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Limited liability companies (LLCs) are rapidly becoming the favored vehicle through which many entrepreneurial companies are choosing to carry on their business. While an LLC has many corporate characteristics, most LLCs are taxed as partnerships. This dual nature creates significant benefits, but also significant challenges—particularly in the area of equity compensation.

The use of equity compensation plays a significant role in compensating and retaining key personnel. Traditional forms of corporate equity compensation such as incentive, or nonqualified, stock options are not available to an LLC. Nevertheless, an LLC does have several compensation tools in its arsenal through which it may provide incentive compensation.

The basic forms of equity compensation that an LLC may issue include: 1) a profits interest, 2) a capital interest, and 3) an option to acquire a capital interest. While there are various tax and nontax considerations that must be addressed in selecting the appropriate form of incentive compensation, the following paragraphs raise some of the more important tax consequences and unresolved issues associated with these arrangements.

A "profits interest" generally entitles the recipient to share in the future earnings and appreciation in the value of the LLC arising after the date of grant. The transfer of a profits interest will not result in income recognition to the service provider if certain requirements are satisfied, including the requirement that the service provider not dispose of the profits interest for two years. Correspondingly, the LLC will not be entitled to a tax deduction. A profits interest is generally desirable when the goal is to avoid immediate income recognition.

A "capital interest" generally entitles the recipient to an immediate interest in the underlying assets of the LLC, as well as the ability to share in future profits. The recipient of the capital interest will generally recognize income upon the grant of the capital interest equal to the excess of the value of the interest received over the price paid, if any. The LLC will be entitled to a deduction equal to the amount of compensation recognized by the service provider. The grant of a capital interest may be 100 percent vested or, alternatively, subject to a vesting schedule (similar to restricted stock).

As an alternative to granting an outright capital interest, an LLC may also grant a right (e.g., option) to acquire an interest in the underlying assets of the LLC (i.e., a capital interest). Upon exercising the option, the recipient will have an immediate interest in the underlying assets and future revenues of the LLC. The recipient will not recognize income upon the receipt of the option. Rather, upon exercise, the service provider will recognize income in an amount equal to the excess of the fair market value of the LLC interest received over the exercise price, if any, and the LLC will be entitled to a corresponding deduction.

While the tax consequences flowing from the above arrangements appear relatively straightforward, there are a number of issues that require additional consideration. For instance, one significant drawback to the issuance of a capital interest is that the LLC may recognize gain on the transfer equal to the excess of the fair market value of the LLC interest transferred over the LLC's basis in its underlying assets. Therefore, unlike a corporation, an LLC may have its compensation deduction offset by a gain on a deemed transfer of its assets.

Of greater concern is the Internal Revenue Service's position that an LLC member cannot also serve as an employee of the LLC in which he or she is a member (i.e., a partner). This position can have unanticipated employment tax and benefit consequences. A member may be subject to self-employment taxes on his wages (at a rate of 15.3 percent), whereas an employee's share of FICA is only 7.65 percent. It is imperative that the LLC address this concern with its employees up front in order to avoid unanticipated tax consequences from the employee's perspective. Some form of gross-up payment may be required to place the employee on equal footing with his corporate counterpart. Likewise, an LLC must also address whether the distributions it makes to its members are subject to self-employment tax. While LLC members may be considered limited partners and, therefore, not subject to self-employment tax on their share of the partnership distributions, it is imperative that this issue and many similar issues be addressed in advance to avoid any unexpected surprises.

TAX ADVICE DISCLAIMER: Any federal tax advice contained in this communication (including attachments) was not intended or written to be used, and it cannot be used, by you for the purpose of (1) avoiding any penalty that may be imposed by the Internal Revenue Service or (2) promoting, marketing or recommending to another party any transaction or matter addressed herein. If you would like such advice, please contact us.