LLCs taxed as partnerships as a choice of entity have their drawbacks, which we have discussed elsewhere. However, LLCs do have one advantage over corporations when it comes to granting equity interests to service providers–they can grant what is know as profits interests to their partners.
See IRS Rev. Proc. 93-27 and 2001-43. A profits interest is an interest in an entity taxed as a partnership that entitles the holder to a share of profits in the entity going forward (and no share of the liquidation proceeds if the entity were liquidated immediately after receiving the interest).
The receipt of profits interest is not taxable to the recipient. This is different from and a more advantageous treatment than the receipt of stock of a corporation by a service provider. When a service provider to a corporation receives stock, the service provider will have an immediate tax impact if the stock is fully vested or if the service provider makes a Section 83(b) election. If the stock is not fully vested, the service provider will have a tax impact upon vesting–when the stock may have risen in value.
The recipient of a profits interest does not have a tax impact upon receipt or vesting.
(See also IRS Notice 2005-43: “This notice addresses the taxation of a transfer of a partnership interest in connection with the performance of services. In conjunction with this notice, the Treasury Department and the Internal Revenue Service are proposing regulations under § 83 of the Internal Revenue Code. The proposed regulations grant the Commissioner authority to issue guidance of general applicability related to the taxation of the transfer of a partnership interest in connection with the performance of services. This notice includes a proposed revenue procedure under that authority. The proposed revenue procedure provides additional rules for the elective safe harbor under proposed § 1.83-3(l) for a partnership’s transfers of interests in the partnership in connection with the performance of services for that partnership. The safe harbor is intended to simplify the application of § 83 to partnership interests and to coordinate the provisions of § 83 with the principles of partnership taxation. Upon the finalization of the proposed revenue procedure, Rev. Proc. 93-27, 1993-2 C.B. 343, and Rev. Proc. 2001-43, 2001-2 C.B. 191, (described below) will be obsoleted. Until that occurs, taxpayers may not rely upon the safe harbor set forth in the proposed revenue procedure, but taxpayers may continue to rely upon current law, including Rev. Proc. 93-27, 1993-2 C.B. 343, and Rev. Proc. 2001-43, 2001-2 C.B. 191.”)