduct the value of parallel units granted, but may deduct payments made to the service provider when a “trigger event,” like a sale, occurs. Parallel Units, unlike the above equity options, are more akin to a “transaction bonus” in tax treatment and structure.

Contractual Options

Like a stock option, an option to acquire LLC membership interests (“LLC option”) is a contract that allows a service provider to purchase LLC capital interests at a fixed price (the exercise price). Similar to any other option, an LLC option typically has an expiration date at which time the contract can no longer be exercised and expires.

A significant advantage of LLC options is tax treatment: typically, there is no taxable event until the option is exercised. Much like a non-qualified stock option, on the date of the exercise of the option, the service provider will be subject to ordinary income tax on the difference between the fair market value of the membership interest purchased and the exercise price in the option. If a service provider exercises a stock option and then holds the membership units/interests for more than one year, the service provider may be eligible for capital gains treatment in the event of an eventual sale.

While equity compensation can be complicated, hopefully this article helped you understand the equity compensation types and provide a starting point for further discussion.

[1] Any discussion of tax-related items herein is general in nature and may not apply to every situation. Please consult a CPA, tax advisor, or tax counsel for advice specific to you or your business’s specific tax situation.

[2] You should note that LLCs taxed as s-corporations have their own set of options for issuing equity which are much more limited than LLCs taxed as s-corporations. LLCs taxed as c-corporations will normally have substantially similar equity options to those of  c-corporation. See Candace Groth, Equity & Equity-Like Plans for S-Corporations (June 16, 2023) (available online at https://velawood.com/equity-equity-like-plans-for-s-corporations/).

____________________

Candace Groth is a Senior Attorney at Vela Wood Staley Young P.C., where she focuses her practice on mergers & acquisitions and complex LLC matters. Candace is also the 2024 DWLA Liaison to the DAYL Board of Directors.  She may be reached at cgroth@velawood.com.

____________________

Articles on the DAYL website are provided for informational use only, and are in no way intended to constitute legal advice or the opinions or views of the DAYL.