Equity Incentive Compensation Plan Considerations

for a Limited Liability Company

By
James R. Browne
Barnes & Thornburg LLP
Dallas, Texas
February 1, 2019
A privately held company organized as a limited liability company (“LLC”)1 often wants
to offer to key employees and consultants the right to participate in the financial success of the
business through an equity incentive compensation plan. The principal owner and key
employees typically think in terms of a plan comparable to the equity incentive compensation
plans commonly used by publicly traded corporations. But are the typical corporate equity
incentive compensation plans right for an LLC?
This article first describes the four broad types of equity incentive compensation plans
commonly used by publicly traded corporations and most likely to be familiar to business owners
and key employees: restricted stock, phantom stock, stock options, and stock appreciation rights.
The article then explains why certain of these corporate plans may not work well for an LLC
taxed as a partnership, and describes the more tax efficient alternatives for an LLC.2
Key Conclusions:
 For an LLC that wants to award participants an equity interest in the company’s existing
capital and future profits, a phantom equity plan is generally preferable to a restricted
equity plan.
 For an LLC that wants to award participants an interest in future profits only, a “profits
interest” plan is generally preferable to awards of equity options or equity appreciation
rights, although an equity appreciation rights plan involves much less complexity and is
more attractive if the business generates primarily ordinary operating income.
 In the right circumstances, an LLC gain sharing plan (which is a modified form of a profits
interest plan) may achieve tax benefits not available in a traditional corporate or LLC
equity incentive compensation plan (i.e., deferral of income and capital gains), with
minimal tax compliance burdens for participants.

1
The considerations for an LLC classified as a partnership as discussed in this article are also applicable to a
business organized and taxed as a partnership. Special considerations apply to an LLC that elects to be taxed as an S
corporation and are beyond the scope of this article.
2
For a more comprehensive analysis of equity incentive compensation plans for partnerships and LLCs, see
Linda Z. Swartz, A Layman’s Guide To LLC Incentive Compensation (June 25, 2015), available at
http://www.cadwalader.com/uploads/books/a2ce6abeb783d13ad1de50b16e12b72a.pdf. See also Teresa Y. Huang
et. al., Equity Compensation for Limited Liability Companies (2ed. April 2013), available at
http://www.nceo.org/Equity-Limited-Liability-Companies-LLC-ebook/pub.php/id/463/; and Martin D. Ginsburg,
Jack S. Levin, and Donald E. Rocap, Mergers, Acquisitions & Buyouts, ¶ 1505 (Sep. 2015).
 Table of Contents
I.  Overview ............................................................................................................................. 3 
A.  Basic Corporate Equity Incentive Compensation Plan Alternatives ...................... 3 
B.  Comparable Equity Incentive Compensation Plans for an LLC ............................. 5 
II.  Capital and Profits Interests: An LLC Phantom Equity Plan Is Generally Preferable to a
Restricted Equity Plan......................................................................................................... 5 
A.  Tax Consequences of Corporate Restricted Stock .................................................. 6 
B.  Tax Consequences of Corporate Restricted Stock Units (“RSUs”)........................ 7 
C.  Tax Consequences of Corporate Phantom Stock .................................................... 7 
D.  Tax Consequences of LLC Restricted Equity ......................................................... 8 
E.  Tax Consequences of LLC Restricted Equity Units (“REUs”) ............................ 10 
F.  Tax Consequences of LLC Phantom Equity ......................................................... 10 
G.  Summary ............................................................................................................... 12 
III.  Profits Interests: An LLC Profits Interest Is Generally Preferable to Equity Options or
Equity Appreciation Rights............................................................................................... 13 
A.  Tax Consequences of Corporate Stock Options ................................................... 13 
B.  Tax Consequences of Corporate SARs ................................................................. 14 
C.  Tax Consequences of LLC Equity Options .......................................................... 14 
D.  Tax Consequences of LLC Equity Appreciation Rights....................................... 15 
E.  Tax Consequences of LLC Profits Interests ......................................................... 15 
F.  Summary ............................................................................................................... 18 
IV.  Hybrid Interests ................................................................................................................. 18 
A.  Profits Interest With “Catch Up” Allocation ........................................................ 18 
B.  Gain Sharing Interests ........................................................................................... 19 
V.  Holding Company ............................................................................................................. 20 
VI.  Conclusion and Summary ................................................................................................. 21 

Equity Incentive Compensation Plan Considerations for a Limited Liability Company 2

I. Overview
A. Basic Corporate Equity Incentive Compensation Plan Alternatives
Equity incentive compensation plans offered by a corporation to its key employees are
most commonly one of the following four types of plans:
Restricted Stock: The participant is awarded a specified number of shares of the
corporation’s stock, subject to vesting and forfeiture restrictions.3
Phantom Stock: The participant is awarded the right to receive, upon specified
events and conditions, a cash payment from the corporation equal
to the value of a specified number of shares of the corporation’s
stock.
Stock Options: The participant is awarded the right to purchase a specified
number of shares of the corporation’s stock at a specified
“exercise price” during a specified period. The exercise price is
typically equal to the stock’s fair market value on the grant date.
Stock Appreciation
Rights (“SARs”): The participant is awarded the right to receive, upon specified
events and conditions, a cash payment equal to the value of a
specified number of shares of the corporation’s stock in excess of
a specified “strike price”. The strike price is typically equal to the
stock’s fair market value on the grant date.4
As noted, restricted stock and stock options are payable in actual shares of the company’s
stock (i.e., they are “real” equity interests), whereas phantom stock and stock appreciation rights
are settled in cash (i.e., they are “synthetic” equity interests).
In terms of economic rights, restricted stock and phantom stock generally entitle holders
to the same economic rights as owners of corporate stock. A holder of restricted stock or
phantom stock has economic rights based on both the existing value of the corporation’s stock on
the date the award is granted (i.e., an interest in the existing shareholders’ “capital”) plus a right
to share in any appreciation in the value of the corporation’s stock (i.e., an interest in future
“profits,” including capital appreciation). Consequently, restricted stock and phantom stock are
said to entitle the holder to an interest in both capital and profits. In contrast, a holder of a stock

3
In a typical restricted stock plan, the stock awards are forfeited if the employee fails to meet certain service
period (vesting) requirements or upon other events (e.g., termination for cause), and may be subject to limitations on
sale to third parties. See the discussion of vesting and other restrictions below. For financial reporting purposes, the
term “restricted shares” refers to stock that cannot be sold due to contractual or legal restrictions, and the term
“nonvested shares” is used for stock for which the agreed upon vesting conditions (such as a minimum service
period) have not yet been met. This memorandum uses the term restricted stock to refer to outstanding stock that is
subject to vesting or other forfeiture restrictions, and not according to its financial reporting definition.
Restricted stock (as that term is used in this memorandum) is issued and outstanding at the award date, subject
to the applicable restrictions. If the stock is not issued and outstanding at the award date (i.e., the award represents a
mere promise to issue shares in the future upon satisfaction of the applicable conditions), the plan is more in the
nature of a phantom equity plan that is settled in stock rather than in cash.
4
An SAR is considered a cash settled stock option. SARs are sometimes settled in stock, but this is not
common.

