Equity Compensation and Limited Liability Companies.
Limited liability companies (LLCs) are rapidly becoming the favored vehicle through which many entrepreneurial companies are choosing to carry on their business. While an LLC has many corporate characteristics, most LLCs are taxed as partnerships. This dual nature creates significant benefits, but also significant challenges--particularly in the area of equity compensation.
Use of Equity Compensation.
The use of equity compensation plays a significant role in compensating and retaining key personnel. Traditional forms of corporate equity compensation such as incentive, or nonqualified, stock options are not available to an LLC. Nevertheless, an LLC does have several compensation tools in its arsenal through which it may provide incentive compensation.
The basic forms of equity compensation that an LLC may issue include:
a profits interest, a capital interest, and an option to acquire a capital interest.
While there are various tax and nontax considerations that must be addressed in selecting the appropriate form of incentive compensation, the following paragraphs raise some of the more important tax consequences and unresolved issues associated with these arrangements.
A "profits interest" generally entitles the recipient to share in the future earnings and appreciation in the value of the LLC arising after the date of grant. The transfer of a profits interest will not result in income recognition to the service provider if certain requirements are satisfied, including the requirement that the service provider not dispose of the profits interest for two years. Correspondingly, the LLC will not be entitled to a tax deduction. A profits interest is generally desirable when the goal is to avoid immediate income recognition.
A "capital interest" generally entitles the recipient to an immediate interest in the underlying assets of the LLC, as well as the ability to share in future profits. The recipient of the capital interest will generally recognize income upon the grant of the capital interest equal to the excess of the value of the interest received over the price paid, if any. The LLC will be entitled to a deduction equal to the amount of compensation recognized by the service provider. The grant of a capital interest may be 100 percent vested or, alternatively, subject to a vesting schedule (similar to restricted stock).
Option to Acquire Capital Interest.
As an alternative to granting an outright capital interest, an LLC may also grant a right (e. g., option) to acquire an interest in the underlying assets of the LLC (i. e., a capital interest). Upon exercising the option, the recipient will have an immediate interest in the underlying assets and future revenues of the LLC. The recipient will not recognize income upon the receipt of the option. Rather, upon exercise, the service provider will recognize income in an amount equal to the excess of the fair market value of the LLC interest received over the exercise price, if any, and the LLC will be entitled to a corresponding deduction.
While the tax consequences flowing from the above arrangements appear relatively straightforward, there are a number of issues that require additional consideration. For instance, one significant drawback to the issuance of a capital interest is that the LLC may recognize gain on the transfer equal to the excess of the fair market value of the LLC interest transferred over the LLC's basis in its underlying assets. Therefore, unlike a corporation, an LLC may have its compensation deduction offset by a gain on a deemed transfer of its assets.
Of greater concern is the Internal Revenue Service's position that an LLC member cannot also serve as an employee of the LLC in which he or she is a member (i. e., a partner). This position can have unanticipated employment tax and benefit consequences. A member may be subject to self-employment taxes on his wages (at a rate of 15.3 percent), whereas an employee's share of FICA is only 7.65 percent.
Equity Compensation has Unique Self-Employment Taxes in an LLC.
It is imperative that the LLC address this concern with its employees up front in order to avoid unanticipated tax consequences from the employee's perspective. Some form of gross-up payment may be required to place the employee on equal footing with his corporate counterpart. Likewise, an LLC must also address whether the distributions it makes to its members are subject to self-employment tax. While LLC members may be considered limited partners and, therefore, not subject to self-employment tax on their share of the partnership distributions, it is imperative that this issue and many similar issues be addressed in advance to avoid any unexpected surprises.

Introduction to Incentive Stock Options.
One of the major benefits that many employers offer to their workers is the ability to buy company stock with some sort of tax advantage or built-in discount. There are several types of stock purchase plans that contain these features, such as non-qualified stock option plans. These plans are usually offered to all employees at a company, from top executives down to the custodial staff.
