Limited liability companies (LLCs) are a relatively recent form of business organization, but one that has become increasingly popular. LLCs are similar in many ways to S corporations, but ownership is evidenced by membership interests rather than stock. As a result, LLCs cannot have employee stock ownership plans (ESOPs), give out stock options, or provide restricted stock, or otherwise give employees actual shares or rights to shares. But many LLCs want to reward employees with an equity stake in the company. This article explores how this can be achieved.
Profits Interests
The most commonly recommended approach to sharing equity in an LLC is to share "profits interests." A profits interest is analogous to a stock appreciation right. It is not literally a profit share, but rather a share of the increase in the value of the LLC over a stated period of time. Vesting requirements can be attached to this interest. In the typical arrangement, an employee would receive an award and would be treated as if an 83(b) election had been made, proided certain basic safe harbor rules are met (the employee can also affirmatively make the election). This fixes the ordinary income tax obligation at the time of grant. The employee would pay taxes on the value of any difference between the grant price and any consideration paid at ordinary income tax rates, then pay no further taxes until paying capital gains tax on subsequent appreciation at sale. If there is no value at grant, then, the tax is zero, and taxes would only be paid when the interest is sold, at which time capital gains tax rates would apply. Proposed (but never finalized) Revenue Ruling 2005-43 stated that profits interests would not be taxed at grant if they would have no value if the company were liquidated at the same time and the basic safe harbor rules are met. In other words, profits interests must only apply to the growth of the value of the company. The rules require that employees must also hold the interests for at least two years after grant. They also cannot be pegged to a certain stream of income, such as would be the case with a more conventional profit sharing plan. LLCs must enter into binding agreements to comply with these requirements. Grant agreements should also specify terms for the transferability of the interests, if any (generally, they would not be transferable). Profit interests can be tax-free at grant only if provided to employees or other service providers. If profit interests are held for at least one year after the interests vest, the amount received in a redemption of the award is treated as a long-term capital gain; otherwise, it is a short-term gain. In addition, if profits interest holders make an 83(b) election, they must be treated as if they had an actual equity stake in the company. That means that they would receive a K-1 statement attributing their respective share of ownership to them and would have to pay taxes on that. Distributions can be made by the LLC for this purpose. Income attributed to their limited partner status is not subject to employment taxes. If the employee forfeits the profits interest (because they never become vested, for instance), a special allocation must be made to reverse the effects of any gains or losses attributable to the employee. Employees would also be subject to self-employment taxes (FICA and FUTA) on their salaries, would not be eligible for unemployment insurance, and could not receive tax-deductible retiremnent and health-care benefits. Some companies gross up employee pay to cover this additional tax burden. It is unclear whether a profits-interest holder would be treated as an employee if there are no vested interests, but the IRS regulations refer only to the grant of the interest, so the answer is presumably no. Companies also have tried various work-arounds, such as layering entities for that one LLC holds the membership interest and another is the employer. The IRS has ruled against at least one of these approaches, so readers should consult with an attorney on this issue. If an 83(b) election is not made, or deemed to have been made, then the employee would probably not be subject to partnership tax treatment, but the employee would have to pay taxes on gains at vesting as ordinary income rather than only capital gains tax and then only on sale. Because of that, almost everyone who gets these interests chooses 83(b) treatment. (There is some dispute about whether an 83(b) election is really needed under the rules, but that is beyond this article). While there is no statutory requirement to do so, having an outside professional valuation of the profits interest at the time of grant is advisable. That establishes a defensible value on which to base the future benefits subject to taxation. Granting the interests at less than fair market value could also give rise to taxation on the bargain element at grant. Section 409A deferred compensation rules require that, at the least, the company find a way to estimate current fair market value in accordance to standards the regulations set out. Having the board simply pick a number based on some formula or back-of-the-envelope calculation would not meet these requirements. Distributions of earnings can be made to holders of the profits interests, but need not be in proportion to their equity stake. For instance, if the partners had contributed all the capitalization, they might not allow any allocation of distributions until a target return had been met. There are no statutory rules for how profits interests must be structured. Distributions of earnings normally would just be based on vested units, but could be based on allocated units. Any vesting rules the company chooses can be used, although performance vesting would require variable accounting (adjusting the charge to earnings each year based on changes in value and the vested amounts). Otherwise, the charge must be taken at grant based on a formula (such as Black-Scholes) that calculates the present value of the award.
