Is it more complex to make a compensatory equity grant from an LLC (taxed as a partnership) than from a corporation?
- Granting service providers an equity interest in an LLC is much more complex than granting an equity interest in a corporation. Here are just a few of the reasons:
- Once an employee receives equity in an LLC, the employee can no longer be considered an employee for federal income tax purposes. Instead, for federal income tax purposes, they have to be treated as “partners.” (They can still be employees for state law purposes.) This means that instead of having income and employment taxes withheld from their paychecks and receiving a Form W-2, they will instead have to make quarterly tax deposits themselves as a self-employed person, pay self-employment taxes, and receive a Form K1 from the company.
- Employees who receive an equity grant in a corporation, in contrast, continue to retain employee status and receive a W-2 reporting their salary/withholding information.
- W-2 reporting (v. Schedule K1 reporting) is generally easier to understand.
- Usually when a company wants to grant an equity award to a service provider, it doesn’t want the equity award recipient to owe tax upon the receipt of the award. To do this in either an LLC or a corporation, it is necessary to value the equity to be awarded (and in the corporation context grant a stock option at FMV). However, in an LLC, there is really no corollary to granting a FMV stock option. Unless the recipient of the award pays FMV for the award, it is necessary to take the additional steps to ensure that the equity award qualifies as a “profits interest.”
- A “profits interest” is defined in Rev. Proc. 93-27 and 2001-43 to mean an interest that entitles the holder to only a share of the future profits of a company. When the LLC holds assets that have appreciated before the equity grant, in order to grant a profits interest to the recipient, adjustments need to be made on the books of the LLC to reflect the pre-equity grant appreciation in the capital accounts of the existing members. This is often referred to as a “book-up”. The federal tax accounting required to “book up” the capital accounts can be complex. Frequent capital account “book-up” adjustments resulting from compensatory grants can make this difficult for the members to understand and expensive to track, especially if the value of the equity fluctuates significantly between equity grants. Corporations do not have to track capital accounts.
- Suppose Moe, Larry and Curly own an LLC together. They have been working on the LLC’s business for several years. They believe the business is worth $1 Million. Moe, Larry and Curly’s capital accounts, for tax purposes, aggregate to $100,000. Their capital accounts don’t aggregate to $1M because the company has unrealized (unbooked) appreciation in its assets of $900,000. The LLC wants to grant a 10% equity interest to Noob. The fundamental question is – do Moe, Larry and Curly want to give Noob 10% of the current $1M value – a $100,000 equity award. Or do they want to give Noob a 10% share of appreciation in the business from $1M and up?
- Usually Moe, Larry and Curly want to give the Noob just a share in future appreciation in the business above and beyond $1M. To do this in the LLC context, they have to book up their capital accounts to aggregate $1M. This is not necessary in the corporate context.
When favorable circumstances exist, electing to organize a business as an LLC can produce significant tax and legal advantages. However, when it comes to administering equity grants, one should carefully consider the costs and benefits of the additional tax, legal and accounting complexities associated with granting LLC equity interests. Administering a stock option and/or a restricted stock plan in a C corporation context is likely to be much simpler.