The following article is reprinted from The M&A Tax Report, Vol. 12, No. 4, November 2003, Panel Publishers, New York, NY.

ARE WE HAVING FUN YET? EMPLOYEE EQUITY CHOICES FOR LLCs

by Dominic L. Daher and Robert W. Wood

Since the advent of the check-the-box regulations, LLCs have enjoyed run-away popularity (and for good reason). See Daher and Wood, "Bye Bye Love, Bye Bye Happiness: Is Giving Up Flow-Through Taxation to Go Public Really Worth It?" (October issue, page 5). As most of you know, for federal income tax purposes, an LLC (unless it has made an affirmative election to the contrary) is taxed as a partnership. See Treas. Reg. § 301.7701-3(b)(1). This is one of the many reasons for LLC's popularity. How can you beat flow-through taxation combined with limited liability?

Who wants to pay an entity level tax? Why would you want be taxed under the unkind corporate tax regime if you can avert it? Of course, the members of an LLC are generally only taxed once on the earnings of an LLC. See I.R.C. § 701. Hence, LLC members have the advantage of enjoying the same limited liability protection as corporate shareholders, yet being taxed as a partnership (it's like Christmas everyday). All that being said, many people don't realize what employee equity choices are available for LLCs.

How do I get my Piece of the Pie?

There are four primary vehicles for an LLC to provide its employees with equity compensation, all of which could also be used by a corporation: (i) non-qualified options; (ii) restricted equity bonuses; (iii) appreciation rights; and (iv) selling restricted equity interests. Which approach you might select will depend on any number of factors. As would be the case with a corporation, should an LLC decide to utilize any of the foregoing employee equity vehicles, it could create an additional class of non-voting membership interests to insure the principles maintain control of the company (you don't want to end up working for your employees).

With all of the devices we describe here, except with appreciation rights, you will need to give away or sell actual equity in the LLC. In contrast, appreciation rights allow an LLC's employees the economic equivalent of participating in the future growth of the company, but the LLC does not have to give up any actual ownership or voting power.

Non-Qualified Options

A non-qualified option provides the recipient a right to buy ownership (usually stock in a corporation, but here membership interests in an LLC) at a specific price for a definite period of time. Usually the granting company sets the price at the fair market value at the time the option is granted. However, where the employer wants to give the employee or worker instant appreciation, the option price can be set below the current fair market value.

Recipients of non-qualified options are not taxed when the option is granted, but instead, only when the holder exercises the option. Any increase in value from the grant date until the exercise of the option is considered ordinary income and taxed at ordinary income rates. Upon exercise, the issuing company receives a deduction equal to the holder's taxable income with respect to the option. For tax purposes, the effect on the company will mimic its payment of compensation.

The non-qualified option is a popular choice for employers because it provides an incentive to the worker without immediately upsetting the equity structure of the company, and significantly burdening the company financially. Moreover, a vesting schedule for the exercise of options can be set at whatever length is desired (might not want to give the new guy options that vest immediately), and the company can personalize incentive goals for individual workers.

Restricted Equity Bonuses

Instead of awarding options, a company (either a corporation or an LLC) may decide to reward employees with bonuses consisting of equity interests. In a typical equity bonus program, the equity interests are awarded without cost to the participants, but with restrictions affecting their resale (you don't want these babies falling into the wrong hands). The equity interests become available to the participants as restrictions lapse over time, generally after a continuous period of employment. When the restrictions ultimately lapse, the participant is taxed (at ordinary income rates) on the value of the equity received. If the participant prefers, he can make an election under I.R.C. § 83(b) to pay the tax at ordinary income rates at the time the restricted membership interest is granted. The tax paid is based on the value of the equity at the time of election. Thereafter, when the restrictions lapse and the equity is sold, (assuming that 12 months have passed between the election and sale), the participant will pay tax at favorable capital gains rates on any income earned. (For a discussion of I.R.C. § 83(b) elections, See Wood, "Stock Options vs. Restricted Stock: The Following Microsoft" August issue, page 5).

Equity bonus programs are popular among small and medium sized firms because of their flexibility. The restricted equity granted by the company addresses the company's desire to foster worker loyalty by allowing the company to place buy back rights on the equity should the worker leave the company.

One drawback of the equity bonus program is the company's inability to immediately deduct the value of the shares granted. Specifically, the company can only take its deduction in the amount of the participant's ordinary gain at the time of exercise. That may be many years after the equity was initially granted.

Appreciation Rights

Appreciation rights, commonly known as stock appreciation rights, or phantom stock rights, involve the creation of units that are analogous to shares of stock. Although traditionally used with corporations and stock, appreciation rights can be used by LLCs. Recipients are granted, without payment, appreciation rights in the company's equity.

However, the appreciation rights contain no voting rights nor do they have any actual equity value (hence the name phantom stock when used by a corporation). This type of "equity" tracks the company's actual equity, and the company pays participants income based on an increase in the value of that equity. There is no tax to the employee when the appreciation rights are granted. Instead, ordinary income treatment is applied when the company pays the employee for the value of the equity appreciation. Upon payment, the company receives a deduction for compensation paid.

For small companies, the upside of this appreciation right approach is that there is no worry of diluting actual equity. Disadvantages of the appreciation right approach include the difficulty of continuously valuing the company's equity, and the reduction in earnings caused by appreciation payments that are treated as compensation.

Restricted Equity Sales

Another approach is simply to sell restricted membership interests in the LLC to key employees at a reduced price. Like the bonus plan discussed above, no income tax implications would arise until the restrictions lapse, at which time the participant would owe tax at ordinary income rates on the difference between the purchase price and the current fair market value. This is perhaps the least appealing plan from the employees' perspective since the employee would have to purchase the equity. However, the purchase price can be set at a bargain level providing equity at a reduced price

What about ISOs?

So let's cut to the chase, what about ISOs? Unfortunately, under current law, qualified options can only be issued by corporations. Alas, we can only hope that sometime in the near future Congress will consider amending Section 422 to afford LLCs the tax benefits currently provided only to corporations.

Are We Having Fun Yet? Employee Equity Choices for LLCs, by Dominic L. Daher and Robert W. Wood, Vol. 12, No. 4, The M&A Tax Report (November 2003), p. 1.