Structuring LLC with Capital Interest, Profits Interest, NCO, Compensatory Option, and Convertible Debt
By Oleg Polyatskiy
Under the check-the-box regulations, multi-member LLCs are classified, by default, as partnerships for federal income tax purposes.1 Under Subchapter K of the Internal Revenue Code2 such LLCs3 may issue various types of interests. Each type of interest has different economic and tax characteristics, and is suited solely for a specific type of stakeholder. By properly aligning LLC interests and stakeholders, these interests may be used to incentivize and provide supplemental compensation to employees, re-characterize employees’ compensation from ordinary income into capital gain, defer investors’ recognition of gain, adjust investors’ level of risk and return, decrease an LLC’s interest expense, and provide other benefits. This article will describe the economic and tax characteristics of the following LLC interests and the type of stakeholders that they best suit: capital interest, profits interest, noncompensatory option, compensatory option, and convertible debt and equity.
CAPITAL Interest. The most common type of an LLC interest is a capital interest, which an LLC issues in exchange for a prospective member’s contribution of cash, property, or services. Generally, the capital interest entitles the investor to a portion of the LLC’s current value equal to the fair market value (“FMV”) of her contribution (which, generally, she is entitled to receive upon the LLC’s liquidation) and an allocation of the LLC’s future profits.
If an investor contributes cash or property in exchange for an LLC’s capital interest, the general rule is that neither the investor nor the LLC recognizes gain or loss.4 However, if a service provider contributes services in exchange for an LLC’s capital interest, the FMV of the received capital interest (i.e., the received current value) is treated as compensation, causing the service provider to recognize compensation income and entitling the LLC to a compensation deduction (to avoid this result, see Profits Interest section below).5 After being granted the interest, the new member annually receives her Schedule K-1 with allocation of LLC’s income and loss upon which she is taxed. If the member sells her interest after holding it for more than one year, she recognizes: (i) ordinary income on any gain allocated to inventory, unrealized receivables, and depreciation recapture (“hot assets”),6 and (ii) long term capital gain (“LTCG”) on the remaining amount of gain.7
In light of the foregoing economic and tax factors, it is optimal for the LLC to issue a capital interest when an investor is seeking: (i) to contribute cash or property (not services since such contribution is taxable); (ii) a rate of return that is proportionate to the LLC’s overall return; (iii) risk that is mitigated by the received capital interest that entitles the investor to receive her portion of the LLC’s value in case of a liquidation; (iv) to currently recognize her share of the LLC’s income and loss, which may be capital gain or ordinary income; and (v) upon disposition of her interest, to recognize LTCG (subject to ordinary income on “hot assets”).
PROFITS INTEREST. Generally, a profits interest is issued to a service provider in consideration for her performance of services for the LLC. Unlike a capital interest that entitles a member to her share of the LLC’s current value, a profits interest entitles the contributor solely to a portion of the LLC’s future value (i.e., profits). Having a stake in the LLC’s future profits aligns the service provider’s incentives with the remaining members to increase the value and profits of the LLC. Profits interests may be structured in a variety of ways to ensure that they properly align service providers’ incentives. For instance, profits interests may be granted that: (i) only allocate the LLC’s profits to service providers upon the sale of the LLC (no allocation of operating income); (ii) only allocate certain types of income that arise directly from the service provider’s efforts; (iii) vest only in case the service provider continues her employment with the LLC for a certain period of time; or (iv) vest only in case the LLC or service provider achieves a certain level of performance (e.g., sales volume or EBITDA-earnings before interest, taxes, depreciation and amortization). In addition to being a good incentive mechanism, a profits interest is also a form of supplemental compensation to the service provider, which may be a vital tool for an LLC to attract talent in its initial stages when cash flow to pay salaries is lacking.
