In a recent post, I recommended that the typical startup should start as an LLC (limited liability company) and remain an LLC as long as possible. One ever-present challenge with LLCs is that most entrepreneurs (present company included) like to try to force-fit corporate concepts and structures into an LLC format. This is not always easy or even possible — pass-through (partnership-style) taxation means that LLC membership interests are very different than corporate stock. These differences have a big impact on equity incentive compensation for employees.

In the corporate context, options are far and away the most common form of equity incentive compensation. In the LLC context, options are rarely used because they have uncertain, and largely unwelcome, tax consequences. So, how do an LLC’s employees get to share in the growth of an LLC’s value?

Capital Interest and Profits Interests

An LLC membership interest can either be a capital interest or a profits interest. A basic capital interest is similar to common stock — it has the right to a proportionate share of the capital, profits and residual value of the LLC. A basic profits interest is just like a capital interest, except that it gets a zero dollar interest in the value of the company on the date of grant. Like capital interests, profits interests share in the profits and residual value of the LLC (other than the initial value on the date of grant). In other words, the profits interest starts out with a zero dollar value and grows in value as the LLC grows in value. In this way, it is most similar to SARs (stock appreciation rights) in the corporate context.

One of the things that routinely causes confusion is that the term “profits interest” is a partial misnomer. The word “profits” in this term includes both actual profits and “value accretion”. Of course, true profits are allocated to members as they are earned. In addition, when an LLC grows in value and an allocation event occurs, the LLC allocates the value accretion as if it were profits. (Note that allocations of value, unlike actual profits, do not automatically result in taxable income for the recipient of the allocation.)

Profits interests are, in fact, a great way to provide equity compensation to LLC employees. Assuming certain tax rules are met, the profits interest is not taxable on the date of grant but still participates in the upside growth of the business. The problem is that an employee who owns a profits interest is a member (owner) of the LLC and, therefore, cannot be treated as an employee for tax purposes (they may still be considered an employee for federal and state employment law purposes). Instead of receiving income reported on the standard W-2 tax form, they receive their income reported on a K-1. This simple difference has several corollaries: (1) the employee has to file quarterly estimated tax payments instead of having taxes withheld from every paycheck; (2) the company does not match FICA payments but instead the employee has to pay ‘both sides’ of the tax; and (3) certain benefits to the employee, such as medical insurance, may be taxable. Generally speaking, an employee who receives a profits interest needs to receive higher compensation in order to have the same after-tax money as an employee who does not hold a profits interest.

Unit Appreciation Rights

An alternative to profits interests for an employee that does not want to have the tax attributes of a member is the issuance of UARs (unit appreciation rights). UARs have similar (not identical, but similar) economic consequences to profits interests, but still allow the employee to be treated as an employee for tax purposes. It should be noted that profits interests give rise to income that is taxed at either ordinary income rates or capital gains rates depending on the source of the underlying company income (typically the sale of the business will create mostly capital gain), while UARs will always give rise to income taxed at ordinary income rates.