Equity education

Understanding equity incentive plans for LLCs

December 15, 2022
The Carta Team

Using equity to motivate employees is just for venture-backed startups—right? If you’ve structured your business as a limited liability company (LLC), you may think that you can’t award equity to employees and independent contractors. Luckily, this isn’t the case. No matter what type of business you run—a manufacturing company, a brewery, a software firm—you can offer your employees equity and still take advantage of all the benefits of an LLC.

In fact, equity incentive plans for LLCs are becoming more common, and there are several types of equity plans LLCs can choose from. 

What you’ll learn:

  • Benefits of equity-based compensation plans for LLCs
  • Types of plans available to LLCs
    • What are profits interests?
    • What are membership interests?
    • What is phantom equity?
    • What are options to acquire LLC interests? 
  • How to get started

What are equity incentive plans for LLCs?

An equity-based compensation plan for an LLC is a written agreement that explains how the company shares ownership with employees and consultants. It’s a way to compensate your employees and independent contractors beyond salary and cash bonuses. Some plans also have the potential to get your employees more involved in the future of the company by allowing them to vote on mission-critical decisions. 

Equity incentive plans for LLCs are different from those that corporations can offer. The biggest differences between the plans include taxation, voting rights, and employee status. Startup corporations usually either issue shares of stock or stock options. With LLCs, ownership stakes come in many forms. You can use one plan type, or you can combine plans as needed. 

How equity-based compensation vests 

Most equity grants, including some forms of LLC equity-based compensation, vest over a period of time. Vesting, or earning equity by hitting milestones specified in an agreement, can inspire employees to stay and contribute for longer. (These are usually time-based, such as vesting over a period of four years. They can also be performance-based, or a combination.) 

LLCs have the flexibility to structure vesting schedules in the way that makes the most sense for their business. For example, a pharmaceutical company’s plan might require completion of the drug trial phase before some of the equity vests, or a tech company might need to hit a revenue target.

Valuations for LLC equity

Starting an equity plan often requires a valuation to determine the current fair market value (FMV) for each share of the company. For plans that pay equity holders based on the growth in profits and company value over time, a valuation establishes a baseline to grow from. 

Benefits of equity compensation for LLCs

Compensating employees with equity helps them feel like owners with a real stake in the success of the business. It can motivate employees and attract candidates because equity has the potential to grow significantly in the long term. 

Potential tax advantages

Some equity plans have potential tax advantages. Some of them benefit the employee and some are more beneficial to the employer. Kevin Vela—a managing partner at Vela Wood, a law firm with deep LLC expertise—explains: “LLC equity plans are a trade-off on the tax treatment—with either the employee or the company getting the better bargain, and the other party the less favorable treatment. Companies need to consider the tax consequences of an LLC equity plan, in the short term and long term, for the company and for the participants.”

Potential for liquidity

Public company stocks are bought and sold on the public market. Equity holders of LLCs can’t get liquidity through the public stock market, but there are some other ways—such as with an exit like an acquisition or merger. Also, sometimes LLCs offer yearly distributions so that equity holders can find liquidity with a payout of earnings. They might also be able to sell through the secondary market, tender offer, or company buy-back. 

Equity plans and voting rights in an LLC

Governance in LLCs determines who has voting rights, or the authority to make important decisions, such as whether to merge with another company or how to compensate executives. Some LLCs are governed by members (also known as member-managed). In those, equity holders run the business and handle most of the decision making. 

The other option is manager-managed, which is more common. The distinction between the two is that managers don’t have to be members of the LLC or hold equity. In this case, managers make most decisions for the company, though there may be some decisions that require members to vote.

According to Candace Groth at Vela Wood, in Minnesota there’s even a third governance structure called board management, which is more similar to a board of directors of a corporation. In this case, managers make most decisions for the company, though there may be some decisions that require members to vote. 

LLCs should have a well-drafted company operating agreement that clearly lays out duties and rights of managers and members. In either of these documents, you can also formalize the voting and non-voting types of membership needed to grant equity. 

Profits interests or incentive unit plans

A profits interests plan lets employees benefit from your company’s future profits—either from a sale of the company or from annual operating profits shared as yearly distributions. Profits interest units (PIUs) require award agreements to include a threshold or hurdle valuation, which determines what the business is worth at the date of the incentive grant. 

For example, assume that the company’s equity value is $10 million on the PIU grant date. The liquidation threshold of those PIUs would be $10 million. If the company liquidates on that grant date, $10 million has to be paid to outstanding equity holders first, leaving $0 of exit proceeds for the newly granted PIUs. But if the company exited on a future date for $20 million, those PIU holders could participate pro rata (or proportionally). They would share the $10 million of increase in the company’s equity value from the exit proceeds.

Employee status with PIUs

When an employee takes an ownership stake in their company, they generally can’t be considered an employee anymore. Instead, they become a member when they accept their equity grant—which adds new tax implications both for the business and for the member. 

Members of an LLC that is taxed as a partnership can no longer be classified as W-2 employees; instead, they’re considered to receive “guaranteed payments” and must report quarterly self-employment income and make estimated tax payments to the IRS. Your company must also provide K-1s (tax forms that provide information on the member’s share of earnings, losses, deductions, and credits) for each member at the end of the year. 

It’s best practice for a PIU holder to file an 83(b) election and pay taxes within 30 days of receiving the award. Doing so has two benefits. It allows the holder to pay taxes on the total FMV at the time of issuance (which can be lower or nothing at all), and it kickstarts the capital gains holding period. If the holder doesn’t file an 83(b) and the equity grant is subject to a vesting period, they may owe taxes each time a new batch of units periodically vests based on the FMV at the time of vesting.