Equity Incentive Compensation Plan Considerations for a Limited Liability Company 3

option or a stock appreciation right generally has no interest in the existing value of the
corporation’s stock (due to the exercise price or strike price being set at such value), and
therefore is entitled to only a share of future profits and capital appreciation (i.e., a profits
interest). This is illustrated in Table 1.
Table 1 – Classification of Common Corporate Equity Compensation Plans

Real Equity Synthetic Equity

Restricted Phantom
Capital and Profits
Stock Stock

Stock Stock
Profits Only
Options5 Appreciation Rights

As discussed in more detail below, the principal tax difference between real equity and
synthetic equity in the context of corporate stock plans is that (a) real equity interests present the
potential for long-term capital gains for the participant on “post-inclusion date” appreciation, but
at the cost of no deduction to the company for the capital gain amount, whereas (b) synthetic
equity interests are taxed entirely as ordinary income, but allow the company to take a full
deduction for the income taxed to the participant. These differences are summarized in the
following table.
Table 2 – Key Tax Distinctions Between Real and Synthetic Corporate Equity

Real Equity Synthetic Equity

Potential for capital gain on

Participant All ordinary income
post-inclusion appreciation

No deduction for post-

Company Full deduction
inclusion appreciation

There can be almost infinite variations of the basic arrangements noted above and in
Table 1. One common variation is to adjust the number of shares of stock or options awarded, or
the cash equivalent payments, based on some performance measure over a specified period (so-
called “performance based” awards). For example, the number of shares of stock awarded or
referenced in the award agreement could be increased or decreased based on the corporation’s
earnings or other performance metrics over a specified performance period relative to specified
benchmarks for the performance period.

5
Assumes the exercise price for the stock option is equal to the fair market value of the underlying stock on the
grant date.

Equity Incentive Compensation Plan Considerations for a Limited Liability Company 4

 In a typical plan, the equity or equity-linked award would be subject to vesting and
possibly other forfeiture or transfer restrictions. For example, an award might vest ratably over a
period of years. Vesting might be accelerated upon certain events, such as a change in control of
the company. If the employee quits before the expiration of the vesting period, unvested shares
would usually be forfeited. If the employee is terminated for cause or breaches post-employment
covenants, both unvested and vested shares might be forfeited.
Special considerations apply if the corporation’s stock is not publicly traded. In such
cases, it is often difficult to set the exercise price for stock options (or the strike price for SARs)
at the grant date at a price equal to the fair market value of the underlying stock on the grant
date. In addition, vesting of restricted stock generally triggers a requirement that the participant
recognize taxable income equal to the fair market value of the vested stock on the vesting date.6
The lack of a ready market for the stock makes it difficult to determine the value to be
recognized in taxable income, and also generally makes it impractical to sell some of the vested
shares in the market as a means of funding the related tax liability. Equity incentive plans for a
non-publicly traded corporation must be carefully designed and implemented to deal with these
valuation and liquidity issues.
B. Comparable Equity Incentive Compensation Plans for an LLC
It is possible to construct an equity incentive plan for an LLC that has the same pre-tax
economic terms as the corporate plans listed above. It is in theory as simple as substituting the
term “equity” for “stock” in the description of the plan (to reflect that fact that an LLC’s
ownership or “equity” interests are represented by membership interests, whereas a corporation’s
ownership interests are represented by shares of stock). However, due to the unique tax
characteristics of an LLC taxed as a partnership7 as compared to a corporation, the after-tax
consequences of the various plans for an LLC will be quite different from the after-tax
consequences of the plans for a corporation. Due to these tax considerations,
1. In cases where key employees and other participants are to receive an equity
interest in capital and profits, it will generally make sense to use a phantom equity
plan in lieu of a restricted equity plan.
2. In cases where key employees and other participants are to receive an equity
interest in future profits only, a “profits interest” plan may have advantages over
equity options or equity appreciation rights. However, this is not always the case,
and in some situations an equity appreciation rights plan may be preferable.
3. For certain types of businesses, a gain sharing plan might provide an optimal mix
of tax and non-tax benefits.
The considerations influencing these choices are discussed below.
II. Capital and Profits Interests: An LLC Phantom Equity Plan Is Generally
Preferable to a Restricted Equity Plan
The discussion below first describes, in very general terms, the most significant tax
consequences of a typical corporate restricted stock plan and phantom equity plan. It then

6
I.R.C. § 83.
7
References in this article to an LLC assume that the LLC is classified as a partnership for federal income tax
purposes under Treas. Reg. § 301.7701-3 and is not a publicly traded partnership as defined in I.R.C. § 7704.

Equity Incentive Compensation Plan Considerations for a Limited Liability Company 5

explains why a traditional restricted stock plan has potentially significant disadvantages in the
context of a private LLC, and why a phantom equity plan is generally a better alternative for an
LLC in cases where the objective is to provide participants with an economic interest in both
existing capital and future profits (including capital appreciation).
A. Tax Consequences of Corporate Restricted Stock
In general, the value of restricted stock awarded to an employee or other plan participant
as compensation for services is included in the participant’s taxable income, as ordinary
compensation income, when the stock becomes “substantially vested” (i.e., the stock is either
transferable or is not subject to a substantial risk of forfeiture).8 The amount included in income
is adjusted for any amount paid for the stock.9 Any appreciation in the value of the stock after
the date the stock is substantially vested (the “vesting date” or “vesting”) is generally taxed as
capital gain.10
Alternatively, the participant can make a “section 83(b) election” to have the value of the
stock on the grant date (less any amount paid for the stock) included in taxable income on the
grant date, notwithstanding the fact that the stock is not substantially vested on the grant date.11
A section 83(b) election must be made within 30 days of the grant date, and there is no relief for
a failure to timely file a proper election. If a section 83(b) election is timely and validly made,
any appreciation in the value of the stock after the grant date is taxed as capital gain, but the
participant generally cannot claim a deduction for any loss in value of the stock after the grant
date.12
The participant is generally treated as the owner of restricted stock only upon vesting,
and if the participant receives a dividend paid with respect to the restricted stock prior to vesting,
the dividend is treated as a payment of compensation and is not eligible for the reduced tax rate
applicable to qualified dividend income.13 If, however, the participant makes a section 83(b)
election with respect to the restricted stock, the participant is treated as the owner of the
restricted stock as of the grant date and dividends received by the participant with respect to the
stock can qualify as qualified dividend income.
The corporation may claim a compensation deduction at the time the participant
recognizes taxable compensation income in an amount equal to the amount recognized as
compensation income by the participant (plus any applicable employer taxes).14 The corporation
has no deduction for any amount taxed to the participant as capital gain.

8
Treas. Reg. §§ 1.83-1(a)(1) and 1.83-3(b).
9
Treas. Reg. § 1.83-1(a)(1).
10
I.R.C. §§ 1222, 1221.
11
I.R.C. § 83(b).
12
Treas. Reg. § 1.83-2(a). A loss can be claimed only if the stock is sold for less than the amount (if any) paid
for the stock.
13
Treas. Reg. § 1.83-1(a); I.R.C. § 1(h)(11).
14
Treas. Reg. § 1.83-6.

Equity Incentive Compensation Plan Considerations for a Limited Liability Company 6

