Haley Ayure is attorney and counsel and John McGrady is an attorney and shareholder at Buchanan Ingersoll & Rooney
Any opinions, analyses, and conclusions or recommendations expressed in this article are those of the authors alone and do not reflect the views of their employer or eShares, Inc. DBA Carta, Inc.
Your company is organized as an LLC (or partnership), and you plan to keep it that way for the foreseeable future. You want to incentivize your key employees with equity, but need to do so in a way that does not require either the company or the employees to put up a large amount of cash, whether to pay Uncle Sam or otherwise.
Here’s a possible equity solution. For companies organized as LLCs taxed as partnerships, there is an equity option for employees that is both non-taxable and requires no cash payment—the profits interest. This is the most common type of equity grant made by LLCs.
One benefit to profits interest over some of the more traditional corporate-style equity awards is that a profits interest (1) does not have to be purchased by the employee (like stock options), and (2) is non-taxable at grant.
That means LLCs can issue profits interests to key employees with comfort that neither the company nor the employee will need to come out of pocket at the time of grant.
Why this equity structure might work best
One of the largest downsides of the more traditional corporate-style equity awards, particularly for early-stage startups, is that they can sometimes require a sizable cash payment by the employee. For example, stock options are granted to employees in exchange for services. The employee does not have to pay for the options on the date of grant, and the options are non-taxable on the date of grant. However, in order for the employee to actually own stock in the future, the shares underlying the options have to be purchased. The purchase price for these shares (i.e., the “exercise price” or “strike price”) is based on the fair market value of the shares on the date of grant. Even if the options are granted by a startup with little value, that exercise price (when multiplied by many shares of stock) can be significant.
This means that in order to exercise the options, the employee will usually have to come out of pocket to pay the purchase price or take less shares to cover the cost. Additionally, in order to ensure compliance with applicable tax laws (including Section 409A), the exercise price must be established in good faith, which commonly requires retaining a qualified independent appraiser.
As another example, when a corporation grants restricted stock to an employee, the restricted stock does not have to be purchased, but the employee will be deemed to have received income based on the value of restricted stock on the grant date (or, if later, the date the award vests). If the award is subject to vesting, the employee can elect to be taxed on the date of grant by making an 83(b) election (which is usually the recommended approach to keep the tax as low as possible). Where an 83(b) election is made, the employee will pay tax based on the fair market value of the restricted stock on the date of grant. Again, even if the company is a startup, any value that is not nominal can add up, resulting in a sizable tax bill for the employee.
Granting profits interest awards
The so-called “profits interest” generally represents the right to share in the future earnings and/or future appreciation in the value of the LLC’s assets. While a profits interest is economically similar to a stock option, it has significant advantages over a stock option that have made it the preferred choice of award in the LLC setting.
For example, unlike an option holder, the recipient of a profits interest is not required to pay an exercise price to become an owner. Additionally, if properly structured, the recipient of a profits interest will not recognize income on the receipt or vesting of the profits interest (more detail on both of these points below). Lastly, and potentially the most significant tax advantage, upon the disposition or redemption of the profits interest, all or a significant portion of the gain will potentially be taxed as a capital gain.
An LLC usually has some existing value at the time it brings on a new employee. If the company is a startup, that value is likely much lower than it will be in the future if the company does well, but “lower” doesn’t necessarily mean “insignificant.” If the LLC were to grant the employee what is called a “capital interest” (that is, a regular, full-value equity interest in the LLC), the employee would own a percentage of the existing value at the time of grant. This is similar to restricted stock in that the employee would be treated as having income (and thus taxed) on the employee’s percentage of the existing value of the company at the time of grant.
However, as an alternative, the company can grant the employee a profits interest, which, as mentioned above, is essentially a right to a percentage of any increase in the value of the company, but not a right to any of the existingvalue. This often makes economic sense, because, after all, the new employee did not contribute to any of the existing value.
Because the profits interest only entitles its holder to a right to share in future appreciation and future profits, the value of the profits interest on the grant date is $0. $0 value means $0 in taxes. It’s a win-win.
Example of profits interest
J&G LLC (a hypothetical company) was formed by two co-founders, Jen and Gina. Jen and Gina each put in $250,000 to start the company, for a total capital contribution of $500,000. Jen and Gina want to hire their first key employee, Joe, and give him a 10% interest.
If J&G LLC were to grant Joe a 10% capital interest, he would be deemed to have received income in the amount of $50,000. At the time of grant, then, he would owe taxes on that $50,000. Assuming a 25% tax, that’s $12,500 he would owe the IRS. Ouch.
Alternatively, if J&G LLC were to grant Joe a 10% profits interest, he would be getting a right to 10% of any value over the original $500,000. On the date of grant, his profits interest would be worth $0, so he would not owe any tax. Ten years later, when the company is sold for $5 million and makes distributions, Jen and Gina would get their original $500,000 back before Joe gets a payout. After that, Joe would share in 10% of the appreciation above $500,000.
