In a startup company, its common for certain employees to be compensated with some form of equity. When you incorporate, you would adopt a stock option plan and then issue options to the corporation’s employees to compensate them for their past services and to incentivize them to stay and keep up the hard work – make sure you vest!
With LLCs becoming ever more common, the owners of a startup organized as an LLC want to be able to compensate and motivate their employees and contractors in the same manner. They can do so by granting employees LLC profits interests.
By way of background, LLC owners each have membership interests, which can be represented by membership units. The membership interest carries with it the ownership interests of the members, including capital interests – which carry with it the the right to current LLC value as well as the right to the future profits. The capital interests is what you think of when someone says they own a business, they indirectly own what the business owns and have the right to enjoy any increase in the value of the business. If, for example, the LLC is sold to a third party or liquidated, the owner of the LLC capital interests would receive value for his or her proportionate share of ownership of the LLC (or its assets).
An LLC profits interest represents only ownership in the LLC’s future profits. In other words the holder of an LLC profits interest enjoys any increase in the value of the LLC, and profits interest at the time of grant has zero value. In IRS Rev. Proc. 93-27, the IRS drew a distinction between a “Capital Interest” and a “Profits Interest”. The former being taxable at time of grant and the later not. The test to determine the two types of interests is generally referred to as the “constructive liquidation test”, which you use by viewing the interest granted and determine that if on the day of the interest grant, the company were to liquidate (either shut down or be bought for cash), would the holder of the interest be entitled to receive anything on that day? If the answer is yes, even just a cent, then the interest is a capital interest and not a profits interest.
Prior to recent IRS Revenue Rulings there was some uncertainty as to whether when the profits interest is granted, the recipient should recognize compensation income in the year of grant in the amount of the FMV of the interests. Now it is clear, or at least as clear as the IRS can be. In Rev. Proc. 93-27 4 & 2001-43, the IRS laid out four criteria, which if met should not trigger income to an employee for services rendered:
(1) no substantial and predictable income stream,
(2) profits interest is not sold for two years,
(3) the interests are not publicly traded, and
(4) the LLC treats the recipient as a member.
These four must be met at the time of grant, regardless of whether it is vested. Vesting adds another layer of complexity onto it. We will discuss in a later post.
Profits interests can be granted by the Company in different ways. No matter how you do it, it requires a new class of units (or membership interests) be created, a valuation of the company be obtained (or a value agreed upon). The profits interest can be granted just like other membership interests, or they can be granted through a more formal Profits Interest Plan and Profits Interest Agreement.