VENTURE CAPITAL

Equity Compensation Plans for LLCs

New IRS Guidance Enhances Planning Opportunities

April 2002

By Dodd S. Griffith, Esq.*

Businesses often associate regulatory guidance with additional red tape — particularly when it comes from the IRS. Consequently, it may surprise many entrepreneurs to learn that the IRS has been very helpful in making it easier for limited liability companies ("LLCs") to offer service providers equity stakes that do not come encumbered by negative tax consequences.

LLCs offer many potential advantages to business owners. Typically, LLCs are organized to operate as a hybrid entity — offering their owners the shield against liability previously available only to corporations, and the pass-through tax benefits of a partnership available under federal law. The owners of many growing companies, particularly those with high start-up and development costs, may be able to benefit from the ability to flow partnership losses through to their personal federal income tax statements, though the right to claim such losses is subject to various IRS limitations. Similarly, established companies often find LLCs to be an advantageous means of holding an operating subsidiary, because if the company is the sole owner of the LLC, it will not be treated as separate entity for purposes of federal income tax.

Notwithstanding these potential advantages, some business people were reluctant to use LLCs because of a perceived inability to offer equity compensation plans similar to the stock option plans used by many corporations. There were a number of uncertainties concerning how such plans would be treated in the context of an LLC, and whether the grant of such equity compensation would have the unintended effect of causing the LLC's employees an undesired tax burden. Fortunately, the IRS has issued guidance that effectively alleviates these uncertainties.

The guidance comes in the form of two revenue procedures: Rev. Proc. 93-27 and Rev. Proc. 2001-43. These revenue procedures provide a roadmap that make it possible for LLCs to issue equity compensation to service providers without having to worry about unintended tax consequences to the LLC or the service provider. The first guidance removed the uncertainty about how the IRS would treat such equity compensation generally, but did not go far enough because it did nor answer questions about how vesting restrictions would effect the grant of such equity compensation. The second guidance clarified the IRS's position on how vesting provisions affect such grants.

Rev. Proc. 93-27 — IRS Guidance on the Treatment of a Profits Interest

The IRS's initial attempt at resolving the problems relating to LLC equity compensation plans, Rev. Proc. 93-27, made clear that a person who receives a "profits interest" for services rendered to a partnership as a partner or in anticipation of becoming a partner (i.e. as a service provider who receives an unvested equity stake in the LLC) will not be treated as a taxable event for the LLC or the service provider. Without going into technical detail, in the context of an LLC, a profits interest is a membership interest (or option or similar right exercisable for a membership interest) that would have a liquidation value of no more than the service provider paid for it if the LLC were liquidated immediately after it was granted. If the membership interest can be immediately liquidated for cash or other property with a fair market value that exceeds the purchase price paid, then it may not qualify as a profits interest. In such cases, however, it may be that the LLC and service provider can still obtain some tax benefit, because the taxable amount arguably may be limited to the excess of the value received over the purchase price paid. The IRS imposed certain other conditions for qualification as a profits interests, including that the interest be held for a minimum period of two years.

While Rev. Proc. 93-27 was helpful, it did not answer many questions relating to the typical situation in which a business wishes to grant an equity stake that is subject to vesting requirements. The utility of equity compensation to companies that offer it hinges on the ability to tie service providers to the company through vesting.

Rev. Proc. 2001-43 — The IRS Addresses Profits Interest Vesting Issues

The IRS was proactive in addressing this problem. Rev. Proc. 2001-43 made clear that when an LLC grants a service provider an equity interest that qualifies as a "profits interest" that is subject to substantive vesting requirements:

• The service provider will be treated as receiving the interest on the date of its grant.
   
• The IRS will not treat the grant of the profits interest or the event that triggers vesting of the profits interest as a taxable event for the service provider or LLC, if: (1) from the date of grant, and at all times thereafter, both the LLC and the service provider treat the service provider as a partner for purposes of all of their respective federal tax filings, (2) upon the grant of the profits interest or its vesting, neither the LLC or any of its members deducts any amount for the fair value of the interest, and (3) all of the conditions of Rev. Proc. 93-27 are met.
   
• That the service provider who receives the profits interest need not file an election under §83(b) of the IRS Code in order to avoid taxable income when the profits interest vests. (Note — most practitioners still advise the filing of a §83(b) election as a precaution.)

While the above discussion offers only a simple overview of some complex tax rules, the result is that business owners and investors now have certainty in structuring equity compensation packages for use with LLCs. There is no longer any need to choose between the potential tax benefits of an LLC and the benefits derived from a well constructed equity compensation plan.

*Dodd S. Griffith is admitted in New Hampshire.

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