A Layman's Guide To LLC Incentive Compensation

1. INTRODUCTION

   This outline examines the U.S. tax consequences surrounding the use of equity based compensation by partnerships and limited liability companies1 (each, an "LLC").2 The grant of compensatory LLC equity interests and the vesting of restricted LLC equity interests raise some of the thorniest issues of Subchapter K, including the necessity of bookups, the occurrence and effect of capital shifts and other hypothetical transactions, and the ancillary tax consequences of a service provider becoming a member.3

   These issues are discussed in detail in Section II of this outline and are also discussed briefly in subsequent sections with respect to different types of LLC interests. Sections III through VI discuss the federal income tax consequences to service providers, LLCs and other LLC members of granting restricted and unrestricted capital and profits interests, options to acquire LLC interests, and virtual options such as equity appreciation rights.

   As the following sections make clear, there is no single "best" type of compensatory LLC interest for all parties. Certain types of interests are more favorable for service providers (e.g., interests for which taxation is deferred or for which a section 83(b)4 election may be made showing a zero value for the interest). Other types of interests may be more favorable for the other LLC members (e.g., fully vested interests that produce an immediate deduction for the LLC). Accordingly, the choice of what type of interest to issue will vary depending on the importance accorded each party's tax position in a given transaction.

   The degree of certainty parties require with respect to the tax treatment of the compensatory interest will also be an important factor in choosing among interests, since each type of compensatory interest raises different tax questions. In particular, there are more questions than answers regarding the taxation of restricted profits interests and options. After spending altogether too many hours contemplating these issues, I am sure of only one thing-some element of the tax treatment of each type of LLC compensatory interest is, at best, gray.

2. GENERAL ISSUES REGARDING COMPENSATORY LLC INTERESTS

   The issuance and vesting of LLC compensatory interests raise a host of issues regarding bookups, capital shifts and attendant deemed asset transfers. As a threshold matter, it is well worth considering whether the cost of administering the mark to market regime described below, including bookups, capital shifts and deemed asset transfers, is justified. Granted, bookups (and to a lesser extent, capital shifts) are clearly fundamental to the workings of the section 704(b) safe harbor. Stepping outside those rules, however, it is less clear that any benefit obtained by requiring LLCs to mark to market non-liquid assets and members' interests each time a new compensatory interest is granted or vests (sometimes weekly, at the height of the dot.com boom) is worth the administrative cost of complying with the complex rules and policing those who fail to comply. While this paradigm may have served its original purpose well-policing the sale of tax benefits through real estate tax shelters-the author would submit that it doesn't work nearly as well for the dot.com LLCs and other operating company joint ventures of the new millennium. A. Revaluations of LLC Assets

   The tax consequences and, more importantly, the quantum of interest transferred to a service provider, will often vary considerably depending on whether the assets are marked to market in connection with the issuance and vesting of compensatory interests. This result can be achieved either through a "bookup" of the LLC's assets or through the issuance of a separate class of LLC units representing an interest in profits/capital created after the date of issuance. As described below, the latter choice often has significant appeal. As discussed below, regulations now permit an LLC to take advantage of the section 704(b) rules to effect a bookup.5 If an LLC's assets are not marked to market, the recipient of a profits interest would also effectively receive an allocable portion of the appreciation in...