However, there is another type of stock option, known as an incentive stock option, which is usually only offered to key employees and top-tier management. These options are also commonly known as statutory or qualified options, and they can receive preferential tax treatment in many cases.
Key Characteristics of ISOs.
Incentive stock options are similar to non-statutory options in terms of form and structure.
Schedule: ISOs are issued on a beginning date, known as the grant date, and then the employee exercises his or her right to buy the options on the exercise date. Once the options are exercised, the employee has the freedom to either sell the stock immediately or wait for a period of time before doing so. Unlike non-statutory options, the offering period for incentive stock options is always 10 years, after which time the options expire.
Vesting: ISOs usually contain a vesting schedule that must be satisfied before the employee can exercise the options. The standard three-year cliff schedule is used in some cases, where the employee becomes fully vested in all of the options issued to him or her at that time. Other employers use the graded vesting schedule that allows employees to become invested in one-fifth of the options granted each year, starting in the second year from grant. The employee is then fully vested in all of the options in the sixth year from grant.
Exercise Method: Incentive stock options also resemble non-statutory options in that they can be exercised in several different ways. The employee can pay cash up front to exercise them, or they can be exercised in a cashless transaction or by using a stock swap.
Bargain Element: ISOs can usually be exercised at a price below the current market price and, thus, provide an immediate profit for the employee.
Clawback Provisions: These are conditions that allow the employer to recall the options, such as if the employee leaves the company for a reason other than death, disability or retirement, or if the company itself becomes financially unable to meet its obligations with the options.
Discrimination: Whereas most other types of employee stock purchase plans must be offered to all employees of a company who meet certain minimal requirements, ISOs are usually only offered to executives and/or key employees of a company. ISOs can be informally likened to non-qualified retirement plans, which are also typically geared toward those at the top of the corporate structure, as opposed to qualified plans, which must be offered to all employees.
Taxation of ISOs.
ISOs are eligible to receive more favorable tax treatment than any other type of employee stock purchase plan. This treatment is what sets these options apart from most other forms of share-based compensation. However, the employee must meet certain obligations in order to receive the tax benefit. There are two types of dispositions for ISOs:
Qualifying Disposition: A sale of ISO stock made at least two years after the grant date and one year after the options were exercised. Both conditions must be met in order for the sale of stock to be classified in this manner. Disqualifying Disposition: A sale of ISO stock that does not meet the prescribed holding period requirements.
Just as with non-statutory options, there are no tax consequences at either grant or vesting. However, the tax rules for their exercise differ markedly from non-statutory options. An employee who exercises a non-statutory option must report the bargain element of the transaction as earned income that is subject to withholding tax. ISO holders will report nothing at this point; no tax reporting of any kind is made until the stock is sold. If the stock sale is a qualifying transaction, then the employee will only report a short-term or long-term capital gain on the sale. If the sale is a disqualifying disposition, then the employee will have to report any bargain element from the exercise as earned income.
Say Steve receives 1,000 non-statutory stock options and 2,000 incentive stock options from his company. The exercise price for both is $25. He exercises all of both types of options about 13 months later, when the stock is trading at $40 a share, and then sells 1,000 shares of stock from his incentive options six months after that, for $45 a share. Eight months later, he sells the rest of the stock at $55 a share.
The first sale of incentive stock is a disqualifying disposition, which means that Steve will have to report the bargain element of $15,000 ($40 actual share price - $25 exercise price = $15 x 1,000 shares) as earned income. He will have to do the same with the bargain element from his non-statutory exercise, so he will have $30,000 of additional W-2 income to report in the year of exercise. But he will only report a long-term capital gain of $30,000 ($55 sale price - $25 exercise price x 1,000 shares) for his qualifying ISO disposition.
It should be noted that employers are not required to withhold any tax from ISO exercises, so those who intend to make a disqualifying disposition should take care to set aside funds to pay for federal, state and local taxes, as well as Social Security, Medicare and FUTA.
Reporting and AMT.
