Profit Interests in California Limited Liability Companies

A limited liability company is a type of legal entity that possesses many of the same characteristics as a standard corporation. A limited liability company, or LLC, is attractive to many business owners because it combines the limited liability feature of a corporation with the flexibility of a partnership. A key component of the flexibility offered by an LLC is related to how it is taxed. The members of an LLC may elect to have it taxed like a partnership, thereby allowing for pass-through taxation. Although these unique characteristics offer a clear benefit, they can also make compensating LLC members for their equity in the company more complicated.

90376_accounting_calculator_tax_return.jpgOne common way that LLCs motivate their employees or service providers to grow and improve the business is to give them an equitable interest in the company. There are two basic forms of equity compensation in an LLC: the profit interest and the capital interest. A profit interest allows the holder to share in the profits and residual value of the LLC, while a capital interest is an ownership in both the LLC’s future profits and its current and future assets upon liquidation.

The recipient of a profit interest receives distributions of future profits of the LLC and an equity interest based on the increased value of the company after the grant of the profit interest. For example, ABC, LLC grants a 5% profit interest to an employee on January 1, 2014 at which time the value of ABC, LLC is $10,000,000. At the time ABC, LLC is sold, it is valued at $15,000,000. The employee’s interest at the time of sale is equal to 5% of $5,000,000 (the increase in the value of the company since the grant date) or $250,000.

Issuing profit interests to employees or service providers of an LLC is similar to a corporation issuing stock options. Like a stock option, a profit interest has little worth unless the LLC increases in value after the date the interest is granted. Usually, a profit interest will be conferred through a written agreement establishing the specific terms of the interest including in most cases a vesting schedule. Further, a profit interest will generally be subject to a repurchase right or right of first refusal by the LLC should the holder cut ties with the LLC or attempt to transfer or sell the interest.

Tax Implications Of Profit Interests

As mentioned above, the grant of a profit interest can create some complex tax issues. Because each member of an LLC is treated as a direct owner of the company’s assets, liabilities and operations, each member is subject to tax on the LLC’s operations. Accordingly, each member must individually report their respective shares of the LLC’s profits and losses. A holder of a profit interest will be a member of the LLC to the extent of their interest and will therefore receive a share of any pass-through items of income, loss and deductions from the company. This also means that the profit interest holder may, for tax purposes, be considered self-employed and subject to the self-employment tax.

Another complication with the granting of profit interests is the associated administrative costs involved with managing such interest. Any time an LLC grants a profit interest, it must determine the value of the company at the time of the grant so that any subsequent increase in the value of the profit interest can also be calculated.  As valuing a company can be a complex and expensive process, the frequent granting of profit interests in an LLC can quickly become a heavy burden.

Presently, the grant of a profit interest is not a taxable event for the recipient, and, if the interest is held for more than one year, distributions received upon the sale of the company are treated as long-term capital gains.  On the other hand, the grant of a capital interest is a taxable event.  The tax is essentially levied on a phantom income.  For instance, if an service provider is granted a 10% membership interest in the company worth $500,000, he will be taxed on his share ($50,000) without actually having received any monies. See Taxation and Sweat Equity

Due to the various complications involved in granting profit interests in a California limited liability company, it is advisable to consult with an attorney during the process.  If you have questions about equitable interests in LLC’s, consult a San Diego corporate attorney today.

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