A general tax principle under Code § 83(a) is that a service provider is taxed upon the FMV of property she receives in exchange for her services. With respect to a capital interest, as mentioned above, a service provider is taxed upon the FMV of the capital interest she receives in exchange for her services.8 Conceptually, a profits interest entitling the owner to future profits has value. Had the general tax principle under Code § 83(a) applied, the issuance of profits interest would be a taxable event. The service provider would be taxed upon the FMV of the profits interest she receives in exchange for her services. However, the IRS has adopted a liquidation approach for measuring the value of a profits interest for tax purposes. In Rev. Proc. 93-27, the IRS stated that it will not treat the issuance of profits interest as a taxable event as long as the granted interest would not entitle the service provider to receive any proceeds if immediately following issuance of the interest the LLC was liquidated (“Deemed Liquidation”) by selling its assets for FMV and distributing the proceeds to its members (“Liquidation Approach”). Hence, under the current tax regime, issuance of a properly structured profits interest to a services provider in exchange for services is not a taxable event for the service provider or LLC.9
To comply with Rev. Proc. 93-27, prior to the issuance of the profits interest the LLC must revalue its assets and allocate any book gain (i.e., current value that has been accrued but not recorded on books) to its current members’ capital accounts.10 The revaluation ensures that upon issuance the recipient of the profits interest is not entitled to receive any liquidation proceeds, as required under Rev. Proc. 93-27. After the issuance of the profits interest, the service provider annually receives her Schedule K-1 with allocation of the LLC’s income, at which time she is taxed on the K-1 allocation. Although the profits interest is granted in exchange for services, it entitles the service provider to a portion of the LLC’s future gain, which may be capital or ordinary. Hence, allowing the service provider’s compensation that would otherwise be taxed as ordinary income to be potentially re-characterized into capital gain. Further, if the service provider sells her interest after holding it for more than a year she recognizes LTCG (subject to ordinary income on “hot assets”); again potentially re-characterizing consideration she receives for her services from ordinary income into LTCG that is taxed at preferential capital gain rates.11
An LLC may also issue substantially unvested profits interest that is contingent upon a service provider’s continuance of employment with the LLC for a certain period of time (e.g., five years) or achievement of certain performance (e.g., two million in sales). Under Rev. Proc. 2001-43, neither the issuance nor vesting of the unvested profits interest is a taxable event as long as (i) the service provider is treated as a member of the LLC, with her salary being treated as self-employment income; (ii) the service provider takes into account her distributive share of the LLC’s gain and loss; and (iii) the LLC does not take a deduction upon the issuance or vesting of the interest.12 The IRS Rev. Proc. 2001-43 provides that neither the issuance nor vesting of the unvested profits interest will be a taxable event provided the following requirements are met: First, the service provider must be treated as a member of the LLC from the time the unvested profits interest is issued. This means that the service provider will receive an annual Schedule K-1 and her salary will be treated as self-employment income. Second, the service provider must take into account her distributive share of the LLC’s gain and loss during the time the profits interest is unvested and vested; however, if the profits interest is eventually forfeited, the service provider is prohibited from taking a deduction for the previously allocated gain.13 Third, the LLC is not allowed to take a compensation deduction upon either granting or vesting of the profits interest.
However, if an LLC’s issuance of any unvested profits interests falls outside of the protection provided under Rev. Proc. 93-27 and 2001-43, then the general tax principle of Code § 83(a) applies, causing the service provider to recognize the FMV of any vested interest as compensation taxed as ordinary income. For instance, in year 1 an LLC that is then worth $100,000 grants a service provider a 5% profits interest that will vest upon the sale of the LLC. The LLC incorrectly revalues its assets causing the service provider to receive a $1,000 capital interest in addition to the 5% profits interest, and thereby lose the protection of Rev. Proc. 93-27 and 2001-43. In year 7 the LLC is sold for $5,100,000. The service provider is entitled to $250,000 of the sale proceeds. Without the protection of Rev. Proc. 93-27 and 2001-43, Code §83(a) may characterize the full $250,000 as compensation for services, taxable as ordinary income. To avoid this draconian result, the recipient of the profits interest should make a Code §83(b) election within 30 days of receipt of the profits interest. Code §83(b) election allows the granted unvested profits interest to be treated as a vested interest.
