¶ 1501
Overview
Scope of the chapter. An LLC that wishes to reward the people who build its business with a share of its growth has a choice that a corporation lacks. A corporation can issue stock or options, each of which carries a value at grant and a set of tax consequences fixed by statute and regulation. An LLC taxed as a partnership can issue an interest in future profits alone: an interest that gives its holder nothing if the LLC were liquidated on the day of grant, and a share of everything the LLC earns or gains afterward. This chapter examines that interest, the profits interest, and the alternatives to it. It treats the distinction between capital and profits interests, the administrative safe harbors on which the tax treatment of profits interests rests, the 2005 proposed regulations that would have replaced them, the interaction with section 83 and vesting, the mechanics of thresholds and catch-up allocations, the three-year holding period of section 1061 for carried interests, the status of a member who also works for the LLC, the alternatives of options, phantom equity and appreciation rights, the securities-law exemption for compensatory grants, and the state-law mechanics of issuance, termination and repurchase.
Why the form matters. The attraction of a profits interest is that, properly structured, its receipt is not a taxable event, and the holder's later share of the LLC's capital gain retains its character as capital gain. A corporate employee who receives stock worth $100,000 has $100,000 of ordinary income on receipt or on vesting. An LLC service provider who receives a profits interest that would entitle her to $100,000 if the LLC later sold its business has no income on receipt and, if the sale produces long-term capital gain, reports her share as long-term capital gain. The difference can be large. It is available only to entities taxed as partnerships. An LLC that has elected to be taxed as a corporation, including one that has made an S election, cannot issue a profits interest in the tax sense (see infra chs. 39 and 43).
The limits of the form. The favorable treatment rests largely on administrative guidance. The receipt of a profits interest is not addressed by any provision of the Code, and the regulations that would have addressed it were proposed in 2005 and never finalized. A practitioner relying on the safe harbors must satisfy their conditions, observe their exceptions and accept the risk that the guidance may change. The service provider who receives a profits interest also becomes a partner for tax purposes, with consequences for payroll, benefits and self-employment tax that surprise many recipients who were previously employees. Those costs are examined in ¶ 1570.
Organization. The chapter proceeds in nine parts: capital and profits interests (¶ 1510); the safe harbors and the cases that preceded them (¶ 1520); the 2005 proposals and later guidance (¶ 1530); vesting and section 83 (¶ 1540); thresholds, hurdles and catch-up allocations (¶ 1550); section 1061 and carried interests (¶ 1560); the status of the service provider as partner or employee (¶ 1570); alternatives and securities law (¶ 1580); and issuance, termination and drafting (¶ 1590).