a. Design:
i. As you may know, limited liability companies (“LLCs”) have become a very popular form of business organization. They provide a “liability shield” for their owners, and are similar to S corporations and partnerships in that they are pass-through entities for income tax purposes. However, unlike S corporations, ownership interests are in the form of membership interests (or “units”) rather than stock.
ii. When businesses first started to use the LLC format, executive compensation attorneys were faced with the issue of how to provide equity incentives to individuals. At first, they mimicked what they did for corporations, and established “unit option plans” that were virtually identical to stock options, but were based on LLC units rather than shares of corporate stock.
iii. However, a much more tax-efficient form of equity grant has been favored by the owners of many LLCs and their legal advisors. This is the so-called “profits interest” which, in essence, is an interest in the increase in value of a certain number of units from the time the interest is granted to the date the LLC is liquidated or the interest is redeemed.
iv. In virtually all cases, LLC operating agreements are drafted to provide that profits interests are paid out upon a liquidation of the LLC. In the case of an operating company, this would work in the case of a sale of the LLC’s assets and the subsequent liquidation of the company and distribution of its cash assets. However, in many cases, operating companies are sold in equity, rather than asset, transactions. The structure of an equity transaction would necessarily be very complicated in order to insure that the holders of the profits interests would receive proceeds that do not exceed the appreciation in their interests from the date of grant. The easiest way to deal with the equity-sale scenario is to establish a two-tiered structure. The operating company would be a single-member LLC which is wholly owned by a “Management LLC” in which all individual investments (including investments in whole units and profits interests) are made. If the operating company was sold in an equity transaction, the Management LLC would receive the proceeds from the sale and then liquidate (whereupon distributions can be made to the holders of the various equity interests of the Management LLC pursuant to the liquidation provisions of the operating agreement). Similarly, if the assets of the operating LLC were sold, then the operating company would liquidate and distribute its cash assets to the Management LLC, which, in turn, would also liquidate and distribute its assets as described above.
b. Federal Income Tax Implications:
i. Impact on the Individual:
1. If carefully drafted, the grant of the profits interest will not be a taxable event and any gain received from the disposition of the right will be taxed at capital gains rates. Furthermore, these favorable tax consequences will apply even if the profits interests are subject to time and/or performance vesting requirements.[1]
2. The rules that must be followed to qualify for this advantageous tax treatment are quite simple:
a. Again, the profits interest must only apply to the increase in the value of the LLC from the date of grant. Thus, it must have a $0.00 value if the LLC was liquidated at the time the interest is granted. Although there is no legal requirement to do so, it would be wise to obtain a third-party valuation of the LLC as of the date of grant as an added layer of insurance that the IRS will respect the tax advantaged nature of the grant.
b. The recipients must hold their profits interests for at least two years after the date of grant.
c. The recipients must not be entitled to a certain stream of income from the LLC in conjunction with the profits interests. From an income / loss standpoint, they should be treated no better than any other equity owner.
ii. Impact on the Company:
1. The company is not entitled to an income tax deduction at the time the profits interest is granted nor at the time the LLC is liquidated.
[1] Under current rules, a “Section 83(b) election” need not be made to qualify for the capital gains treatment. However, it would be prudent to make a “protective Section 83(b) election” just as a precaution.