Although qualifying ISO dispositions can be reported as long-term capital gains on the IRS form 1040, the bargain element at exercise is also a preference item for the alternative minimum tax. This tax is assessed to filers who have large amounts of certain types of income, such as ISO bargain elements or municipal bond interest, and is designed to ensure that the taxpayer pays at least a minimal amount of tax on income that would otherwise be tax-free. This can be calculated on IRS Form 6251, but employees who exercise a large number of ISOs should consult a tax or financial advisor beforehand so that they can properly anticipate the tax consequences of their transactions. The proceeds from sale of ISO stock must be reported on IRS form 3921 and then carried over to Schedule D.
The Bottom Line.
Incentive stock options can provide substantial income to its holders, but the tax rules for their exercise and sale can be complex in some cases. This article only covers the highlights of how these options work and the ways they can be used. For more information on incentive stock options, consult your HR representative or financial advisor.

Incentive stock options in llc

Accounting for Incentive Units in a Limited Liability Corporation.
THIS DRAFT SHOULD NOT BE RELIED UPON FOR ACADEMIC, SCIENTIFIC, LEGAL OR OTHER USES. THIS DRAFT CONSISTS OF UNVETTED, UNVERIFIED STATEMENTS THAT COULD CHANGE AT ANY TIME.
When a company is incorporated as a Limited Liability Corporation ("LLC"), the company gives some employees incentive units which vest when certain conditions are met (e. g. employment period exceeds three years). The employee has the right to purchase these units which are voting equity units at a strike price which is stated in advance.
This summary assumes that the unit’s strike price is higher than the fair value at the time the unit is vested.
After searching both published and unpublished literature and inquiring with various technical publications we found no technical literature that addresses incentive units in LLCs or partnerships. Inquiry with the American Institute of Certified Public Accounts showed that there is no authoritative literature in effect.
Some accountants have treated such equity instrument in the same manner of stock options, as mandated by APB 25 and FAS 123.
Financial Account Board’s Financial Accounting Statement No. 123 ("FAS 123") Accounting for Stock-Based Compensation superceded APB Opinion No. 25 Account for Stock Issued to Employees . The main effect of FAS 123 over APB 25 is that under the preferred FAS 123, fair value is measured by a stock-option value method and not by the "intrinsic value" method prescribed in APB 25.
According to FAS 123 it "applies to all transactions in which an entity grants shares of its common stock, stock options or other equity instruments to its employees, except for equity instruments held by an employee stock ownership plan". This application is in connection to "providing goods and services", by either employees or suppliers (par. 6).
Stock Options and Incentive Units.
LLC’s incentive units appear in substance to be similar to stock options. They have a pre-determined vesting conditions and periods, pre-determined price and similar business reasons of granting, i. e. compensating employees without cash outflow. Internal Revenue Code ("IRC") section 424 governs the application of incentive stock options.
Some differences are present however:
Deductibility of Stock Options by Employers.
Incentive stock options trigger ordinary income to the employer equal to the proceeds received from the employees. These options are also not subject to ERISA but a report of incentive stock options exercised is required as supplementary to the W2 report to employees.
Incentive units in an LLC are, under FAS 123 allocated over the vesting period as compensation costs (or payment to service provider, if given to non-employees).
Incentive stock options are options given to employees to purchase stock at favorable conditions, with little risk of loosing if the stock underperforms when the option is vested. They are granted only to employees who own less than 10% of the voting power in the employer’s stock.
Incentive units, if viewed as stock options do not have such restrictions and can be granted to non employees (e. g. suppliers); Incentive units granting disregards the current ownership level of the recipient.
Incentive stock options are limited in their vesting schedule for $100,000 per year for tax purposes.
Incentive units, treated like stock options do not carry such limitation.
Accounting Treatment of Stock Options.
Both APB 25 and FAS 123 are acceptable treatment, although FAS 123 is preferred. However, if APB 25 is adopted, pro-forma income statement should be disclosed to the results under the fair-value method prescribed in FAS 123 (par. 45).