Any appreciation of such deemed vested interest is not subject to Code §83(a). In the above example, if a Code §83(b) elected had been made, upon the sale of the LLC $1,000 of the granted capital interest would be treated as compensation taxed as ordinary income, while the remaining $249,000 would be treated as proceeds from sale of the LLC subject to capital gain tax rate and ordinary income rate upon hot assets.
In light of the foregoing economic and tax factors, it is optimal to issue profits interest when a stakeholder is seeking: (i) to contribute services; (ii) to share the upside of the LLC’s appreciation; and (iii) to potentially re-characterize consideration received for services from ordinary income to LTCG with a preferential capital gain tax rate for the service provider.
NONCOMPENSATORY OPTION. A noncompensatory option (“NCO”) tends to be a high-risk, high-return investment interest. In a common scenario, an investor pays a premium to the LLC in exchange for an option to purchase a certain portion of the LLC’s capital interest (“NCO Interest”) for a specified term and exercise price. An investor generally would exercise the option only if the FMV of the NCO Interest exceeds the exercise price. The high-risk associated with an NCO arises from the possibility that the NCO Interest may fail to appreciate above the exercise price, causing the investor to abstain from exercising the option and losing her entire investment of the premium payment (compare to a capital interest, with which the investor does not lose any portion of her investment if the LLC does not appreciate). The high-return attribute of an NCO arises from the chance that the LLC may appreciate, in which case the investor may realize a return that is disproportionately greater than the LLC’s overall growth (compare to a capital interest, with which the investor tends to realize a return proportionate to the LLC’s rate of return). By adjusting the size of the NCO Interest, the premium, exercise price, and term of the NCO, the LLC and investor can adjust the level of risk and anticipated return.
An investor’s payment of the premium for the NCO and payment of the NCO exercise price is not a taxable event for the investor or the LLC.14 However, a contribution of property for the NCO in lieu of a premium payment is treated as a taxable exchange solely for the investor, causing the investor to recognize any built-in-gain in the contributed property and the LLC to receive the property with a FMV basis.15 Until the investor exercises her option, she is not considered a member of the LLC and does not receive an annual Schedule K-1 with allocation of the LLC’s income or loss. When the investor exercises the option, the LLC revalues its assets16 to book up its capital account to FMV, and provides the investor with the LLC’s capital interest that was subject to the NCO. The investor’s basis in her capital interest consists of the aggregate amount of her premium and exercise price for the NCO. If the member disposes of her LLC interest after holding it for more than a year, she recognizes LTCG (subject to ordinary income on “hot assets”).
The characteristics of an NCO are demonstrated by the following example. Investor A pays a premium of $2,000 for an NCO that allows him to acquire a 20% capital interest in an LLC for a $50,000 exercise price within the next five years. The LLC is currently valued at $200,000, with a 20% capital interest worth $40,000. By the fourth year, the LLC appreciates to a value of $400,000, so that a 20% capital interest is worth $80,000. Investor A exercises her NCO by paying the LLC the $50,000 exercise price. Upon the exercise of the option, the LLC revalues its assets and provides investor A with an LLC interest that represents 20% of the LLC’s current FMV; her capital account equals a value of $80,000. Her tax basis in her LLC interest is $52,000. Although the investor is credited with gain on her capital account, neither investor A nor the LLC recognizes any gain for federal income tax purposes upon the premium or exercise payment. If investor A sells her interest more than a year after acquiring it, she recognizes LTCG (subject to ordinary income on “hot assets”).
In light of the foregoing economic and tax factors, it is optimal to issue NCO when an investor is seeking: (i) to invest cash as a premium payment (since contribution of property and services are taxable); (ii) a high rate of return that is disproportionate to the LLC’s overall return; (iii) a high risk of losing her entire investment; (iv) no allocation of LLC’s income and loss until the option is exercised; and (v) upon disposition of her NCO Interest, recognizing LTCG (subject to ordinary income on “hot assets”).
