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A limited liability company (“LLC”) cannot issue stock options to employees as a form of compensation because an LLC does not have shares of stock. Stock is a term that relates to corporations; corporations have shares of stock as the unit of ownership, LLC’s have membership interests or units.
It is possible for LLCs to provide a form of option ownership plan to employees if the LLC is treated as a corporation for tax purposes, issues ownership in form of units with equal voting and liquidation rights, the units in the plan have the highest voting and dividend rights provided by that LLC, the LLC issues dividends and allocates profits and loss pro rata. However, most LLCs are taxed as partnerships and many do not conform to the other requirements listed here.
For LLCs that cannot use option plans, there are mechanisms by which an LLC can provide compensation to employees that is similar to a more traditional stock option. These are generally called “profits interests.” If you are thinking about providing profit interests to your LLC employees, seek the advice and counsel of an experienced San Diego corporate attorney and also the guidance of a trusted tax professional.
At a very general level, and there are many nuances, a “profits interest” is a right to receive the designated percentage of the future profits of the LLC as set forth in the applicable vesting schedule. The key is that the profits interest does not grant an ownership interest in the current value of the LLC; but rather an interest in the future profitability of the LLC. If the profits interest grants ownership of current value, then it is granting a standard ownership interest in the LLC. Most profit interests are designated with a specific vesting date or a rolling vesting schedule. Vesting schedules can be time-based or calculated based on various predetermined defined goals or performance metrics. It is also necessary that the grant list the various definitions and criteria for what constitutes profits and profitability. Profits interests can be granted by the LLC to employees and can be granted to non-employees working with the LLC such as managers and service providers. Again, professional legal and tax guidance is needed because the IRS rules and regulations are complex. If done correctly, the grant of profits interest to the recipient can be tax free (although payments of profits are likely to be taxable to the recipients).
Another reason for the complexity is that issuing profits interests has the effect of changing the tax status of the recipient for tax purposes and for purposes of who is considered to be a “member” of the LLC by the IRS. Even if not granted formal membership in the LLC, according to the tax treatment required by the IRS, once a given individual who was an employee of the LLC is given a profit interest, that person ceases to be an employee and must be paid as a member for tax purposes. This conversion from W-2 employee to a type of partner receiving a Schedule K-1 has individual tax consequences. Thus, again, professional legal and tax advice should be sought before issuing profit interests. Employees should be made aware of how the change will affect them. As noted, profit interests can be granted to non-employees. But, again, that affects the status of those non-employees as they become LLC members for tax and other purposes.
Profit interests are a great tool for incentivizing employees and those working with your San Diego LLC. However, as with stock options, the tax rules are complicated, and any grant of a profit interest must be done correctly to accomplish the desired goals.
Contact San Diego Corporate Law Today
For more information, contact attorney Michael Leonard, Esq., of San Diego Corporate Law. Mr. Leonard can be reached at (858) 483-9200 or via email. Mr. Leonard provides a full panoply of legal services for businesses and proudly serves the San Diego business community. Like us on Facebook.