Under APB 25, companies recognize compensation expense stemming from employee stock option based on the difference between the strike price (typically lower, and the fair value of the stock on day of grant. That difference in the proceeds from employee’s stock option is attributed to compensation and is recognized as compensation expense under APB 25. For example, on January 1, 2001 an employee is granted a strike price of $10. The employee exercises their strike price on January 1, 2001. The employee stock option vests on December 31, 2003. On December 31, 2002 the stock’s value is $17 on the open market. On December 31, 2003 the company grants the employee the stock – which is now vested and recognizes compensation expense of $7 per share.
Under FAS 123, the excess of the projected estimated fair value (par. 9) of the stock option upon vesting over the strike price is allocated over the service period (par. 30). The service period starts at the date of exercise and ends at the date of vesting. The projected price of non public companies may result in a minimum value for the stock option because market price volatility is unknown. For example, an employee exercises a stock option on January 1, 2001 at a strike price of $10 per share and the stock option vests in three years, on December 31, 2003. On January 1, 2001 the stock option fair value, using a projection model, is estimated to be $19 per share. The company will recognize a $3 ($9 / 3 years = $3) per year of compensation expense. On December 31, 2002 the employee’s option is vested and the company grants the employee a stock.
While the employee’s option is not vested the company also reclassifies the unissued stock as restricted. Generally, the projected fair price (in the example above, $19) is the value upon restriction.
Some Employee Stock Option Plans (ESOP) does not qualify as stock options that trigger compensation expense recognition. Generally, when employees can purchase the stock at a small discount ( de-minimus ), and when substantially all full time employees qualify, the excess of the fair value of the stock over the strike price is not compensation expense to the company.
A mandatory repurchase agreement does not change the accounting treatment of stock-options (par. 219).
Generally, additional compensation for dividends on unvested stock options, or stock options that allow the employee to keep such dividends is charged as compensation expense in the period of payment.
Generally, prepaid compensation expenses are not tax deductible. The time value of the compensation, which is "built in" the projected estimated value upon the option’s vesting is also not tax deductible. Therefore, a temporary difference (resulting in a deferred tax asset) is accounted for based on the accumulated applicable compensation costs and reduced by a valuation allowance (par. 227).
Once vested and granted, the actual compensation cost in excess of the accumulated compensation cost that was used for the deferred tax asset should be recognized as additional paid in capital and not as deferred tax asset (par. 228). However, if the actual compensation cost is below the compensation cost that was used for the deferred tax asset, the write off should first be taken from additional paid in capital that is attributed to any prior excess, and then as an expense on the income statement. (par. 229).
Incentive units are more similar in substance to stock options than to incentive stock options. Although no direct authoritative literature exist to mandate the accounting treatment of an LLC’s incentive units.
FAS 123 require the fair value method to be applied to the stock options upon exercising them by the employee or service provider. The excess of the projected fair value of the option over the strike price should be allocated over the vesting period. When the stock vests, the difference between the accumulated allocation and the actual fair value of the option is charged to APIC.
If the vesting and excersising occurs simulataniously, the charge is to the period of exercised and the difference if to APIC for excess or as a loss to the income statement.

The Venture Alley.
A blog about business and legal issues important to entrepreneurs, startups, venture capitalists and angel investors.
The Venture Alley.
A blog about business and legal issues important to entrepreneurs, startups, venture capitalists and angel investors.
Home Startups Options for Issuing Employee Equity in LLCs.
Options for Issuing Employee Equity in LLCs.
Choosing the best type of entity for a company can be a challenge. C corporations are the norm for most emerging growth businesses, particularly those raising money from investors. However, LLCs are becoming more widespread, even for operating businesses. Founders may want to have the tax benefits of LLCs, which are not subject to a company-level tax (as is the case with C corporations) and may enable more tax deductions.
This potential for tax savings does not, however, come without a cost. LLCs tend to be more complicated and expensive to setup and manage, particularly for operating businesses. LLCs can become even more tricky for businesses that want to issue equity to incentivize employees or other service providers. This article addresses some of the ways LLCs can use equity to incentivize service providers, and the implications of each option (pardon the pun).
Profits Interests Subject to Vesting.