 B. Tax Consequences of Corporate Restricted Stock Units (“RSUs”)
A restricted stock unit (“RSU”) is an unfunded promise by the corporation to issue a
share of the corporation’s stock upon satisfaction of specified vesting conditions. Because the
participant does not receive the stock unless and until the vesting conditions are satisfied, the
participant does not have voting or dividend rights during the vesting period,15 and the
participant cannot file a section 83(b) election with respect to the receipt of an RSU (because the
stock is not issued until it is substantially vested).16 In this manner, the corporation (rather than
the participant) controls the timing of the compensation deduction and preserves the possibility
of a larger deduction should the value of the stock increase prior to vesting. Additionally, the
corporation does not need to keep track of whether participants have made section 83(b)
elections.
Other than the participant’s inability to file a section 83(b) election for an RSU, the tax
consequences of RSUs are the same as the tax consequences of restricted stock.
C. Tax Consequences of Corporate Phantom Stock
A participant in a corporate phantom stock plan is generally taxed only as and when the
participant receives payments with respect to the phantom stock, and the entire amount received
by the participant is taxed as ordinary compensation income.17 The corporation generally may
claim a compensation deduction at the time the participant recognizes taxable compensation
income.18
The participant in a phantom stock plan forgoes the ability to obtain capital gain
treatment on appreciation in the value of the underlying stock.19 In this respect, a phantom
15
A plan may provide that RSU holders receive dividend equivalent payments during the vesting period.
16
For this reason, RSUs are generally not used for issuance of “founders’ shares” in a startup company. At the
formation of a startup company, the initial share awards have little or no value at the grant date and there is therefore
little or no tax cost to making a section 83(b) election), and the corporation is less likely to be able to get an
immediate cash benefit for the tax deduction upon vesting.
17
Treas. Reg. § 1.83-3(e) (property does not include an unfunded and unsecured promise to pay money or
property in the future).
18
I.R.C. § 162(a)(1).
19
A possible exception is for phantom stock transferred in a taxable transaction. The transferee may be able to
argue that the phantom stock right is a capital asset and that amounts received pursuant to the phantom stock right
constitute capital gains. Cf. Hurford Investments No. 2, LTD. v Comm’r, T.C. Unpub. Order (Apr. 17, 2017), 2017
TNT 74-31 (Doc. 2017-50328) (phantom stock transferred by holder’s surviving spouse to a limited liability
company is a capital asset in the hands of the transferee company following the death of the surviving spouse, and a
subsequent “redemption” of the phantom stock gives rise to long-term capital gain under I.R.C. § 1234A, relating to
termination of contract rights). A decision in the Hurford Investments case is still pending, so it is unclear whether
the IRS will appeal the ruling (when the decision is entered) and whether the IRS will challenge the theory of the
ruling in other cases involving transferred phantom stock rights.. In that regard, I.R.C. § 1234A confers capital gain
treatment on gain from the termination of a right or obligation to buy or sell property (e.g., a stock option), but not to
the termination of ownership of the property itself (e.g., the underlying stock). Pilgrim's Pride Corp. v. Comm’r,
779 F.3d 311 (5th Cir. 2015). Without much discussion, the Tax Court in Hurford Investments characterized
phantom stock as a right to buy or sell a capital asset, and not as ownership of property. However, it seems quite
clear that phantom stock is a contractual right to receive an amount of cash based on the value of referenced stock,
and is not a right to buy or sell the referenced stock or any other underlying asset. The very name of the contractual
arrangement – “phantom” stock – communicates that there is no underlying property to buy or sell. Accordingly, it
is unclear whether the Tax Court’s application of I.R.C. § 1234A in Hurford Investments to phantom stock rights
will be upheld on appeal (if an appeal is filed) or followed in other cases.

Equity Incentive Compensation Plan Considerations for a Limited Liability Company 7

equity plan is generally considered less attractive to participants than a restricted equity plan. In
addition, a restricted equity plan gives participants “real” equity in the corporation, typically with
real voting rights and other rights associated with ownership, rather than a synthetic or derivative
equity interest that does not carry those rights. However, a phantom equity plan solves certain
valuation and liquidity issues associated with non-traded restricted stock. In addition, whereas
the corporation obtains no tax deduction for restricted stock appreciation taxed to the participant
as capital gain, the corporation obtains a deduction for the entire amount of income recognized
by the participant with respect to phantom equity, typically making phantom equity a more tax
efficient alternative for the corporation and overall.
D. Tax Consequences of LLC Restricted Equity
Awards of restricted equity (membership interests) in an LLC classified as a partnership
for federal income tax purposes are generally taxed in the same manner as corporate restricted
stock. The restricted equity award is included in the participant’s income on either (a) the award
date if the award is substantially vested on that date or if the participant makes a timely and valid
Section 83(b) election, or (b) in all other cases, such later date on which the equity interest
becomes substantially vested.20 The amount included in the participant’s income is the excess of
the value of restricted equity on the inclusion date over the amount paid for the equity, and this
amount is classified as ordinary compensation income. Because the LLC is not a publicly traded
entity,21 it can be difficult to fund the participant’s tax liability on the inclusion date. The
company may need to make arrangements to buy back a portion of the equity or to provide loans
to the participant to cover the participant’s tax liability. The LLC issuing restricted equity is not
required to recognize gain on the participant’s share of Company assets.22
The participant is not regarded as a member of the LLC for tax purposes until the
inclusion date described in the preceding paragraph.23 Until then, any amount paid for the
restricted equity represents a conditional credit to the LLC capital. If the restricted equity award
vests, the conditional credit is transferred to the participant’s capital account on the inclusion
date, and the participant’s capital account is also credited for any amount recognized in income
at that time.24 If the restricted equity award is forfeited, any conditional credit is apparently
transferred to income and closed to members’ capital accounts.
Once the LLC restricted equity is included in the participant’s income (either by vesting
or by making a section 83(b) election), the participant is considered a member of the company

20
See Crescent Holdings, LLC v. Comm’r, 141 T.C. No. 15 (2013) (service provider partner is not taxed on
receipt of substantially non-vested interest in partnership capital and profits in the absence of a section 83(b)
election, and is not allocated any partnership tax items with respect to such interest if it is forfeited prior to vesting).
21
See footnote 7 (for purposes of this memorandum, an LLC is assumed to be classified as a partnership for
federal tax purposes and is assumed to not be a publicly traded partnership).
22
Some commentators have suggested that the Company should be required to recognize gain on the
participant’s share of the Company’s assets as if the Company had transferred an undivided interest in the assets to
the participant as compensation, and the participant had then contributed those assets back to the Company. The
IRS has rejected this analysis. REG–105346–03, 70 Fed. Reg. 29675, 29679 (2005) (“partnerships should not be
required to recognize gain on the transfer of a compensatory partnership interest”).
23
Treas. Reg. §§ 1.83-1(a), 1.83-2(a); Crescent Holdings, LLC v. Comm’r, 141 T.C. No. 15 (2013).
24
REG–105346–03, 70 Fed. Reg. 29675, 29677 (2005).

Equity Incentive Compensation Plan Considerations for a Limited Liability Company 8

for tax purposes.25 and must be issued a Schedule K-1 for the participant’s share of company tax
items each year, whether or not any cash distributions are made to the participant.26 The
participant’s share of company tax items will generally be taxed as ordinary income or as capital
gain depending on the character of the income to the company. Special tax distributions to
participants may be required to fund their tax liability on company tax items allocated to them
for tax purposes. LLC income taxed to the participant is effectively deductible by the other LLC
members in that the income is “deflected” to the participant. In contrast, a holder of corporate
restricted stock is generally not taxed on company profits until distributed as a dividend, such
dividends are taxed entirely at favorable long-term capital gain tax rates,27 and the corporation
does not obtain any deduction for dividends paid to the participant.
If the participant receives reasonable compensation (guaranteed payments) for services
rendered to the LLC in the participant’s capacity as an employee of the LLC or in any other
service provider capacity, the participant may be able to take the positon that the participant’s
distributive share of the LLC’s income and gains accruing with respect to the participant’s
restricted equity interest is exempt from self-employment tax by virtue of I.R.C. § 1402(a)(13)
(distributive share income of a limited partner), and is also exempt from net investment income
tax under I.R.C. § 1411(c)(2), assuming the income is derived from a business that is not trading
in financial instruments or commodities and is not a passive activity as to the participant (taking
into account the participant’s participation in the business as an employee). This position will
depend on the structure and activities of the LLC and the participant’s rights and activities as a
restricted equity interest holder.
Upon disposition of LLC restricted equity, the participant’s gain is capital gain except to
the extent attributable to the participant’s share of company “hot assets” (generally defined as
assets that would produce ordinary income if sold).28 An LLC can increase the basis of its assets
to account for any gain recognized by the participant on the disposition of the participant’s
restricted equity.29 This effectively creates a deferred deduction for the LLC equal to the gain
recognized by the participant. In contrast, in the case of a sale of corporate restricted stock, there
are no hot asset rules (all gain is capital gain), and there is no basis adjustment (deferred
deduction) available for gain recognized by the participant on the sale of the restricted stock.
Once LLC restricted equity is taxed to the participant and the participant is classified as a
member of the LLC (i.e., following the inclusion date), the participant may also be subject to
state tax filing requirements in all states in which the LLC does business, and may be subject to
state income tax on the participant’s share of company income and on the participant’s gain from
the disposition of the LLC restricted equity. In contrast, a holder of corporate restricted stock is
generally not subject to tax on income from the stock in any state other than the state in which
the participant’s maintains his or her domicile.

