Like corporations, limited liability companies (“LLCs”) often incentivize employees with equity awards. Lots of companies and employees are familiar with equity awards from corporations (e.g., stock options), but LLCs use profits interests awards and phantom equity.
Profits interests are the most common form of LLC equity compensation. Someone holding a profits interests will share in the increased value of the company after award is granted. The award has no value on the grant date, but as the company’s value increases, so too does the value of the profits interest award.
If properly structured, profits interest awards are not taxed on the grant date or on vesting and are generally subject to capital gains treatment upon sale. To ensure there’s no tax when the award vests, a profits interest holder is very likely to file an “83(b) election” immediately after receiving the award.
To maintain capital gains treatment, the recipient must, among other things, be treated as an owner of the company from the grant date forward and must hold the profits interests for at least two years before selling. The difference in tax rates can be significant. Current capital gains rates currently have a 20% ceiling, while the highest ordinary income tax rate is currently 37%.
Conversion from Employee to Owner
Under IRS rules, the recipient of any profits interest award becomes an owner of the LLC and is no longer an employee. In most cases, this has negative tax and other consequences that must be weighed against the benefits of receiving the award. Some negative consequences for the recipient include:
- The recipient’s salary becomes self-employment income, and the recipient will likely become subject to self-employment taxes at a rate of 15.3% instead of the 7.65% rate employees pay.
- The company will no longer withhold employment taxes. Instead, the recipient must make estimated quarterly tax payments.
- The recipient will be disqualified from participation in any employee-only benefit plans.
- The recipient will not be eligible for unemployment benefits.
Phantom equity mimics owning equity in the LLC. These awards entitle the recipient to a “bonus” that approximates owning real equity at the time of specified liquidity events (e.g., merger or acquisition). Phantom equity is not as commonly used by LLCs as profits interests are, but phantom equity avoid some risks inherent to profits interests.
Phantom equity is not taxed on the grant date; however, the proceeds received by the recipient on a liquidity event will be taxed at ordinary income rates, instead of capital gains rates. As mentioned above the difference in these rates can be significant. To ensure that phantom equity plan works as intended, attorneys and accountants will ensure a plan complies Tax Code Section 409A.
Recipient Remains an Employee
Unlike profits interest awards, a phantom equity award does not affect the recipient’s status as an employee of the company. Consequently, the employee does not have negative employment tax consequences and remains eligible for all company-sponsored employee-only benefit plans and unemployment benefits.
Because of their beneficial tax treatment, profits interests tend to be the preferred method for incentivizing LLC employees with equity. However, for equity awards that are small by comparison to the recipient’s salary, the negative consequences of becoming an owner of the LLC may outweigh the benefits of the award. In such cases, phantom equity awards can be an excellent alternative for incentivizing employees.
From the company’s perspective, profits interests are more complex and require more administrative work than phantom equity. Nonetheless, the tax savings for your LLC’s key staff may justify the overhead expense of profits interests. A LLC could implement both plans, with phantom equity for staff with shorter tenure and lower compensation and profits interests designed for long-term and higher-paid service providers.
For more information about choosing which type of equity incentive is appropriate for your LLC, please contact attorneys Russ Rotondi, Marco Materazzi, Dave Kopilak, Shannon Hartwell, Jake Cormier, Jay Purcell, or Genny Kiley from our Business Transactions practice group.