LLCs are able to grant ‘equity’ to their service providers by issuing profits interests that entitle the recipient to a percentage of future appreciation of the business (after the date of such issuance, based on the valuation on teh date of grant). Profits interest in an LLC can be a best-case-scenario for companies granting equity as they can have tax advantages over incentive stock options, but they are more complicated to setup and may not be right for every business based on future needs.
General Comparison to Corporate Stock Options. As a result of Code Section 409A, corporations will almost universally grant stock options with exercise prices at or above market value on the date of grant. The issuance of profits interests in an LLC is very similar in many ways to stock options having an exercise price equal to the fair market value of common stock as of the date of grant. Economically, the incentives are very similar – the interests do not generate economic benefit for the service provider if the company does not increase in value after the grant date. For securities purposes, the issuances are both securities issuances, requiring satisfaction of securities law filings (including based on a 701 exemption). Administratively, profits interests and stock options generally are both granted pursuant to a plan and agreement/notice that sets forth the particular terms of the interests; however, the ‘plan’ provisions also may be set forth in the LLC agreement and the LLC agreement may need to be restated in order to accomodate profits interests (and differentiate those interests from other existing membership interests). As with corporate stock options, profits interests may be subject to repurchase rights if the service provider is no longer providing services to the company and/or rights of first refusal on behalf of the company and/or its members should the service provider attempt to transfer the interest.
Unlike stock options, the holder of a profits interest is the owner of that interest (subject to vesting restrictions), similar to shareholders of a corporation that hold their shares subject to ‘reverse vesting’ requiring them to forfeit the interest if the vesting restrictions are not satisfied. Alternatively, LLCs can give service providers an option to receive a profits interest, discussed below. Where profits interests have been issued subject to vesting, the LLC agreement typically will provide that distributions with respect to unvested profits interests generally will either (i) not be distributed to the profits interest member but instead held by the LLC on behalf of the service provider pending vesting ( i. e ., held in escrow by the company), or (ii) be distributed subject to contractual obligations of the service provider to repay excess distributions ( i. e ., a ‘clawback’).
Tax and Administrative Implications of Profits Interests. As discussed in the introduction, LLCs are usually taxed as partnerships to avail their members of certain tax benefits, including the avoidance of company level taxation (often referred to as the “double-layer” of tax). As a partnership for tax purposes, the LLC itself does not – for tax purposes – have a separate legal existence from its members. Instead, the LLC’s tax obligation is determined under Subchapter K’s aggregate theory of taxation, where each member of the company is treated as the owner of a direct and undivided interest in the LLC’s assets, liabilities and operations. The LLC files a tax return but is not itself a taxpaying entity; instead, the LLC’s members are subject to tax on the LLC’s operations and individually report their respective shares of the LLC’s “pass-through” separately stated items of income, loss and deduction.
Each service provider that receives a profits interest will be a member of the LLC as to that profits interest and will receive their allocable share of any pass-through items of income, loss and deductions from the company on an annual basis. As a result, the LLC must issue each of them a Form K-1 setting forth these allocations, which will complicate their personal tax return filings. Each profits interest holder, as a member of the LLC, also may be treated as self-employed, subject to self-employment tax and not be eligible for certain employee benefits.
What are the tax benefits of a profits interest? A service provider generally will not have taxable income on its receipt of pure a profits interest in an LLC because the interest will have no value as of the date it is issued (by definition). Profits interests usually are granted subject to vesting, and service providers usually file ‘protective’ 83(b) elections on such profits interests with a goal of ensuring that any future gains are taxed at capital gains tax rates rather than ordinary income; capital gains treatment should be available assuming the interest is held for at least a year (or, in the context of an asset sale of the LLC, as to assets that the LLC has held for at least a year, regardless of the service provider’s holding period on its profits interest). As a comparison, incentive stock options trigger capital gain on sale as well but only upon satisfaction of certain holding period requirements and, even if taxed at capital gainst rates, may trigger the alternative minimum tax. Another benefit of profits interests is that the employee does not need to fund an exercise price (and the company does not need to accomodate the potential complexities of a net exercise).