Tax impact to the grantee
As discussed above, there is $0 tax to the grantee on the grant date.
A holder of a profits interest is treated as a “partner” of the LLC and will receive allocations of profit and loss. As with any membership interest in an LLC taxed as a partnership (or partnership interest in a partnership), there could be an allocation of profit, notwithstanding that no cash distributions sufficient to pay the tax on that profit have been made.
In that case, many LLCs may (but are not required to) include a provision in their operating agreements providing for mandatory distributions to cover the tax payments required to be made by their partners. Accordingly, it is important to review the LLC’s operating agreement to determine if any revisions are necessary or desirable.
Determine the best LLC equity type for your company
Further, it is important to also be aware that even when an operating agreement provides for mandatory tax distributions, there are almost always exceptions, such as when the company does not have sufficient funds or needs its cash to fund debt obligations or other priorities.
It is often recommended that the grantee make a protective 83(b) election in connection with any grant of a profits interest. An 83(b) election allows a grantee of certain types of equity awards to pay the tax on such awards in full on the grant date (rather than upon vesting), notwithstanding that the award may not have vested in full by that time, and notwithstanding that it may never vest.
The reason the 83(b) election is usually a good idea is because by electing to pay the tax early, the employee is able to pay the tax based on the fair market value of the equity award on the grant date, rather than on the date of vesting, at which point the fair market value is likely to be much higher (assuming the company has done well).
In the context of profits interests, the 83(b) election is merely a protective election. That means, it is not required to ensure you owe $0 tax on the grant date, but rather, it is advisable to make an 83(b) election to protect against the possibility that the profits interests award does not otherwise satisfy all of the conditions necessary to qualify as a profits interests under applicable IRS Guidance.
It is important to understand that the 83(b) election must be made within 30 days of the date of grant—no exceptions. See more information about 83(b) elections.
One of the conditions to granting a profits interest is that the LLC and the employee must treat the employee as the owner of the partnership interest from the date of its grant (whether vested or unvested). Accordingly, the service provider takes into account the distributive share of LLC income, gain, loss, deduction, and credit associated with that interest in computing the service provider’s income tax liability for the entire period during which the employee holds the interest.
It’s important to know that an individual cannot serve as both an employee and an LLC member (to the extent the LLC is taxed as a partnership). The IRS takes the position that bona fide partners are not employees for federal income and employment taxes. Accordingly, upon the grant of a membership interest, the employee will now be treated as partner (self-employed) and amounts that have been previously paid to employees as wages will be taxed as guaranteed payments, subject to self-employment taxes.
Organizations commonly use some form of tiered structure in order to overcome this issue (i.e., the profits interest is granted in an upper-tier partnership that is separate from the operating LLC in which the individual is employed).
Tax impact to the LLC and the other members
The LLC issuing the profits interest does not get a tax deduction in connection with the grant or the vesting of a profits interest.
The final regulations under Section 409A do not specifically address the transfer of an interest in a partnership or LLC. Until future guidance is issued, however, taxpayers may continue to rely on the interim guidance issued by the IRS, which provides that taxpayers may treat the issuance of a partnership interest (including a profits interest) with the same principles that govern the issuance of stock. Accordingly, properly structured equity awards in an LLC should be exempt from Section 409A.
Threshold value: Determining the preexisting value
Prior to the issuance of a profits interest, the fair market value of the LLC must be determined (commonly referred to as the “threshold value” or “hurdle”). The threshold value establishes the floor, with the profits interest recipient being entitled to share in any future appreciation above and beyond that floor. Obviously, this determination is important, as it will affect the amount of distributions members will receive when the LLC is sold. Where possible, an appraisal from an independent third-party appraiser (such as Carta) provides the best evidence of fair market value.
This article provides a brief overview of the potential benefits associated with issuance of profits interests by an LLC. While it is also possible for LLCs to offer equity incentive arrangements similar to those utilized by corporations, in either case, employers will need to consider and address a variety of tax and legal considerations, including, without limitation, employee eligibility and grant sizes, vesting and forfeiture conditions, repurchase rights and valuation issues (i.e., establishing the threshold value).
DISCLAIMER: This publication contains general information only and Carta is not, by means of this publication, rendering accounting, business, financial, investment, legal, tax, or other professional advice or services. This publication is not a substitute for such professional advice or services nor should it be used as a basis for any decision or action that may affect your business or interests. Before making any decision or taking any action that may affect your business or interests, you should consult a qualified professional advisor. This communication is not intended as a recommendation, offer or solicitation for the purchase or sale of any security. Carta does not assume any liability for reliance on the information provided herein.