Capital Interests
Capital interests are the LLC equivalent of restricted stock grants in S or C corporations. Rather than give the employee the right to the increase in the value of membership interests, the employee receives the full value. Rules for vesting and whether the employee is considered a partner or an employee would be similar to a profits interest grant. The employee can make an 83(b) election at grant and pay tax on any value conveyed at that time as ordinary income (this may be nominal in a start-up). When the interests are sold, the employee would pay capital gains taxes. Otherwise, the employee would pay no tax at grant but ordinary income tax on vesting, even if the interests cannot be sold at that point. Any subsequent gain would be taxed at capital gains rates at sale. Because the tax treatment of profits interests is generally more favorable (the 83(b) election triggers no current tax), they are much more common than capital interest grants, but capital interest grants might make sense in mature LLCs that want to reward employees for existing value, not just growth. Captal inteests are rarely graned in LLC's, however, because the tax cnseuences ot the LLC are uncertain and potentially costly. It is arguably possible that the grant could cause a taxable income or gain event for the LLC and/or pre-existing members.
Unit Plans
A simpler approach that many LLCs find attractive is to issue the equivalent of phantom shares or stock appreciation rights. There is no agreed-upon legal definition for what these would be called in an LLC, but we refer to them as unit rights plans or unit appreciation rights plans. In a units rights plan the employee is granted a hypothetical number of LLC membership interests that are subject to vesting over time. Typically, when they vest, the value of the awards is paid out in cash. In a unit appreciation rights plan, the same things happens, but only the increase in value is paid out. In either case, the employee is subject to ordinary incomes tax at the time of payout and the amount of the payout. The payment is treated in the same way as a bonus would be. The employee is considered an employee of the company, not a member. For companies where the tax benefits to employees of profits interests is not critical, unit plans are simpler and provide employees with the often substantial benefits of actually being taxed as an employee. Employees also do not have to file estimated income tax returns or deal with K-1 statements. These benefits can make these approaches compelling in broad-based plans.
ERISA Issues
Ant kind of deferred compensation that pays out benefits in ways similar to retirement plans may be subject to Employee Retirement Income Security Act (ERISA) rules, the same rules that govern pension and other retirement plans. That can create multiple issues for companies, with complex compliance requirements and no offsetting benefits of actually having the plan be qualified for tax benefits. There are no clear regulations on this, just a handful of relevant court cases almost always initiated by an employee. If plans are "top-hat" (Just available to key employees, usually defined as 15% or less), the plans will not be subject to ERISA. If plans pay our periodically, such as every three to five years on vesting of awards, they will also not be subject to ERISA. If plans do not pay out until termination of employment, they probably will be. Less certain is if you can condition vesting on a change of control or other liquidity event. Arguably, if such events are anticipated in the reasonably near term, the plan should not be seen as a retirement plan, but some attorneys are more cautious. Also see our book Equity Compensation for Limited Liability Companies (LLCs).
FAQs
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.
What are the incentive options for LLC? ›
There are four common methods of granting equity or equity incentives in an LLC: (1) outright membership interest or membership unit grants, (2) LLC incentive units (aka “profit interests”), (3) a phantom or parallel unit plan (aka. synthetic equity), and (4) options to acquire LLC capital interests.
Do LLCs have equity interests? ›
As stated previously, there are two types of equity interests avail- able in LLCs. However, as an alternative to the grant of an outright interest, LLCs can issue options to acquire either a capital interest or a profits interest.
How is equity distributed in an LLC? ›
What Are LLC Member Distributions? An LLC's members do not own shares of stock in their company. Instead, they receive ownership interests that entitle them to a percentage of the LLC's profits, which is usually proportionate to the amount of capital they contributed to the business.