Administrative Cost. There is an administrative burden in managing profits interests, which increases exponentially with the number of different times the company wants to make a grant. Following each date of a grant, the LLC must determine the value of the entity at the time of each grant of a profits interest. This is best done using a third-party valuation firm, as a corporation may do for its 409A valuations. The LLC also usually will need to account for unrealized appreciation in the LLC as of each grant date by adjusting the existing members’ capital accounts or allocation rights to ensure that the recipient of the profits interest does not inadvertently share in any pre-grant value in the LLC; the LLC generally will need to either (i) “book up” the capital accounts of the existing members in the LLC in the amount of the unrealized appreciation as of the date of the grant, or, alternatively, (ii) the company and its members may elect to amend the LLC’s operating agreement to provide for a special allocation of that pre‑grant unrealized appreciation among its existing members (“Capital Account Adjustment”). Without these Capital Account Adjustments, the intended economic deal could be frustrated. For example, upon the LLC’s subsequent realization of unrealized gain lurking within the LLC, such as upon a sale of some of its assets having unrealized appreciation at the time the profits interests were granted. , could be allocated to the profits interest member, effectively giving that member an interest in the value of the LLC that existed prior to their grant. Such an allocation to the profits interest member would have substantially different tax implications; it would be a capital interest in the existing value of the company rather than a profits interest. Receipt of a capital interest shifts existing value from the existing members to the new member, which is immediately subject to tax as compensation and at ordinary income tax rates.
Due to the above complexity with valuations and capital accounting, LLCs should avoid issuing profits interests on more than a few occasions because tracking the multiple valuation dates and making the necessary Capital Account Adjustments can quickly become an accounting nightmare.
Options to Purchase Profits Interests.
An LLC also may issue options to acquire capital interests entitled to a percentage of the company’s value as of the exercise date of the option (I will call this an “Option for Capital Interest”).
An Option for Capital Interest may have a stated acquisition/exercise price to mimic a corporate stock option. For tax purposes, there may be a capital shift on the exercise date of such option (immediately taxable to the service provider at ordinary income rates). The LLC still needs to do a valuation on the date of the grant and then again on the date of exercise in order to determine the future capital shift, if any. In addition, Capital Account Adjustments may need to be made to avoid giving the service provider a capital interest in any pre-grant company value.
The tax treatment of options issued by an LLC is not entirely settled, which can create additional complexity and uncertainty. Furthermore, granting options rather than outright profits interests probably increases the likelihood of the option holders having multiple exercise dates, which could dramatically increase the administrative burdens associated with managing the different grants (as discussed above). For example, even if an LLC issues all options on a single date, the options ultimately might be exercised by the grantees on multiple dates. These complexities could be mitigated by setting pre-determined allowable exercise dates, but doing so might further reduce the value of the option to the service provider.
Phantom Equity/Management Carve-Out Plan.
To avoid the tax, valuation, accounting and other problems created by the use of profits interests or options, LLCs sometimes instead grant phantom equity. Phantom equity is relatively simple to administer but without the tax benefits of profits interests. A phantom equity grant essentially gives the service provider the right to receive a cash bonus equivalent to what they would have received if they held a profits interest ( i. e. , based on the LLC’s valuation as of a future date). A significant benefit of phantom interests over profits interests is their ease of administration and implementation. Unlike with profits interests, the holder of a phantom equity grant is not a member of the LLC and has no equity interest in perpetuity, regardless of whether the holder has ‘vested’ as to any phantom payments; instead, the phantom interest exists only as long of the holder is providing services (and their economic rights terminate when they stop providing services). Bonus under a phantom equity plan are compensation taxable at ordinary income rates, which is less favorable for the service provider than a profits interest.
Phantom equity plans can also be structured to trigger payments only upon a change of control transaction, similar to a management carve-out plan in the corporate settings.
Stock Option Grants from a Corporate Member.
