Page 18 —
COLORADO REAL ESTATE JOURNAL
— August 5-August 18, 2015
experience
momentum
Law & Accounting
H
istorically, corpora-
tions’ use of equity
to offer incentive for
employees has been common
practice. The use of qualified and
nonqualified stock options has
been a standard practice and tax
implications for both employer
and employee are well-settled
and accepted. With the partner-
ship and limited liability compa-
ny (the term LLCwill encompass
both structures in this article)
structures beingmore prominent,
the use of equity to compensate
employees in those structures has
been the subject of uncertain – or
at best, evolving – tax rules. We’ll
look at equity compensation
types used by LLCs and the tax
consequences as well as tangen-
tial considerations on the use of
equity compensation in an LLC
setting. As a final note, July 22nd,
Treasury issued proposed regula-
tions that would change the taxa-
tion of LLC interests issued for
services. These proposed regula-
tions are not effective until issued
in final form, but we call your
attention to them.
n
Profits interest vs. capital
interest.
Equity given to employ-
ees can be classified as a profits
interest or a capital interest. The
distinction lies in what employ-
ees receive on the date of the
award. If they receive a right to
future income or capital appre-
ciation, it’s a profits interest. If
the LLC were liquidated imme-
diately after they receive the
interest and they receive a share
of the liquidation proceeds, they
received a capital interest.
n
Profits interest.
The taxa-
tion of the employee on receipt
of a profits interest is straightfor-
ward: There is no taxable com-
pensation to the employee nor is
there a compensation deduction
to the LLC. This seems to be the
logical answer, as the employee
received nothing more than the
right to share in future income
and appreciation of the LLC’s
assets. The potentially troubling
aspect of the profits interest is the
annual allocation and reporting
of taxable income or loss on the
LLC’s Form K-1. Revenue Proce-
dures 93-27 and 2001-43 state the
employeemust include in income
his or her distributive share of the
taxable income, as determined
under the operating agreement.
This is true whether the profits
interest is vested or nonvested
and whether
the income is
distributed in
cash or not. In
exchange for
this treatment,
the Revenue
Proc edure s
clarify that,
even absent
a timely Sec-
tion 83b elec-
tion, there will
be no taxable
compensation
to the employ-
ee at the time
the interest actually vests, regard-
less of the value of the interest at
that time.
n
Capital interest.
If the inter-
est received by the employee is a
capital interest, he or she actually
received something of value on
the date of receipt. That value is
expressed in the form of a capi-
tal account, generally stated as a
dollar amount in the cap table of
the revised operating agreement.
Under Revenue Procedure 93-27,
this value is taxable income to the
employee and deductible com-
pensation to the LLC on the date
of receipt (if fully vested at that
date), or the date there is no lon-
ger a substantial risk of forfeiture
– generally the vesting date. An
employee who received a capital
interest that is fully vested will
receive an annual K-1 report-
ing his or her share of taxable
income as determined under the
operating agreement. However,
if the capital interest is not fully
vested, a recent tax court case,
Crescent Holdings LLC v. Com-
missioner, added clarity on who
should report the taxable income.
The tax court ruled any undis-
tributed income allocable to the
nonvested capital interest is not
taxed to the employee owning
the nonvested capital account;
instead, that income is allocated
and taxed to the remaining LLC
members. Stated another way,
the employee would report as
taxable income only the amount
of cash distributions (or value of
like-kind distributions) received.
n
Annual K-1 reporting.
While receipt of a K-1 may be
commonplace, it can be a frus-
trating aspect to the employee
or, to be more accurate, partner.
The employee is used to filing his
return as soon as he receives his
W-2 and a few other documents
and almost always anticipates a
refund. Now the employee will
have to wait for a K-1, might
need to make quarterly estimate
payments and could be required
to file in multiple states due to
the activities of the LLC. Perhaps
the most onerous result of the
employee now being a partner
is that, technically, he or she can-
not be both an employee and
a partner. What previously was
his salary, with withholdings and
the employer covering 50 percent
of the FICA tax, now becomes a
guaranteed payment for which
he or she is responsible for feder-
al and state tax via quarterly esti-
mated tax payments; the employ-
ee also likely is responsible for
100 percent of the FICA tax via
the self-employment tax. In addi-
tion, a partner also has additional
limitations regarding how certain
benefits, such as health insur-
ance, are treated.
While the positive benefits
of key employees being equity
owners in the LLC may be obvi-
ous, they should be looked at in
light of the effect on the econom-
ics of the LLC and the employee.
It may turn out that a good old-
fashioned bonus arrangement
tied to capital appreciation can
achieve the same result without
the equity ownership complexi-
ties of incentive interests.
This article is for general informa-
tion purposes only and is not to be
considered as legal advice.
s
Tad A.
Goodenbour,
CPA
Partner, BKD LLP,
Colorado Springs
While the
positive benefits
of key employees
being equity
owners in the
LLC may be
obvious, they
should be looked
at in light of the
effect on the
economics of
the LLC and the
employee.
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