25
Treas. Reg. §§ 1.83-1(a), 1.83-2(a).
26
I.R.C. § 702.
27
I.R.C. § 1(h).
28
I.R.C. § 751.
29
I.R.C. §§ 734, 743, 754.

Equity Incentive Compensation Plan Considerations for a Limited Liability Company 9

 The IRS view is that a person who owns an equity interest in an LLC classified as a
partnership for federal income tax purposes cannot also be an employee of the LLC.30
Accordingly, under the IRS view, following the inclusion date, the participant must have regular
compensation and bonuses reported as guaranteed payments on Schedule K-1 rather than as
compensation income on Form W-2. This can have potentially significant collateral effects,31
and can be confusing to participants. Similarly, it is possible that a compensation paid to a
participant that is an independent contractor might have to be reported on Schedule K-1 rather
than on Form 1099, leading to similar confusion. It may be possible to avoid having participant
compensation reclassified as guaranteed payments using a variety of legal structures,32 but these
structures add cost and complexity.
In summary, the tax reporting for the holding and sale of corporate restricted stock is
much simpler than the tax reporting for the holding and sale of LLC restricted equity, and the
issuance of corporate restricted stock does not interfere with the participant’s existing
employment relationship with the company. For these reasons, a restricted equity plan is
generally not be the best choice for an LLC equity incentive compensation plan.
E. Tax Consequences of LLC Restricted Equity Units (“REUs”)
An LLC restricted equity unit is an unfunded promise by the LLC to issue a unit of LLC
equity upon satisfaction of specified vesting conditions. The tax consequences are the same as
for LLC restricted equity that is subject to vesting conditions and for which no section 83(b)
election is filed. As with corporate restricted stock units, LLC restricted equity units are
generally issued when the LLC wants to prevent the filing of a section 83(b) election with
respect to restricted equity awards and thereby control the timing of the inclusion date, avoid
having to track section 83(b) elections, and obtain a deduction for any appreciation in the value
of the underlying units between the award date and the vesting date.
F. Tax Consequences of LLC Phantom Equity
Under a phantom equity plan, participants are awarded nominal equity units (“Phantom
Units”) that represent a contractual right to receive a cash payment equal to the value of a unit of
LLC membership interest upon defined payment events. An LLC phantom equity plan has
essentially the same tax consequences as a corporate phantom equity plan (i.e., taxation deferred
until payment, and all payments taxed as compensation income).

30
Rev. Rul. 69-184, 1969-1 C.B. 256. See also Treas. Reg. § 54.4980H-1(a)(15) (a partner is not an employee
for purposes of the “shared responsibility payment” imposed under the 2010 Affordable Care Act). But see
Armstrong v. Phinney, 394 F.2d 661 (5th Cir. 1968) (partner treated as an employee for purposes of the exclusion for
meals provided to employees for the convenience of the employer).
31
See Noel P. Brock, Treating partners as employees: Risks to consider, J. Accountancy (Aug. 1, 2014).
32
One solution involves forming a holding company to own the equity interests of participants, with non-
participant owners continuing to own equity interests in the operating company. See Swartz, supra n. 2, pp. 22-24,
and Illustration 1 below. Previously, many advisors recommended that the operating company form a wholly-
owned subsidiary to act as the employer of the participants. However, the IRS has indicated that it will challenge
such an arrangement, and has requested comments on the application of the employee/partner prohibition of Rev.
Rul. 69-184 to tiered partnership arrangements. See Treas. Reg. § 301.7701-2T(c)(2)(iv)(C)(2) and -2T(e)(8) (a
partner in a partnership may not be treated as an employee of a disregarded entity owned by the partnership) and
T.D. 9766, 81 Fed. Reg. 26693 (May 4, 2016).

Equity Incentive Compensation Plan Considerations for a Limited Liability Company 10

 For an LLC, a phantom equity plan has several advantages over a restricted equity plan,
including:
1. Whereas owners of LLC restricted equity are taxed on their allocable shares of the
LLC’s income after vesting or an 83(b) election, whether or not the income is distributed,
Phantom Units are taxed more like restricted stock in that the holder of Phantom Units is only
taxed as and when cash is distributed to the holder.
2. Because owners of Phantom Units are not considered equity owners, their status
as employees of the company is not affected by the issuance of Phantom Units. Accordingly,
they can continue to be issued a Form W-2 for their wages, bonuses, and other compensation and
benefits (including payments in respect of the Phantom Units).
3. Equity owners of an LLC are generally deemed to be doing business wherever the
LLC is doing business, and are therefore required to file state (and local) income tax returns
everywhere the LLC does business, and pay tax on their share of LLC income attributable to
other states and cities imposing an income tax. The company can usually arrange to file
composite tax returns on behalf of its equity owners, but the equity owners are typically still
responsible for payment of the taxes. In contrast, assuming a participant works exclusively in his
or her state of domicile, amounts received with respect to Phantom Units would not be subject to
any state or local income tax outside the participant’s state of domicile, and neither the
participant nor the company would be required to file any additional state or local income tax
returns for the participant.
4. Awards of restricted equity are generally taxed to the participant no later than the
date the restricted equity becomes vested, whereas Phantom Units are not taxed to the participant
until the specified payment date. A phantom equity plan therefore eliminates the need for special
provisions to either defer vesting or to provide liquidity for payment of taxes on vested restricted
equity.33
5. If a restricted equity plan includes arrangements to allow participants to sell a
portion of the restricted equity at vesting in order to pay the tax due, the participant has a smaller
percentage interest in any future appreciation in the value of the business. There is no similar
need to reduce the invested balance of a holder of Phantom Units.
6. The issuance of restricted equity can trigger taxable income to other LLC
members (including participants that have previously vested restricted equity) to the extent the
LLC has debt and holds hot assets.34 These deemed income rules don’t apply to the issuance of
Phantom Units.
7. Although not of direct concern to participants, all payments by the company with
respect to Phantom Units are immediately deductible by the company. In contrast, any payment
made to retire restricted equity is generally not immediately deductible by the company but must

33
If a phantom equity award vests (i.e., is no longer subject to a substantial risk of forfeiture) prior to payout
(e.g., upon death, or permanent disability), the company might be required to pay and withhold social security and
other employment taxes on the value of the award as and to the extent it becomes vested. See I.R.C. §§ 3121(v)(2)
and 3306(r)(2). Withholding can be taken from other wage payments to the affected participant, or IRS Notice
2005-1, IV Q&A 15(f) allows for acceleration of payments to pay employment taxes, and to pay income tax
withholding on the accelerated payments, without violating I.R.C. § 409A.
34
I.R.C. §§ 751, 752.

Equity Incentive Compensation Plan Considerations for a Limited Liability Company 11

instead be added to the basis of undistributed company assets and recovered through depreciation
or other basis recovery provisions.
8. A phantom equity plan avoids significant accounting complexities for the LLC
associated with recalculating all equity owners’ capital accounts, sharing ratios, and tax basis
allocations every time additional equity interests vest or are retired. These administrative costs
can drain significant value and resources from the business without producing any value for the
participants or the other investors.
An LLC phantom equity plan is subject to several potential disadvantages as compared to
a restricted equity plan:
1. The entire amount received by a participant with respect to Phantom Units is
taxed as compensation income; none qualifies as tax favored capital gain. In contrast, a
significant portion of the appreciation in the value of restricted equity might be taxed as capital
gain. This tax detriment associated with Phantom Units is mitigated by (a) the fact that the
participant hasn’t had to pay tax on the vesting of the Phantom Units, and therefore may have
larger percentage interest in any such appreciation under a phantom equity plan, and (b) the fact
that the LLC obtains an ordinary compensation deduction for the compensation income
recognized by the participant (see paragraph 7 above).35

2. Income and gain from restricted equity might qualify as exempt from both self-
employment tax and net investment income tax, whereas income from a phantom equity plan is
always subject to FICA tax (at the same rate as self-employment tax).