Yet another option for issuing equity in an LLC, although not the least complicated, is to setup a C or S corporation and to grant that newly-formed corporation a profits interest in the LLC in the amount of all future profits interests being contemplated ( i. e. , grant the total size of the pool to the corporation at one time). This triggers the profits interest issuance issues discussed above in Section 1, but only on a single occasion since there is only one grant date. Thereafter, the corporate entity may issue stock or options directly to the LLC’s service providers. Having only one grant date mitigates the problems with multiple valuation dates and Capital Account Adjustments discussed above in Section 1. This option, however, is relatively complex to implement for other reasons. For example, it obviously requires the formation of a separate corporate entity and stock option plan, potentially mitigating the tax benefits of an LLC as to the profits interest granted to the corporate member (since the corporate member would pay corporate tax on allocations from the LLC before flowing through to the option holders). In addition, the stock option plan for the corporate entity needs to be drafted very carefully to ensure that the option holders do not have their interests accrete or dilute based on changes in the company’s capitalization; the corporate member will have a fixed profit interest in the LLC while its option holders may come and go over time, so the option plan will differ from a typical corporate plan in that it should tie back to the LLC such that any ungranted interests or interests that are forfeited/unexercised revert to the LLC (and add to the relative interests of all members, rather than solely the corporate member). Finally, the issuance of option grants from the plan of a corporate member will need to rely on an applicable exemption for securities exemption, but Rule 701, which is the exemption typically used for stock option grants by companies to their employees, may not be available because the issuer of the grants (the corporate member) usually would be a minority owner of the LLC. The exemption under Rule 701 generally is available to issuers only where the issuances are to service providers who provide services to a majority-owned subsidiary. For this reason, it may be necessary to explore having the corporation be a subsidiary of the LLC or to obtain an exemption for securities issuances under the corporations’ plan under Rule 504, Rule 506 or Reg D, which depend on the facts presented at the time of the subsequent issuance(s) ( e. g. , size of the offering, sophistication/accreditation of the service provider, etc.).
Conclusion.
LLCs are flexible entities that provide tax efficiencies not available in corporations; however, tend to be more expensive to form and administer than corporations, particularly when used for operating businesses. Whether it makes sense for an operating company to issue equity to service providers but remain a pass-through entity (such as an LLC) for tax purposes generally is a balancing act that weighs ( x ) the amount of tax savings projected from the use of the pass-through structure and the projected timing of those savings, against ( y ) the significant added time and expense in the administration of the company’s projected equity grants. I generally advise against the use of an LLC for operating companies that plan to actively grant employee incentives, except in rare circumstances where the exit path is clear and the potential tax savings is sufficient to justify the added cost and complexity. Even in situations where the tax savings offered by a pass-through entity are projected to be significant, LLCs should be careful to (a) consider a plan with a much smaller scope than in a typical corporate setting (for example, giving only a few grants to key employees and on a few occasions, in order to mitigate the administrative and accounting issues created by these grants), or (b) implement a phantom equity plan that incentivizes employees for so long as they continue to provide services for the company, understanding that such a phantom equity plan would have the benefit of simplicity at the cost of less favorable tax treatment.
DISCLAIMER: The tax rules in this area are extremely complex. This post is intended as practical guidance with a mere introduction to the tax and accounting issues that may be implicated, in an effort to allow readers to better understand some of this complexities. Make sure to speak with an attorney capable of addressing these issues before trying to implement any of these approaches. If you have any questions, feel free to contact me.
This is a very good summary for advisors and founders of LLCs. Founders and their accountants are quick to organize a start-up as an LLC without talking about the tax and administrative implications. Founders who received restricted stock and options in prior companies are surprised at the differences. Lawyers from big firms trained to work with venture-backed C corps later join smaller firms or go out on their own, to find themselves in unfamiliar LLC territory. The practical problem I find is the understandable reluctance of start-up founders to pay for independent valuations in order to issue profits interest grants while the product is still in development. Is there a best practice for handling this as the management team is recruited through the early stages of an LLC, or C-corp for that matter (with respect to restricted stock grants in that case)?