What are PIUs with a separate holding company?
Under current tax law, when a W-2 employee of an LLC is issued equity in their employer, that employee becomes a “partner” for tax purposes (assuming that the LLC is taxed as a partnership and not a corporation). Although this individual will continue to be treated as an “employee” for non-tax purposes (e.g., for labor law purposes, etc.), the IRS has long taken the position that a direct member of an LLC cannot be reported as an “employee” for tax purposes. This can mean they will lose certain benefits previously provided by the company when they were an employee, including employer contributions to certain medical, and welfare benefits, eligibility for certain retirement and welfare benefits, and the employer payment of a portion of FICA taxes (i.e., Social Security and Medicare under the Federal Insurance Contribution Act).
To continue treating an individual as an “employee” for tax and benefits purposes, many companies create a separate entity that holds the profits interests (let’s call it “EmployCo”). Under this arrangement, an employee can typically maintain their status as an employee of the company while, at the same time, holding equity in EmployCo (which is economically tied to the profits interests of the company). There are different ways of structuring such plans, and companies should consult with attorneys.
It should be noted that, as of the date of this article, the IRS has invited comments on the tax consequences of structures that rely on an EmployCo, the viability of which may be limited once the IRS issues further guidance.
From the employee’s perspective, there is no change to their eligibility or costs for benefits, they can share in the appreciation of the company if there is a change of control transaction, and such appreciation will benefit from the capital gains tax treatment if applicable requirements are met.
However, there is an additional administrative burden and cost to the company because it has to establish a new entity and prepare the corresponding annual filings. Companies should discuss their proposed holding company structure with tax counsel to determine whether the employee’s benefit outweighs this additional burden and costs.
Recipients retain employee status
Unlike regular PIUs, which require the recipient to become a direct member of the LLC, this version of PIUs allows recipients to remain employees and continue to receive employee benefits.
Recipients retain tax advantages and simplicity
Profits can be taxed at a long-term capital gains rate, (if applicable requirements are met) and the employee can continue to receive a W-2 for their regular salary and wages.
Employees don’t have to pay
There’s no payment needed by recipients to acquire the profits interest—it is granted by the LLC and entitles the recipient to benefit from the future growth of the company.
Payout protection for existing owners
In the event of a payout, as in a sale or change of control of the company, members do not get a share of the value that was created by previous recipients.
Incentives aligned among employees, company
Because profits interests only provide the holder a slice of equity that they directly helped create, recipients are incentivized to do their best work, stick around longer, and contribute more, since they’re going to want to create as much value as possible to increase the value of the company and, as a result, their equity.
Extra burden and cost to the company
The company must create and maintain an additional entity, devoting time and legal costs.
The IRS may issue rulings in the future that make this a less viable option. As with all equity programs, it’s important to discuss this with a tax lawyer that specializes in this subject.
For the company:
Similar to regular PIUs, the company can’t deduct from its taxes the amount paid to the recipient as a compensation expense, although at the time of exit or other distribution on the PIUs, the PIU holder’s share of proceeds are directly taxable to that holder, thus providing an “effective” tax deduction to the other members.
Like regular PIUs, the recipient is not taxed at the time of the grant (and the recipient will typically file an 83(b) election with the IRS on a protective basis upon receipt). If and when there is a payout, and the employee has held the PIU for the required holding periods, the profits can be taxed at a long-term capital gains rate.