3. A phantom equity plan will normally be subject to the deferred compensation

rules of I.R.C. § 409A, whereas a restricted equity plan is generally not subject to those rules.36
I.R.C. § 409A specifies permissible payment events, restrictions on funding, requirements for
deferral elections, and other applicable requirements. Failure to comply with the requirements
can subject participants to acceleration of income and penalties. Nevertheless, with careful
drafting, an LLC phantom equity plan can comply with I.R.C. § 409A without undue
interference with the company’s compensation objectives.

G. Summary
Considering all of the factors discussed above, an LLC phantom equity plan is generally
preferable to an LLC restricted equity plan for both the participants and the LLC.37

35
The LLC members might not have sufficient ordinary income in the year in which the Phantom Units are paid
to fully absorb the LLC’s deduction for Phantom Unit payments, and a portion of the LLC’s deduction might offset
long-term capital gains. If this occurs, the holders might pay tax at ordinary income rates whereas the LLC
members might get a tax benefit at lower long-term capital gain rates.
36
Treas. Reg. § 1.409A-1(b)(6), (7).
37
See the discussion in Sections IV(F) and V below regarding profits interests and gain sharing interests with a
“catch up” allocation. It may be possible to structure a profits interest that has no capital account value upon
issuance, but which is allocated a preferential share of future profits (either from all sources, or solely from capital
transactions) equal to the capital interest that is forgone at the issue date (sometimes referred to as a “catch up”
allocation). In this manner, a profits interest or gain sharing interest can mimic the effects of a phantom equity plan
while conferring on the participant the opportunity for capital gains treatment.

Equity Incentive Compensation Plan Considerations for a Limited Liability Company 12

III. Profits Interests: An LLC Profits Interest Is Generally Preferable to Equity Options
or Equity Appreciation Rights
This section describes, again in very general terms, the most significant tax consequences
of corporate stock options and corporate stock appreciation rights (“SARs”), and compares those
tax consequences to the tax consequences of the LLC equivalent plans. The discussion also
describes a “profits interest,” which is a special form of equity appreciation right available to
LLCs classified as partnerships. As discussed below, an LLC profits interest is generally
preferable to equity options or equity appreciation rights. But for businesses that don’t expect to
generate significant capital gain income (e.g., a professional service business), or where the
complexities of a profits interest plan are untenable, an equity appreciation right may be a
preferred alternative.
A. Tax Consequences of Corporate Stock Options
In general, no taxable income is recognized on the grant or vesting of a corporate stock
38
option. Rather, when such an option is exercised (and assuming the stock is substantially
vested when purchased or a Section 83(b) election is filed in connection with the exercise39), the
participant recognizes ordinary compensation income equal to the excess of the value of the
stock on the exercise date and the amount paid to acquire the stock (i.e., the exercise price).40
Any appreciation in the value of the stock after the exercise date is generally taxed as capital
gain.

38
The discussion in text assumes that the option does not have a readily ascertainable fair market value, covers
a fixed number of shares, and has an exercise price not less than the fair market value of the underlying stock on the
grant date. See Treas. Reg. § 1.83-7 and Treas. Reg. § 1.409A-1(b)(5)(i)(A). Treas. Reg. § 1.409A-1(b)(5)(iv)
provides safe harbors for establishing the fair market value of stock. A stock option that has an exercise price below
the fair market value of the underlying stock on the grant date is subject to tax under I.R.C. § 409A on the vesting
date, plus a 20% penalty, unless the option is mandatorily exercised either (a) within the short-term deferral period
after the vesting date, or (b) only on a permitted payment date under I.R.C. § 409A (i.e., a predetermined date,
separation from service, death, disability, unforeseeable financial emergency, or a change of control). See Treas.
Reg. § 1.409A-1(b)(4)(iii) (Example 8). See also Sutardja v. United States, 109 Fed. Cl. 358 (2013).
39
If the stock purchased upon exercise of the option is substantially nonvested (i.e., is subject to a substantial
risk of forfeiture and is non-transferrable as determined under Treas. Reg. § 1.83-3) and no Section 83(b) election is
filed, there is no taxable income upon exercise. Instead, the participant recognizes ordinary compensation income
when the stock becomes substantially vested in an amount equal to the excess (if any) of the value of the stock at
that time over the purchase price paid for the stock pursuant to the option exercise. The service recipient obtains a
corresponding deduction. Any subsequent appreciation in value is eligible for capital gain treatment. To avoid the
risk of failing to properly account for the tax consequences of the exercise of a compensatory stock option in the
case of purchased stock that is substantially nonvested, some plans require the participant to file a Section 83(b)
election in connection with all stock option exercises.
40
Treas. Reg. § 1.83-7. The discussion in text deals with “non-qualified” stock options, meaning options that
are not “incentive stock options” covered by I.R.C. § 422. The advantage of an incentive stock option is that there is
potentially no tax on exercise of the option (rather, tax is due only when the underlying stock acquired upon exercise
of the option is ultimately sold) and the entire gain on the sale of the stock acquired upon exercise of the option may
qualify for long-term capital gain treatment. The disadvantage (which generally outweighs the potential advantages)
is that the company is not allowed any tax deduction for the grant or exercise of the option or for the sale of the
underlying stock. See I.R.C. § 421(a).

Equity Incentive Compensation Plan Considerations for a Limited Liability Company 13

 There is generally no ability to accelerate gain recognition (i.e., no section 83(b) election)
with respect to the receipt of a compensatory corporate stock option.41
The corporation may claim a compensation deduction at the time the participant
recognizes taxable compensation income, and the amount of the corporation’s deduction is equal
to the amount recognized as compensation income by the participant.42 The corporation has no
deduction for any amount taxed to the participant as capital gain.
Stock options were at one time the favored form of equity incentive compensation for
emerging growth companies because the corporation was not required to recognize any expense
for financial reporting purposes with respect to the issuance or exercise of the options. That
favorable financial reporting treatment was changed in 2005,43 and the financial reporting
treatment for restricted stock is now generally considered more favorable than for stock options
(because the value, and associated financial reporting expense, of stock options tends to be
overstated by applicable valuation models). As a result, beginning in 2006 many publicly traded
corporations began preferring restricted stock to stock options as a means of providing equity
incentive compensation to key employees.
B. Tax Consequences of Corporate SARs
A corporate SAR is taxed in the same manner as a corporate phantom equity plan
(described above). Payments are taxed as ordinary income only when paid to the participant, and
the corporation can deduct the payments as compensation expense at that time.
C. Tax Consequences of LLC Equity Options
The IRS has not issued definitive guidance on the tax consequences of LLC equity
options. Until definitive guidance is issued, the tax rules for LLC equity options are generally
assumed to be the same as for corporate stock options. That is, there are no tax consequences
associated with the grant or vesting of equity options44, but if and when the option is exercised,
assuming the equity received on exercise is substantially vested, the participant recognizes
ordinary compensation income equal to the spread between the value of the underlying equity on
the exercise date and the exercise price, and the LLC has a deduction for the amount included in
the participant’s income. Following exercise, the participant becomes an equity owner with a
capital account equal to the value of the underlying equity taken into account in determining the
participant’s compensation income. Going forward, the participant is allocated a distributive
share of LLC tax items and receives a Schedule K-1.45 The participant’s holding period for the