What is equity based compensation for corporations partnerships and LLCs? ›
Equity-based compensation includes any compensation paid to an employee, director, contractor, consultant or other service provider that is based on the value of a specified stock of a corporation or unit of a partnership or LLC.
How do equity incentive plans work? ›
Equity incentive plans allow companies to conserve cash by offering lower salaries in exchange for equity. While workers still get a monthly salary, they may accept less pay than usual because they recognize the value of having equity in the company instead.
What are the three types of incentive plans? ›
Incentives can be generally classified as financial (monetary) incentives and non-financial (non-monetary) incentives.
- Financial (Monetary) Incentives. Financial incentive pertains to those incentives which are in the form of money or can be measured in monetary terms. ...
- Non-Financial (Non-Monetary) Incentives.
Preferred equity is a general term used to describe any class of securities (stock, limited liability units, limited partnership interests) that has higher priority for distributions of a company's cash flow or profits than common equity.
What are the equity accounts for an LLC? ›
The equity accounts in the chart of accounts are called partner's capital, partner's draw and retained earnings.
What is equity in an LLC called? ›
Membership units (sometimes called capital interests) represent equity similar to a common share of a C-corporation.
How to make an LLC Capital Contribution. You can deposit cash, write a check, or transfer money from your personal bank account to your LLC bank account. This money then becomes the available funds for the LLC operating expenses.
How is equity paid out in a business? ›
Equity compensation is non-cash pay that is offered to employees. Equity compensation may include options, restricted stock, and performance shares; all of these investment vehicles represent ownership in the firm for a company's employees. At times, equity compensation may accompany a below-market salary.
Can an LLC issue equity shares? ›
A limited liability company (LLC) cannot issue shares of stock. An LLC is a business entity structured to have either a single or multiple owners, who are referred to as the LLC's members.
What is the difference between profit interest and capital interest in an LLC? ›
Profits Interest – A profits interest lets you share in the future earnings and appreciation in value of the LLC. Capital Interest – A capital interest gives you a right to the existing capital of the LLC and any future income of the business.
Is company equity a good benefit? ›
Offering equity compensation to employees can help a company reserve their funding for operations, starting initiatives and investing, and it can help reduce spending money on high salaries. This is especially common for startup companies that may be reliant on seed funding, and may not have a large cash flow.
How does a partnership LLC pay themselves? ›
To get paid, LLC members take a draw from their capital account. Payment is usually made by a business check. They can also receive non-salary payments or “guaranteed payments” — basically a payment that is made regardless of whether the LLC has generated any net income that month or quarter.
What should I look for in an equity incentive plan? ›
Equity incentive plan basics
- Size of equity plan share pool. ...
- Authority to approve equity grants. ...
- Types of equity awards. ...
- Equity award vesting; acceleration. ...
- Repurchase right; right of first refusal. ...
- Type of stock options. ...
- Transferability of stock options. ...
- Early exercise of stock options.
You will pay ordinary income taxes on the difference between the exercise price and the market price when you exercise the options. This amount is reported even if you don't sell your shares and don't actually realize that gain. Your company will likely withhold taxes for you if you are a full-time employee.
How do you structure incentive pay? ›
Structured incentive pay is set by specific sales or production goals and paid to employees at a percentage or flat rate. For example, you set a goal for $50,000 in sales for the fiscal year. If you reach that goal, you give each employee a bonus equaling 2% of their annual salary.
What is the most common form of incentives? ›
The most common type of economic incentive system is payroll: A paycheck motivates people to show up to work and perform their duties.
Disadvantages of Preference Shares
The main disadvantage of owning preference shares is that the investors in these vehicles don't enjoy the same voting rights as common shareholders. 1 This means that the company is not beholden to preferred shareholders the way it is to traditional equity shareholders.
What 3 accounts are in owners equity? ›
The main accounts that influence owner's equity include revenues, gains, expenses, and losses. Owner's equity will increase if you have revenues and gains. Owner's equity decreases if you have expenses and losses.
What are 10 examples of equity? ›
10 equity account types
- Common stock. ...
