By Joe Wallin and Dan Wright of Clark Nuber
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.
I am the founder of a company. If I formed my startup as an S corporation, can I convert it to a C corporation before the end of this year and still get 1202 status for my founder stock?
Section 1202 stock is entitled to a special tax break if held for five years. If acquired between 9/27/10 and 12/31/13 – the break is 100% (subject to a generous cap).*
No. “Qualified small business stock” means stock in a C corporation, if “at the date of issuance, such corporation is a ‘qualified small business.’” A “qualified small business” means a C corporation.
What this means is that if you initially formed your company as an S corporation and you terminate your S election before the end of this year, your founder shares will not qualify for the 1202 stock benefit (because you will have not received them when the company was a C corporation).
If you convert to a C corporation, subsequent investors may obtain the 1202 benefit, however. The reason for this? Because IRC Section 1202 (c)(1) says: “as of the date of issuance, such corporation is a qualified small business.” But shares received while the company was an S corporation cannot qualify.
The answer is different if you are currently an LLC and you incorporate. If you incorporate an LLC, your founder shares can qualify for the Section 1202 benefit.
* For more information on Section 1202 generally, please see this blog post: startuplawblog.com/section-1202-qualified-small-business-stock
By Joe Wallin and Scott Usher of Bader Martin, P.S.
It is not uncommon for founders to start their companies as LLCs and then want to or need to incorporate or convert to a corporation later. Incorporating an LLC does not have to be a difficult or expensive process. It may be, because of exceptional or unusual facts, but frequently it can be quite straightforward.
There are essentially three different ways (well, four, but more on that later) to convert an LLC to a corporation:
- You can form a new corporation, and you can merge the existing LLC (via a state law statutory merger) with and into the new corporation. If you use this method, the separate legal existence of the LLC will terminate on the merger and by operation of law the new corporation will succeed to all of the rights and obligations of the LLC.
- You can form a new corporation, and then have the LLC contribute its assets to the new corporation in exchange for the stock in the new corporation, and then you can liquidate the LLC.
- You can form a new corporation and then have the LLC’s owners assign their LLC interests to the new corporation. Immediately afterward, the LLC will be a wholly-owned subsidiary of the new corporation. You can then either continue to operate the business through the subsidiary LLC or you can liquidate the LLC into the parent corporation. Continuing to operate the business through the subsidiary LLC can work well if the LLC has a bunch of contracts that you don’t want to re-title in the name of the new corporation, or if you don’t want to re-do bank accounts, business licenses, etc. If you follow this route, the transaction looks like this:
Another method to convert an LLC to a corporation for federal income tax purposes is to “check the box” and file form 8832 to treat the LLC as a corporation, but this is not an ideal alternative. While this will change the tax treatment of the LLC, its legal structure is unchanged, causing any number of complications due to the dual status of the entity.
The biggest issue on the incorporation of an LLC is typically tax. You don’t want to trigger a tax on the incorporation of an LLC. The most common way you can do this is if the LLC has debt in excess of the basis of its assets.
One not uncommon reason to incorporate an LLC is to be eligible for a tax-free stock-for-stock exchange. If this is your motivation, you will need to avoid incorporating immediately before the exchange, as the IRS has ruled that such a series of transactions can be collapsed, resulting in a taxable LLC interest for stock transaction.
There may also be different state tax consequences among these methods. A number of states (like California) treat LLCs as separate taxpaying entities. Leaving the LLC intact may add another layer of tax filings and/or additional state tax, while merging it may require additional steps to eliminate the need for future filings.
You should always work closely with your counsel and tax advisors on LLC incorporation. It doesn’t have to be a painful process, but you will want to make sure it is done right.