41
Treas. Reg. § 1.83-7(a). If the stock acquired upon exercise of the option is restricted (i.e., not substantially
vested), a section 83(b) election can be made upon exercise of the option. Also, if the stock option is transferrable
and immediately exercisable, it might be possible to take the position that the option has a readily ascertainable fair
market value on the grant date, in which case the value of the option on the grant date would be recognized as
compensation income on the grant date. See Treas. Reg. § 1.83-7(b)(2), (3).
42
Treas. Reg. § 1.83-6.
43
See Financial Accounting Standards Board, Statement No. 123(R) Share Based Payment (Dec. 2004).
44
The discussion in text assumes that the option does not have a readily ascertainable fair market value, covers
a fixed number of shares, and has an exercise price not less than the fair market value of the underlying equity on the
grant date). See footnote 38.
45
Cf. Prop. Treas. Reg. § 1.721-1(b), 70 Fed. Reg. 29675, 29683 (May 24, 2005) (treating receipt of a
compensatory equity interest, including an equity interest acquired upon exercise of an option granted in connection
with the performance of services for the LLC, as taxable to the participant (service provider) under I.R.C. § 83,

Equity Incentive Compensation Plan Considerations for a Limited Liability Company 14

equity interest begins on the day following exercise,46 and therefore an exercise of an equity
option in anticipation of a sale of LLC equity interest will generally produce ordinary income
(upon exercise) and short-term capital gain or loss (upon a sale of the equity interest within one
year following exercise).
The exercise of an LLC equity option leads to an equity interest that is more complicated
than the stock ownership interest acquired upon the exercise of a corporate stock option.
Whereas a holder of corporate stock recognizes income only to the extent of actual dividends and
gains received, the holder of LLC equity is subject to the complexities and associated with equity
ownership as described above in section III(C) with respect to restricted equity. On the other
hand, unlike in the case of a corporate stock option (where the corporation gets no deduction for
gain realized by the participant after the exercise date), all post-exercise income or capital gain
allocated to the participant reduces income or gain that would otherwise be allocated to the
remaining LLC members, with the effect that the LLC effectively obtains a deduction (deflection
of income) for the post-exercise income or gain realized by the participant with respect to the
LLC equity option.
LLC equity options are not common. A profits interests (discussed below) will generally
be a preferred alternative because profits interests do not require an exercise of option rights,
payment of an exercise price, or valuation of the underlying equity in connection with any such
exercise, and generally provide more favorable tax consequences (although at the cost of some
additional complexity).
D. Tax Consequences of LLC Equity Appreciation Rights
Because equity appreciation rights are merely a contractual obligation to make a future
cash payment by reference to the change in value of the underlying LLC equity, the tax
consequences of an LLC equity appreciation rights plan are the same as the tax consequences of
a phantom equity plan; i.e., the payments are taxed as ordinary compensation income to the
participant as received, and are deducted by the LLC as they are included in the participant’s
income. An equity appreciation rights plan also has some of the same advantages over an LLC
equity option plan that an LLC phantom equity plan has over an LLC restricted equity plan. For
example, an equity appreciation right never leads to an equity ownership interest, so the
complexities of having the participant as a member of the LLC are avoided. Potential drawbacks
of a equity appreciation rights plan are (a) the entire amount paid to the participant is ordinary
compensation income, and (b) the plan may be subject to the requirements of I.R.C. § 409A.
E. Tax Consequences of LLC Profits Interests
A “profits interest” is a special class of LLC equity that entitles the holder to a share in
the LLC’s future profits, but no share in the LLC’s asset values as of the date the award is
granted (i.e., no “capital interest”). Under current IRS rules, a profits interest is not taxable
either at the grant date or at the vesting date. In effect, the participant is deemed to make a
section 83(b) election and include zero value in income at the grant date.47

without giving rise to gain or loss to the LLC). See also Karen C. Burke, Taxing Compensatory Partnership
Options, 100 Tax Notes 1569 (Sep. 22, 2003).
46
Rev. Rul. 78-182, 1978-1 C.B. 265.
47
See Rev. Proc. 93-27, 1993-2 C.B. 343; Rev. Proc. 2001-43, 2001-2 C.B. 191. Note that the safe harbor tax
treatment prescribed in Rev. Proc. 93-27 and Rev. Proc. 2001-43 does not apply if (a) the interest relates to a

Equity Incentive Compensation Plan Considerations for a Limited Liability Company 15

 A profits interest is economically equivalent to an equity appreciation right, but it has
some unique features. In contrast to an equity appreciation right (where any value paid to the
participant is taxed as compensation income), a profits interest causes the participant to be a
partner as of the grant date, and the participant’s income (if any) with respect to the profits
interest depends on the character of the LLC’s income or gains (or the character of its assets
upon a sale or redemption of the profits interest). A profits interest therefore generally creates an
opportunity for the participant to recognize capital gains, whereas an equity appreciation right
results in payments classified entirely as ordinary compensation income.
A profits interest is also economically equivalent to an equity option, except that there is
no exercise price to be paid for the profits interest. And whereas the appreciation in value of an
equity option prior to exercise (i.e., the “spread” at exercise) is taxed as compensation income, a
profits interest creates a greater opportunity for capital gains with respect to such appreciation.
In addition to the opportunity for capital gains treatment on income accruing to a profits
interest, a potential additional tax benefit of a profits interest is the opportunity to avoid both
self-employment tax and net investment income tax on such income (whether capital gain or
ordinary income). If the participant receives reasonable compensation (guaranteed payments) for
services rendered to the LLC in the participant’s capacity as an employee of the LLC (or other
service provider capacity), the participant may be able to take the positon that the participant’s
distributive share of the LLC’s income accruing with respect to the profits interest is exempt
from self-employment tax by virtue of I.R.C. § 1402(a)(13) (income of a limited partner), and is
also exempt from net investment income tax under I.R.C. § 1411(c)(2), assuming the income is
derived from a business that is not trading in financial instruments or commodities and is not a
passive activity as to the participant (taking into account the participant’s participation in the
business as an employee). This position will depend on the structure and activities of the LLC
and the participant’s rights and activities as a profits interest holder.
There are a number of potential drawbacks associated with a profits interest. One
potential drawback is that the participant receives an actual equity interest in the LLC and is
considered a member on and after the grant date regardless of any vesting restrictions.
Consequently, the participant faces the complexities associated with equity ownership discussed
above in paragraphs III(C) (relating to restricted equity interests), including taxation of LLC
income without regard to cash distributions, impact on employee status, state income tax
implications, and liability allocation and tax basis implications for other members. In contrast,
an equity option defers issuance of an actual equity interest until the option is exercised, and a
equity appreciation right never involves issuance of an actual equity interest.

substantially certain and predictable stream of income from partnership assets, (b) the service provider “disposes” of
the interest within two years of receipt; (c) the partnership is a publicly traded partnership, or (d) the partnership or
any partner fails to report the transaction consistent with the treatment of the service provider as having made a
constructive section 83(b) election. In cases where a profits interest may not comply with the requirements of the
IRS safe harbors, it is generally advisable to file a protective section 83(b) election with respect to the receipt of a
profits interest. See Rev. Proc. 2012-29, 2012-28 I.R.B. 49, regarding sample language for section 83(b) elections.
The IRS has proposed an additional limitation on the profits interests safe harbors to curb situations where a
profits interest is issued pursuant to a “fee waiver.” The IRS has proposed to issue a supplemental Revenue
Procedure providing that the safe harbors will not apply to a profits interest issued in conjunction with a partner
forgoing payment of an amount that is substantially fixed (including a substantially fixed amount determined by
formula, such as a fee based on a percentage of partner capital commitments) for the performance of services.
REG‐115452‐14, 80 Fed. Reg. 43652 (Jul. 23, 2015), corrected 80 Fed. Reg. 50240 (Aug. 19, 2015).