Pros:

  • PIU holders can opt to file an 83(b) election to pay tax on their equity before it vests. 
  • LLC profits interest plans may provide members deeper access to company information, such as tax returns and profit and loss statements. 
  • Membership can be structured as voting or non-voting, depending on how company founders want to share decision-making authority. 
  • Holders can receive annual distributions of profits (but don’t have to). 

Cons:

  • The company won’t get a compensation tax deduction when using this equity plan. 
  • Members of the company will no longer be classified as W-2 employees. If workers aren’t used to paying self-employment taxes, this can be a burden, since they might have to personally take on a portion of the company’s taxes once they become members. However, companies can choose to provide tax distributions (also known as cash assistance) to help members pay those taxes.
  • Filing K-1s for members can be time consuming and expensive for the business, if done manually.
  • As non-employees, members may not be able to take advantage of certain employee benefits, including 401(k) plans—but there are ways of structuring your company to work around this

LLCs can grant membership interests or membership units (also sometimes called capital interests) to workers. People with membership interests typically have the same financial rights as other members of the company, and may or may not have voting rights. 

Membership interests have value at the time of grant. Members can pay the LLC for their equity based on the FMV of each unit, or the grant can be considered compensation, meaning that the member will have to pay additional annual income tax. 

LLCs offering membership interests first require a company valuation, most commonly a 409A valuation

Employee status with member interests

As with PIUs, if the LLC is taxed as a partnership, members can’t be considered employees and will be responsible for quarterly self-employment tax reporting and payment. The LLC will need to file K-1 forms. 

Pros:

  • Members get certain rights to company information (like they do with PIUs) and potentially voting rights. 
  • Members can be subject to long-term capital gains when they sell if they exercise and hold for over a year. 

Cons: 

  • Membership interests have to be purchased at the FMV of the units when awarded; otherwise, the units are considered compensation—resulting in income tax. 
  • If the LLC is taxed as a partnership, members can’t be considered employees. See the cons for PIUs above for more information. 

Phantom equity or synthetic equity

“Phantom” refers to the fact that this form of equity is not true ownership; rather, it is rights to future value of the business, functioning more like a profit sharing agreement or bonus structure. This plan pays cash to equity holders during a liquidity event, such as a sale of the business, a merger or acquisition, or an initial public offering. The value paid to the participant can be based either on a percentage of the full sale price of the company at the liquidity event, or on the increase in value of the LLC measured from the date of the award to the date of the liquidity event.

Valuation considerations

You don’t need a valuation to issue phantom equity, as long as the participant’s payout is based on a percentage of the full sale price of the company at a liquidity event. Sometimes companies opt to get a 409A valuation to show the FMV. 

Pros:

  • Companies can deduct the entire value paid out to employees as a compensation expense and deduct from their taxes when a trigger event occurs. 
  • Recipients don’t pay taxes until a liquidity event takes place. Then the resulting payout is generally considered employee compensation by the IRS, and they are only taxed once—instead of potential yearly taxation with other forms of equity.

Cons:

  • The company can’t deduct the value of phantom equity grants from compensation taxes at the time of grant. 
  • Employees might have to wait a long time before that event occurs, delaying their payout. 

Options to acquire LLC interests 

Options to acquire LLC interests is a contract that gives recipients the right to buy equity later on. Much like a corporate stock option grant, it allows employees to exercise LLC interests at the FMV at the time of the agreement. It also sets a deadline for exercising.

Valuation considerations

Granting options to acquire LLC interests requires the company to determine the FMV of an individual option using a third-party valuation. 

Pros:

  • Options grants are only taxed when exercised and sold. 
  • If the membership interests/units have been held for more than one year after exercising, the sale may qualify for long term capital gains. 
  • This plan is flexible because the recipient only becomes an equity holder when they choose to exercise. 

Cons: 

  • LLCs can only issue non-qualified stock options, which are taxed when the equity holder exercises and again when they sell. 
  • The longer the recipient waits to exercise, the larger the difference between the FMV at time of grant and exercise may become, which can lead to a potentially higher tax burden at ordinary income tax rates. 

How LLCs can get started with an equity plan

After getting buy-in from your management team, it’s time to speak with an attorney and accountant. With them, you’ll discuss your desired outcome and the level of employees you’d like to grant equity to. You’ll also work with them to understand any tax implications for your company and employees. They might suggest that you use a combination of plans based on your specific circumstances. 

The right counsel can help you weigh taxation and pick the right plan. LLCs are known for their flexible structures; choosing counsel with expertise in equity-based compensation makes it possible to put together a plan that’s right for you. 

In addition, the right partner can help you keep track of: 

  • What equity has been issued
  • Upcoming form filing dates 
  • Cash distributions and liquidations
  • Quarterly reconciliations 

As Kevin Vela notes, “LLC equity plans can present legal and tax traps for the unwary, or even completely forfeit the company’s tax status if implemented incorrectly. It’s important to have experienced legal and tax advisors review these plans prior to implementation.” 

You can request a law firm referral to help you pick the right plan for your company, discuss the tax implications, and generate the documents you need. Carta’s partnerships team is happy to provide a recommendation.  

You can also learn more about how we help manage the LLC equity process—including fast and accurate valuations like 409A, threshold, and business enterprise valuations. To learn more, schedule a demo.

Thank you to Kevin Wood and Candace Groth of Vela Wood for working with Carta on this piece. We appreciate your help and guidance.