LLCs should carefully choose an incentive compensation plan

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Incentive compensation can be critical to the success of any company, including companies organized as limited liability companies (LLCs). Unfortunately, United States federal income tax law hasn’t quite caught up with the demand from LLCs for simple, equity-based incentive programs.

Corporations have multiple well-established methods to share with employees the upside of the business, such as issuing stock options or restricted stock. While economically similar structures exist for LLCs, they can be more administratively burdensome for the employer and employee alike. Owners of LLCs should carefully consider the type of incentive plan they put in place. Otherwise, the compensation package may not have the desired effect on employee morale, especially if it leads to an unexpected tax burden for the recipient employee.

LLCs have widely become the entity type of choice for new businesses. LLCs seem to enjoy “the best of both worlds” in that members of LLCs have limited liability protection similar to corporations, but without the additional layer of tax. LLCs are typically treated as “flow through” entities because they are classified by default as partnerships for federal income tax purposes.

Incentive compensation plans for LLCs taxed as partnerships generally fit into two categories: profits interest plans and phantom-equity plans. Each has its own costs and benefits to consider.

Profits interest plans have become the most common approach to incentive-based compensation for LLCs. However, a profits interest is an actual grant of equity of the LLC, which comes with some complications.

As background, income of an LLC flows through to its owners, regardless of whether the owners actually receive any distributions from the LLC. An income allocation without a corresponding cash distribution is sometimes referred to as “phantom income.” Phantom income can create a tax liability for a recipient who has no funds to pay it—a bad result for any employee.

Profits interests are economically similar to stock options having a strike price equal to the fair market value of the underlying stock at the time of grant. The profits interest holder participates in the upside of any increase in the company’s value, and earns nothing from the profits interest if it decreases in value. Like stock options, profits interests may be subject to vesting, forfeiture and buy-back provisions, which are usually set forth in the LLC’s operating agreement or a separate award agreement.

The IRS does not treat the grant of a properly structured profits interest as a taxable event. However, profits interest recipients are treated as partners for federal income tax purposes, which means recipients must be allocated income on a flow-through basis pursuant to the LLC’s operating agreement as it is earned by the LLC. Somewhat counter-intuitively, the IRS requires that the recipient be treated as a partner even with respect to non-vested profits interests, meaning the recipient must be allocated income he or she is not yet entitled to actually receive.

Profits interest recipients may be taxed at preferential rates, depending on the activities of the LLC. The character of income earned by the LLC is generally preserved when it flows through to its members, and so income allocated to members may be taxed at preferential capital gains rates to the extent that the LLC realizes income from long-term capital gains. And when the profits interest is sold, gain or loss on the sale is generally taxed as a capital gain or loss.

The tax treatment of profits interests is clearly favorable, but it creates a potential phantom income problem for recipients as described above. An LLC may need to make mandatory tax distributions to its employees, even with respect to non-vested profits interests. Further, the IRS takes the position that a person cannot be both an employee and a partner with respect to an LLC. For some, the added cost of self-employment income may outweigh the benefit of the profits interest.

Profits interests are also administratively burdensome for the employer. Following each grant, the LLC must determine the value of the business, which may involve a third party valuation. The purpose of this valuation is to ensure that the recipient of the profits interest does not inadvertently share in the pre-grant value of the business, which would negate the preferential tax treatment of the profits interest. As additional profits interests are subsequently issued, each with their own valuation hurdles, capital account adjustments and calculation of distributions to senior equity become increasingly complicated. Due to the accounting complexity, LLCs should issue profits interests only in a limited number of tranches.

To avoid the tax and accounting complexity that may come with profits interests, LLCs sometimes choose to adopt a so-called phantom equity plan instead. A phantom equity grant essentially gives the recipient the right to receive a cash bonus that is economically equivalent to a specified percentage ownership of the LLC.

Unlike profits interests, however, phantom equity plans do not create an opportunity for employees to be taxed at more favorable capital gains rates.

All in all, the tax advantages of LLCs continue to attract business owners over corporations. The profits interest plan is a fairly well-established model that can create similar economic and tax benefits for LLCs as corporations enjoy using stock options or restricted stock. However, the administrative cost of such plans, and the potentially unsettling tax consequences to recipient employees, often drive LLCs to adopt simpler but less tax-favorable phantom equity plans.

Jeffrey LaBarge is a partner with Nixon Peabody LLP. He developed this article with Brian Mahoney from the firm’s Business and Finance department.

4/15/2016 (c) 2016 Rochester Business Journal. To obtain permission to reprint this article, call 585-546-8303 or email [email protected].