- Preferred stock. ...
- Retained earnings. ...
- Contributed surplus. ...
- Additional paid-in capital. ...
- Treasury stock. ...
- Dividends. ...
- Other comprehensive income (OCI)
Equity represents the total amount of money a business owner or shareholder would receive if they liquidated all their assets and paid off the company's debt. Capital refers only to a company's financial assets that are available to spend.
What are the four types of equity in a business? ›
There are a few different types of equity including:
- Common stock.
- Preferred shares.
- Contributed surplus.
- Retained earnings.
- Treasury stock.
Equity is a slice of company ownership that founders exchange for investor funding or offer as an employee benefit. It is critical that founders share ownership equitably based on their role and commitment to the business. Keep in mind that equity is finite, so spend it carefully.
How are profits distributed in an LLC? ›
By default, LLC profits are split according to ownership percentage—if you own 50% of the LLC, you get 50% of the profits. However, you can override your state's default requirements for splitting LLC profits by making another arrangement in your operating agreement.
Can I fund my LLC with personal money? ›
One of the most common ways to fund your LLC is with personal funds. This can include your savings, retirement accounts, and personal loans. While this option may not be ideal for everyone, it's a good way to get started if you don't have a lot of capital.
How are contributions to an LLC valued? ›
How to determine the value of a Service Contribution to an LLC. If you are contributing non-related services to an LLC for ownership, you'll need to figure out the fair market value of those services. The fair market value is what it would cost to hire someone else to do the same work.
Does an LLC pay taxes on capital contributions? ›
As with property, you will need to obtain a market value for the value of your services. There also are tax consequences, as you will have to treat this value as if it were actual income you earned for your services, meaning you will have to pay personal income taxes on the value of these services.
Equity compensation is a strategy used to improve a business's cash flow. Instead of a salary, the employee is given a partial stake in the company. Equity compensation comes with certain terms, with the employee not earning a return at first. Startups often try to lure star employees with the promise of equity.
Do equity owners get profits? ›
Instead, the profits are allocated to shareholders according to their stake in the company, and the shareholders report those profits as taxable income on their personal returns. This is the case regardless of whether the shareholders actually received any money.
What is an equity bonus? ›
Equity Bonuses
Performance bonuses paid in the form of equity instead of cash. Provides an incentive to employees to meet performance goals while minimizing cash outlays by the company.
Is an LLC private equity? ›
Private equity funds are closed-end investment vehicles, which means that there is a limited window to raise funds and once this window has expired no further funds can be raised. These funds are generally formed as either a Limited Partnership (“LP”) or Limited Liability Company (“LLC”).
How do you value ownership interest in an LLC? ›
With the income method, your LLC is valued based on the average monthly income for the last 24 to 36 months. Then, add the amount of cash reserves and subtract any debts. The result should be multiplied by a factor established by the members to arrive at the company's value.
How do you perfect an LLC interest? ›
If the membership interests are securities, then you perfect by taking possession or control of the securities – or both. If the membership interests are certificated, then you perfect by taking possession of the certificates and by taking control by having the security interest noted in the company's records.
What is an owner of an LLC interest known as? ›
The term member refers to the individual(s) or entity(ies) holding a membership interest in a limited liability company. The members are the owners of an LLC, like shareholders are the owners of a corporation.
What are the advantages of incentive equity? ›
If the stock appreciates, your money is working for you. If the stock price declines, your investment is worth less than when you started. Incentive stock options give you the potential to participate in the appreciation of a stock with no capital outlay or financial risk on your part.
When should a company use equity? ›
If your business doesn't have the revenues or financial history necessary to successfully apply for a business loan, your other option is equity funding. If your business needs money to grow, equity investors could provide it. They would understand that their return on their investment will come much later on.
What happens when you get equity in a company? ›
In short, having equity in a company means that you have a stake in the business you're helping to build and grow. You're also incentivized to grow the company's value in the same way founders and investors are.
The SBA reports that most small business owners limit their salaries to 50% of profits, Singer said.
