Incentive stock option plan llc
Home Startups Options for Issuing Employee Equity in LLCs. 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. 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 A , corporations will almost universally grant stock options with exercise prices at or above market value on 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. 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.
Tax and Administrative Implications of Profits Interests. As a partnership for tax purposes, the LLC itself does not — for tax purposes — have a separate legal existence from its members. 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. 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.
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 A valuations. Without these Capital Account Adjustments, the intended economic deal could be frustrated.
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.
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. 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.
A significant benefit of phantom interests over profits interests is their ease of administration and implementation.
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. 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.
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.
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.
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 , 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 generally is available to issuers only where the issuances are to service providers who provide services to a majority-owned subsidiary. 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.
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. 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? The Venture Alley A blog about business and legal issues important to entrepreneurs, startups, venture capitalists and angel investors. Menu Home About Contact.
Equity and “Phantom” Equity Based Compensation for LLCs | Benefits Law Advisor
Home Startups Options for Issuing Employee Equity in LLCs Options for Issuing Employee Equity in LLCs By Asher Bearman on April 22, Posted in Startups, VC Funds and Tax.
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