Equity Incentive Compensation Plan Considerations for a Limited Liability Company 16

 Another potential drawback of a profits interest is the valuation and accounting
complexities associated with issuing such interests. Because a profits interest, by definition,
cannot be entitled to share in any portion of the value of the business on the date the profits
interest is issued, the company must determine the value of the business on the issuance date and
must keep an accounting of that value for the benefit of the existing members. This is generally
not a significant problem for a newly formed business having no significant non-cash assets and
wishing to award profits interests to a predetermined class of participants only upon formation or
shortly thereafter. But in the case of business that wishes to award profits interests on an
ongoing basis, the valuation and accounting issues can be more problematic. Even if the value of
the company’s assets can be ascertained with reasonable accuracy on any grant date, the
company generally must adjust the capital accounts of the existing members to reflect that value
prior to the issuance of the profits interest.48 This is commonly referred to as “booking up” the
capital accounts and creating “Section 704(b)” capital accounts. This process can create
significant accounting complexity.49 Accordingly, where the company contemplates issuing
equity interests on an ongoing basis, the valuation and accounting complexities associated with
profits interests might militate against using profits interests as equity incentive awards.
A third potential drawback of a profits interest is the handling of forfeitures (if the
interest is subject to vesting conditions or other forfeiture provisions). Complex special
allocations of tax items may be required for the year of the forfeiture to account for prior
allocations of profits or losses with respect to the forfeited interest.50 There is also an unsettled
question whether the participant is entitled to a deduction for the tax basis of the forfeited
interest. In a worst case, the IRS might argue that the participant is not allowed any deduction
for the tax basis of the forfeited interest,51 and the existing members have an immediate income
recognition event (i.e., a “capital shift”) upon the forfeiture of the interest.52

48
See Treas. Reg. § 1.704-1(b)(2)(iv)(f).
49
As an alternative to the “booking up” (or down) all assets and liabilities and reflecting the net change in the
capital accounts, many LLC and partnership operating agreements provide that a “distribution threshold” amount (or
similar amount) must be specified for each profits interest issued, with the specified amount representing an amount
equal to or greater than the value of the capital interests in the company immediately prior to the issuance of the
profits interests. The profits interests are not entitled to distributions until the distribution threshold has been
distributed to existing members or otherwise reserved for distribution to them. This may avoid the need for
adjusting the assets and liabilities and capital accounts to fair market value each time profits interests are issued.
Nevertheless, there is still significant complexity associated with tracking multiple distribution thresholds for
multiple series of profits interests.
50
Cf. Prop. Treas. Reg. § 1.704-1(b)(4)(xii)(c), 70 Fed. Reg. 29670, 29681 (May 24, 2005) (describing special
allocations for year in which a compensatory partnership interest is forfeited).
51
Cf. REG–105346–03, 70 Fed. Reg. 29670, 29677 (May 24, 2005) (“Comments are also requested as to
whether section 83(b)(1) should be read to allow a forfeiting service provider to claim a loss with respect to
partnership income that was previously allocated to the service provider and not offset by forfeiture allocations of
loss and deduction and, if so, whether it is appropriate to require the other partners in the partnership to recognize
income in the year of the forfeiture equal to the amount of the loss claimed by the service provider. In particular,
comments are requested as to whether section 83 or another section of the Code provides authority for such a rule.”).
52
See Swartz, supra n. 2, p. 46 (noting that forfeiture of a profits interest could raise capital shift issues) and pp.
8-9 (discussing tax consequences of capital shifts). See also Treas. Reg. § 1.704-1(b)(2)(iv)(s)(3) and -1(b)(4)(x)
(allocations with respect to noncompensatory options and related capital shifts; rejecting income allocations in
excess of partnership gross income and deduction items).

Equity Incentive Compensation Plan Considerations for a Limited Liability Company 17

 Because of these drawbacks, an equity appreciation rights plan is sometimes preferable to
a profits interest plan. Note that the company might be able to offer a more generous equity
appreciation rights plan to account for the fact that participants are not allocated underlying LLC
capital gains under an equity appreciation rights plan.53
F. Summary
In the case of a business that generates most of its income in the form goodwill and other
sources of capital gain, a profits interest preserves the participant’s opportunity for sharing in
capital gains generated upon a disposition of the company’s capital assets or upon a sale of the
equity interests. A profits interest may also present an opportunity to avoid surtaxes54 on income
and gains attributable to the profits interest. However, there are significant complexities
associated with a profits interest plan. Where the nature of the business is such that the
opportunity for capital gain is not great (e.g., a professional services business that does not
generate significant gain from goodwill or other sources), or where the complexities of a profits
interest plan are otherwise untenable, an equity appreciation rights plan may be preferable from
an overall tax and simplicity standpoint. An equity option plan is generally not a preferred
alternative because it requires payment of the exercise price for the option and valuation of the
underlying equity at exercise, can have tax disadvantages relative to a profits interest, and has
somewhat uncertain tax consequences.
IV. Hybrid Interests
A. Profits Interest With “Catch Up” Allocation
As previously noted, whereas a restricted equity interest represents a specified share of
both existing capital and future profits, a traditional profits interest involves a specified
percentage of future profits only, and no share of the existing capital. However, it may be
possible to structure an LLC profits interest that mimics the economics of a restricted equity
interest. For example, if the LLC wants to award a participant a full 5% interest in capital and
profits of the LLC (similar to a 5% restricted equity interest), but does not want to saddle the
participant with the tax burden associated with vesting of a restricted equity interest, the LLC
might award the participant a 5% nominal profits interest, but with the added right to receive
100% (or some other disproportionate percentage) of future LLC profits until the participant’s
capital account is equal to 5% of the total capital accounts on the award date, after which time
the participant would be allocated 5% of LLC profits. In this manner, assuming the LLC
generates sufficient future profits to “catch up” the participant’s capital account to its nominal

53
Under a profits interest plan, long-term capital gains (if any) allocated to profits interest holders reduce long-
term capital gains of regular members, thereby producing a tax benefit to regular members at long-term capital gain
rates. In contrast, under a equity appreciation rights plan, payments to rights holders produce an ordinary
compensation deduction to regular members. Provided the regular members have sufficient ordinary taxable income
to fully utilize the ordinary compensation deductions, their more favorable tax treatment under an equity
appreciation rights plan could, if desired, be used to fund a more generous profit sharing percentage for the
participants. In practice, this may be difficult to achieve precisely because of uncertainty regarding the portion of
the company’s future profits constituting long-term capital gain and uncertainty regarding the regular members’
future ordinary income. There may also be tax “leakage” associated with employment taxes on equity appreciation
rights payments.
54
Potentially applicable surtaxes are the employment taxes imposed by I.R.C. §§ 3101 and 3111, the tax on
self-employment income imposed by I.R.C. § 1401, and the net investment income tax imposed by I.R.C. § 1411.
The surtaxes are mutually exclusive, so that the income or gains can be subject to only one such surtax.

Equity Incentive Compensation Plan Considerations for a Limited Liability Company 18

percentage interest, the profits interest will produce the same pre-tax return as a restricted equity
interest, but with tax due only as profits are earned.
B. Gain Sharing Interests
A gain sharing plan is designed to grant participants the opportunity to share in capital
gains on a sale of the business without being subject to the complexities of being a partner during
the operating phase of the business. This is accomplished by granting participants equity
interests that share solely in profits from a sale of the business or other “capital transactions.”
Like a regular profits interest, a gain sharing interest is not taxed on the grant date or the vesting
date because the equity interest has no current liquidating value (i.e., no capital interest) at the
grant date. However, unlike a regular profits interest (which is allocated a share of all company
profits starting immediately after the grant date), a gain sharing interest is only allocated profits
associated with capital transactions. Accordingly, while participants will receive a Schedule K-1
and be treated as an equity owner in the business from the grant date forward,55 the Schedule K-1
will not reflect any tax items until such time as there is a capital transaction. This significantly
simplifies the participant’s interim tax reporting and avoids the need for special tax distributions
to participants and state tax filings. When there is a capital transaction, the participant should
generally recognize capital gain with respect to his gain sharing interest to the extent the gain
from the underlying transaction is capital gain.56
A gain sharing plan is easiest to implement when the operating income of the business is
expected to be relatively modest or negative, and the financial success of the business is expected
to be realized by selling or refinancing the business at a gain. For example, such a plan might be
used for an LLC conducting oil and gas operations, where the objective is to do enough drilling
to prove out the reserves, and then sell the business for reserve value rather than current
operating income. Likewise, certain private equity businesses that are focused on turn around
investments might use such a plan for a portfolio company.
If operating income may be a significant source of free cash flow that the LLC will
periodically distribute to owners, a gain sharing interest that shares only in profits from capital
transactions will not allow holders of the gain sharing interests to fully participate in profits from
the business. In such cases, it might be desirable to allow participants in the gain sharing plan to
share in ordinary distributions through a bonus plan for the participants. The bonus plan would
grant to participants a right to receive bonuses (taxed as ordinary compensation income) tied to
distributions paid to (or profits earned by) the owners of the LLC’s regular equity.
Another way to deal with operating cash flow distributions is to distribute to gain sharing
interest holders additional gain sharing interests in lieu of cash distributions. The additional gain
sharing interests would be payable only to the extent of income or gain recognized in a capital