How do I pay myself profits from an LLC? ›
If you choose to pay yourself as a contractor, you need to file IRS Form W-9 with the LLC and the LLC will file an IRS Form 1099-MISC at the end of the year. You will be responsible for paying self-employment taxes on the amount earned.
What is the most tax efficient way to pay yourself? ›
What is the most tax-efficient way to pay yourself? The most tax-efficient way to pay yourself as a business owner is a combination of a salary and dividends. This will allow you to deduct the salary from your business's income and pay taxes on it.
Can you pay yourself a bonus in an LLC? ›
You can also issue bonuses to LLC members who are employees, including yourself. Again, these must be reasonable related to the salary being paid. You'll need to file IRS Form W-4 to determine the amount of payroll withholding from each paycheck you receive.
What is the main incentive for business owners? ›
Profit is an important incentive that leads entrepreneurs to accept the risks of business failure. Entrepreneurs are individuals what are willing to take risks in order to develop new products and start new businesses. They recognize opportunities, enjoy working for themselves, and accept challenges.
What is an example of profits interest in an LLC? ›
Example: A company is worth $1,000,000 and is later sold for $2,000,000. A worker who receives 10% in stock immediately owns $100,000 of the company's value and receives $200,000 when the company is sold. A worker who receives a 10% profits interest grant owns $0 of the company's value upon receiving the interest.
Can an LLC receive a profits interest? ›
A profits interest is an equity-like form of compensation that limited liability companies (LLCs) can offer to employees and other service providers. The value of a profits interest is based on the growing value of the LLC, which allows employees (or “partners”) to benefit from the LLC's appreciation in value.
Can you do an executive bonus plan with an LLC? ›
The beauty of this technique is its simplicity and effectiveness. An executive bonus plan is available for key employees of all entity types (S or C corporations, LLCs, etc.). An executive bonus plan typically involves the purchase of life insurance on one or more key employees.
What is it called when I pay myself from my LLC? ›
However, you are not paid like a sole proprietor where your business' earnings are your salary. Instead, you are paid directly through what is known as an “owner's draw” from the profits that your company earns. This means you withdraw funds from your business for personal use.
What is it called when you pay yourself and it with an LLC? ›
As an owner of a limited liability company, known as an LLC, you'll generally pay yourself through an owner's draw. This method of payment essentially transfers a portion of the business's cash reserves to you for personal use. For multi-member LLCs, these draws are divided among the partners.
The most common types of state and local incentives for entrepreneurial firms are financial, fiscal, and services.
How are profits paid out of an LLC? ›
The LLC pays its own entity-level taxes on net income by filing a corporate tax return. Whatever money is left after paying taxes is profit, and it goes into the company's retained earnings account. From that account, profits are distributed to members as dividends.
How do you show ownership interest in an LLC? ›
LLC Operating Agreement
The name and ownership percentage of each LLC member should be included in your operating agreement, and the document should be signed by all members. Since an operating agreement is legally binding, it can be used to prove ownership of your LLC.
How do LLC members share in profits? ›
Profit Allocation for LLCs
By default, all profits are allocated by ownership percentage (the same as in a general partnership). This means that if John and Pete equally invested in and own an LLC together, they'll both be allocated 50% of the profits.
How do LLC profits avoid taxes? ›
An LLC is considered a pass-through entity—also called a flow-through entity—which means it pays taxes through an individual income tax code rather than through a corporate tax code. In addition to LLCs, sole proprietorships, S Corporations, and partnerships are all pass-through businesses.
Can you keep profits in LLC without paying taxes? ›
As the sole owner of your LLC, you must report all profits (or losses) of the LLC on Schedule C and submit it with your 1040 tax return. Even if you leave profits in the company's bank account at the end of the year—for instance, to cover future expenses or expand the business—you must pay taxes on that money.
Are LLC profits taxed as capital gains? ›
If you've held your shares of the LLC for over a year you'll be taxed at the lower long term capital gains tax rate, otherwise you'll pay the higher short term rates. Note for high income earners: you may be subject to an additional net investment income tax of 3.8% beyond your capital gains tax rate.
