Incentivizing Employees of an LLC with Profits Interests
Employers often seek ways to incentivize their employees beyond base pay. This additional incentivization can come in the form of raises, traditional bonuses, a long-term incentive plan, a deferred compensation plan or phantom equity. However, these methods are all subject to ordinary income tax. Limited liability companies offer an alternative known as a profits interest.
A profits interest provides an employee with a financial stake in the growth of the company above its value as of the date of the grant. Structured properly, the profits interest when initially granted will have little to no value, meaning the ordinary income tax consequences incurred by the employee, if any, will be negligible. Assuming the long-term capital gain holding period is satisfied, any appreciation in the profits interest will be taxed at the long-term capital gains rate when the interest is sold.
Existing members and managers must exercise caution when issuing profits interests because an employee who receives a profits interest becomes a member of the company and the existing members and managers may not want the newly admitted profits interest holder to have the same rights. Thus, prior to issuing a profits interest, the existing members and managers typically will want to make sure that the company’s operating agreement restricts profits interest-holder rights. This can be accomplished by creating a separate class of membership interests for profits interest holders that may include limited voting rights, provisions that profits interest holders only share in sale proceeds and not in the company’s operating cash flow and which interests have different forfeiture and redemption rights upon the occurrence of an employee’s termination from the company.
However, in the case of Illinois limited liability companies, a profits interest-holder’s rights may not be completely curtailed. For example, the company’s operating agreement may not: (i) unreasonably restrict a member’s right to information or access to records; (ii) eliminate or reduce the implied contractual covenant of good faith and fair dealing; or (iii) restrict the right to approve a merger, conversion or domestication.
A company should understand fully the ramifications of issuing a profits interest to a key employee and what this means to both the current members and potential profits interest holders to determine if this is the right plan for all involved. Additionally, while not the subject of this article, it is important for a company to consider the following concepts, among others, when issuing a profits interest: (a) establishing a company value upon the date of grant; (b) holding periods; (c) vesting; (d) forfeiture; (e) filing Section 83(b) elections with the IRS; and (f) waterfall provisions, whether structured as a make-up distribution or just a share of future growth.