COMPENSATORY OPTION. The compensatory option is issued to a service provider in consideration for her performance of services for the LLC. As with profits interest, a compensatory option may be used to incentivize service providers and as a form of supplemental compensation. The option allows the service provider to purchase a certain portion of the LLC’s capital interest (“Option Interest”) for a set exercise price in the future. As with NCO, the service provider exercises her option only if the FMV of the Option Interest eventually exceeds the exercise price. Issuance of a compensatory option is not taxable unless the option has a readily ascertainable FMV.17 Unlike an unvested profits interest, the service provider cannot make an election under Code §83(b) with respect to the Option Interest. Also, unlike a profits interest, the service provider is not treated as a partner until the compensatory option is exercised (service provider does not receive Schedule K-1, and does not receive an allocation of income/loss to be recognized prior to the option exercise). The service provider continues to be an employee and report her compensation on Form W-2 (not self-employment). Upon exercising the option, the service provider recognizes compensation as ordinary income (unlike profits interests which may generate capital gain), and the LLC receives a compensation deduction, equal to the difference between the exercise price and the then FMV of the Option Interest.18
In light of the foregoing economic and tax factors, it is optimal to issue a compensatory option for service providers seeking: (i) to contribute services; (ii) to share the upside of the LLC’s appreciation; and (iii) to not receive any allocation of the LLC’s income prior to actually exercising the option, nor be subject to self-employment income.
CONVERTIBLE DEBT AND EQUITY. Generally, debt is less risky than equity,19 but its return is limited to its interest rate without sharing any upside of the LLC’s appreciation. A preferred interest in an LLC is often structured similarly to debt by having priority liquidating distribution rights but a limited rate of return. To override the limited return of debt or preferred equity, the LLC may issue convertible debt or equity. The conversion feature permits the LLC debt (or preferred interest) to be converted into an LLC capital interest that has unlimited return and shares the benefits of the LLC appreciation. In return for the debt’s (or preferred interest’s) conversion feature, the LLC is charged a lower interest rate.
Upon the conversion of debt or equity, neither the LLC nor the investor recognizes any gain or loss.20 The LLC revalues its assets21 to book up capital accounts to FMV, and provides the investor with her portion of the LLC’s capital interest. Upon the conversion of debt, the investor becomes a member of the LLC and receives an annual Schedule K-1 with allocation of the LLC’s income or loss. The basis of the investor’s new LLC interest equals the former basis of the converted debt or preferred interest. If the member disposes of her capital interest after holding it for more than a year, she recognizes LTCG (subject to ordinary income on “hot assets”).
The characteristics of convertible debt are demonstrated by the following example. Members A and B contribute $50,000 each to an LLC, and creditor C lends the LLC $100,000 at a 5% annual interest rate in exchange for a promissory note that is convertible into 25% of an LLC capital interest. During each of the first three years, the LLC has income of $5,000, all of which is paid to creditor C as interest. In the fourth year, the LLC invents a new product, dramatically increasing the value of the LLC from $100,000 to $1,000,000. Subsequently, creditor C converts her promissory note into a 25% capital interest in the LLC. Upon conversion, the LLC revalues its assets and credits new member C with a $250,000 capital account (equal to 25% of the company’s FMV). Although the investor realizes a $150,00022 gain on the conversion, neither the investor nor the LLC recognizes any gain for federal income tax purposes. Creditor C receives a $100,000 basis in her 25% capital interest. If she disposes of her interest after more than a year, she will recognize LTCG (subject to ordinary income on “hot assets”). Although prior to the conversion creditor C’s return was limited to her 5% interest rate that was taxed as ordinary income, the conversion allows her to share the upside of the LLC’s appreciation and reap a 150%23 return on her investment that will be taxed as LTCG (subject to ordinary income on “hot assets”).
In light of the foregoing economic and tax factors, convertible debt or equity should be granted when an investor is seeking: (i) to contribute cash or property (services are taxable); (ii) to have a lower rate of return in exchange for a right to share the upside of LLC’s appreciation; (iii) a lower risk due to debt’s or preferred interest’s priority distribution upon liquidation of the LLC; and (iv) with respect to debt, to change the character of income from ordinary income to LTCG (subject to ordinary income on “hot assets”).