55
See text and authorities at footnote 30. Even though the holders of gain sharing interests would not have a
current interest in the LLC’s realized profits, it is likely that they would be treated as partners for tax purposes on
account of their interest in profits from capital transactions. Cf. C.C.A. 201326018 (June 10, 2013) (partner that
holds only an interest in future profits or capital appreciation is a partner that can serve as a tax matters partner as
defined in I.R.C. § 6231(a)(7). See generally Richard Lipton, General Partners Who Only Share in Capital
Appreciation, 119 J. Tax’n 102 (Aug. 2013).
56
So-called “i-Units” issued by some publicly traded partnerships appear to have a similar deferred income
allocation arrangement (with the apparent objective of avoiding recognition of unrelated business income by tax
exempt investors). See Kinder Morgan Management, LLC, Prospectus Supplement (Aug. 7, 2012) p. 23,
http://www.sec.gov/Archives/edgar/data/888228/000104746912008058/a2210603z424b2.htm.

Equity Incentive Compensation Plan Considerations for a Limited Liability Company 19

transaction, and therefore should not be taxable upon issuance and should not attract any
distributive share of operating income or gains.57
A gain sharing arrangement can be combined with a “catch up” allocation of net gains
from capital transactions so that, assuming there are sufficient net gains, the gain sharing interest
holder’s returns are equivalent to the returns to regular equity interest holders. The participant is
effectively given a 100% share of such net gains until the participant’s capital account is equal to
his or her nominal (proportionate) share of members’ equity. If desired, members’ equity could
be calculated taking into account all operating cash flow distributions to regular equity interests
(as described in the preceding paragraph). A catch up allocation approach will achieve the
objective of harmonizing returns to regular equity holders and gain sharing holders only if sale
gains are sufficient to achieve the intended relative capital account balances.58
V. Holding Company
The restrictions on issuing an equity owner a Form W-2 for regular compensation
59
income can be avoided using a holding company to hold equity interests on behalf of
participants. In addition to simplifying the tax reporting with respect to the participants’ regular
compensation payments, a holding company arrangement may have collateral non-tax business
benefits60 and may increase available tax benefits under I.R.C. § 199A (temporary 20%
deduction for qualified business income).61 An arrangement using a holding company to hold
profits interests is shown in Illustration 1. Note that this arrangement can also be used with gain
sharing interests or other types of real equity interests issued by the operating company. A
holding company arrangement is not needed if the participants are properly regarded as
employees of a separate management company (other than a management company that is a
disregarded subsidiary of the operating company that issues equity interests to the participants).62

57
See footnote 56 regarding i-units issued by some publicly traded partnerships.
58
Id.
59
See text and authorities at footnote 30.
60
Some practitioners routinely use a holding company to hold real equity interests that would otherwise be
issued directly to service providers, not as a means of avoiding the IRS restrictions on treating partner compensation
as wages, but as a means of insulating the operating company from claims of service providers based on their status
as members in the operating company. Accordingly, while it should not be necessary to have a non-tax business
purpose for issuing gain sharing interests or other real equity interests to a holding company (cf. Keller v.
Commissioner, 77 T.C. 1014 (1981) (professional services corporation formed for the primary purpose of reducing
federal income taxes)), there may be a material non-tax benefit in doing so.
61
What would otherwise be guaranteed payments that are not counted as W-2 wages for purposes of the
limitations under I.R.C. § 199A(b)(2) are converted to employee compensation that generally should be classified as
W-2 wages for such purposes.
62
See Treas. Reg. § 301-7701-2T(c)(2)(iv)(C)(2) and T.D. 9766 (May 3, 2016) (compensation paid by
disregarded subsidiary of a partnership to an employee who is a partner in the partnership is treated as a guaranteed
payment or distributive share income and is not treated as wages).

Equity Incentive Compensation Plan Considerations for a Limited Liability Company 20

 Illustration 1 – Holding Company Arrangement for Profits Interests

Owners Participants
Restricted
Units

Regular Wages
Equity Interests
Holdco, LLC

Partnership
Profits
Interests

Opco, LLC

Partnership

VI. Conclusion and Summary

A client operating a business as an LLC taxed as a partnership will often try to design an
equity incentive compensation plan to mimic what publicly traded corporations provide for their
key executives. However, because of the tax differences between a private LLC/partnership and
a publicly traded corporation, an LLC involves special considerations. In many cases, it is
possible to achieve results for an LLC that are superior to those available in a corporate context.
Table 3 below summarizes the LLC equity compensation plans discussed in this article,
and Table 4 summarizes the key tax differences between real equity and synthetic equity to the
company and the participants.
Table 3 – Classification of LLC Equity Compensation Plans

Real Equity Synthetic Equity

Capital and Profits Restricted Equity Phantom Equity

Equity Options
(Not Recommended) Equity
Profits Only
OR Appreciation Rights
Profits Interest

“Catch Up” Allocation

Hybrid AND/OR Various64
Gain Sharing Interest63

63
An interest in profits only from capital events.

Equity Incentive Compensation Plan Considerations for a Limited Liability Company 21

 Table 4 – Key Tax Distinctions Between Real and Synthetic LLC Equity

Real Equity Synthetic Equity

Capital gain possible

All ordinary income
post-inclusion
Participant

No surtaxes? FICA applies

Deflection of income and

Company Ordinary deduction
gains post-inclusion

Synthetic equity plans generally offer the best overall mix of tax efficient and simple
LLC equity incentive awards. While the payout to the participant (if any) is taxed entirely as
ordinary compensation income, the tax event is deferred until payout (avoiding any mismatch of
income inclusion and cash payments), and the company obtains an offsetting ordinary deduction
for the full amount included in the participant’s income at payout. Because of the tax advantage
to the company, it can generally afford to be more generous with respect to the equity awards.
And because all payments under a synthetic equity plan are generally processed through the
company’s regular payroll reporting systems, it is typically a very simple plan to administer.
Real equity plans offer participants the potential for capital gains and, in some cases, the
potential for eliminating employment taxes (FICA), but these advantages come at the cost of
greater complexity.65 In addition, the tax benefit to participants from capital gains treatment is
often muted by the fact that other equity owners obtain a reduction in capital gains, rather than an
ordinary deduction, for capital gains accruing to the participants. If participants place a high
emotional value on the opportunity for capital gains and can live with the associated complexity,
a profits interest plan or a gain sharing plan should be considered.
Disclaimer
Information contained in this article is not intended to provide legal, tax, or other advice
as to any specific matter or factual situation, and should not be relied upon without consultation
with qualified professional advisors. Any tax advice contained in this document is not intended
or written to be used, and cannot be used, for the purpose of (i) avoiding penalties that may be
imposed under applicable tax laws, or (ii) promoting, marketing, or recommending to another
party any transaction or tax-related matter.

64
Any type of real equity plan can be replicated (on a pre-tax basis) using a contractual arrangement requiring a
cash payout equal to the economic return of under the corresponding real equity plan. Phantom equity units and
equity appreciation rights are merely two specific examples of such contractual arrangements.
65
One business owner insisted that participants be issued “real” restricted equity so that they would fully
appreciate and share the tax headaches he faced as an owner of the business.

Equity Incentive Compensation Plan Considerations for a Limited Liability Company 22