Colorado Real Estate Journal - August 5, 2015
Historically, corporations’ 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 partnership and limited liability company (the term LLC will encompass both structures in this article) structures being more 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 tangential considerations on the use of equity compensation in an LLC setting. As a final note, July 22nd, Treasury issued proposed regulations that would change the taxation of LLC interests issued for services. These proposed regulations are not effective until issued in final form, but we call your attention to them. Profits interest vs. capital interest. Equity given to employees can be classified as a profits interest or a capital interest. The distinction lies in what employees receive on the date of the award. If they receive a right to future income or capital appreciation, it’s a profits interest. If the LLC were liquidated immediately after they receive the interest and they receive a share of the liquidation proceeds, they received a capital interest. Profits interest. The taxation of the employee on receipt of a profits interest is straightforward: There is no taxable compensation 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 Procedures 93-27 and 2001-43 state the employee must 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 non-vested and whether the income is distributed in cash or not. In exchange for this treatment, the Revenue Procedures clarify that, even absent a timely Section 83b election, there will be no taxable compensation to the employee at the time the interest actually vests, regardless of the value of the interest at that time. Capital interest. If the interest 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 capital 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 compensation to the LLC on the date of receipt (if fully vested at that date), or the date there is no longer 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 reporting 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. Commissioner, added clarity on who should report the taxable income. The tax court ruled any undistributed income allocable to the non-vested capital interest is not taxed to the employee owning the non-vested 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. Annual K-1 reporting. While receipt of a K-1 may be commonplace, it can be a frustrating 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 cannot 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 federal and state tax via quarterly estimated tax payments; the employee also likely is responsible for 100 percent of the FICA tax via the self-employment tax. In addition, a partner also has additional limitations regarding how certain benefits, such as health insurance, are treated. 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. It may turn out that a good old-fashioned bonus arrangement tied to capital appreciation can achieve the same result without the equity ownership complexities of incentive interests. This article is for general information purposes only and is not to be considered as legal advice