By issuing one or more of the forgoing LLC interests, the LLC and potential stakeholders can develop a versatile capital structure to accommodate their goals of converting ordinary income into capital gain, deferring recognition of gain, incentivizing and providing supplemental compensation to employees, reducing LLC debt service expense, and related benefits.
1 TravelCenters of Am., LLC v. Brog, 2008 WL 1746987, at *1 (Del. Ch. April 3, 2008).
2 All reference to the “Code” is referring to the Internal Revenue Code.
3 In this article, all references to an “LLC” means a limited liability company that is treated as a partnership for federal tax purposes.
4 IRC 721(a).
5 Treas. Reg. 1.721-1(b)(1) & 1.721-1(b)(2). The investor’s basis in her received interest equals her basis in the contributed cash or property, increased by any gain recognized upon the contribution, including gain recognized from contribution of services. (IRC 722) The LLC’s basis in the contributed property equals the investor’s basis, increased by any gain recognized by the contributor upon the contribution. (IRC 723)
6 IRC 751.
7 IRC 741.
8 Treasury Regulation 1.721-1(b)(1).
9 Rev. Proc. 93-27, however, nonrecognition does not apply if “(1) If the profits interest relates to a substantially certain and predictable stream of income from partnership assets, such as income from high-quality debt securities or a high-quality net lease; (2) If within two years of receipt, the partner disposes of the profits interest; or (3) If the profits interest is a limited partnership interest in a “publicly traded partnership” within the meaning of section 7704(b) of the Internal Revenue Code.”
10 Treas. Reg. 1.704-1(b)(2)(iv)(f)(5)(iii)
11 Upon the issuance of the profits interest, the service provider receives a zero basis in her interest.
12 See Rev. Proc. 2001-43 and Afshin Beyzaee, Practical Considerations for Issuing Profits Interests, Part 1, TaxPractice, p12 (June 16, 2014).
13 Afshin Beyzaee, Practical Considerations for Issuing Profits Interests, Part 1, TaxPractice, p14 (June 16, 2014); Also see Treasury Regulation § 1.83-2(a).
14 Treasury Regulation 1.721-2(h). However, under Treasury Regulation 1.721-2(b)(1), premium has to be paid with cash for the non-recognition principle to apply. If investor pays the premium with property, then she will recognize the built in gain or loss in such property. Treasury Regulation 1.721-2(a)(1). Under Treasury Regulations 1.721-2(a)(1), exercise price may be paid via cash or property without recognition of gain or loss.
15 Treasury Regulation 1.721-2(b).
16 Treasury Regulation 1.704-1(b)(2)(iv)(s). Upon revaluation the increase in assets is allocated first to the investor up to her capital account.
17 IRC 83(e)(3). Grant of compensatory option is not taxable provided the option does not have a readily ascertainable fair market value.
18 IRC 83(h).
19 Debt is generally less risky than equity because upon liquidation of the entity creditors are distributed proceeds prior to equity holders.
20 Treasury Regulation 1.721-1(d)(1). However, non-recognition does not apply with respect to converting accrued interest on any debt into equity, in which case creditor recognizes income and LLC recognizes a deduction.
21 Treasury Regulation 1.704-1(b)(2)(iv)(s). Upon revaluation the increase in assets is allocated first to the investor up to her capital account.
22 $250,000 - $100,000 = $150,000.
23 ($250,000 - $100,000) / $100,000 = 150%.
Oleg Polyatskiy, JD, MBA, CPA, is an associate at Clingen, Callow & McLean, LLC. He is also currently pursuing his L.L.M. in Taxation at the Northwestern University School of Law. Oleg received his JD/MBA degree from The University of Iowa College of Law and Henry B. Tippie School of Management in 2010. He received his bachelor’s degree in finance from The University of Iowa in 2006.