This slide presentation reviews the options available to limited liability companies in providing equity incentives to their employees, and how limited liability companies should develop a program for maximum effectiveness. This presentation was given at the NCEO Annual Conference in Atlanta April 9, 2014.

1. Presented by
Compensating and Incentivizing LLC
Employees Through Equity Compensation:
An Attractive Alternative to ESOPs
Daniel N. Janich
Officer, Greensfelder, Hemker & Gale, P.C.

2. INTRODUCTION
LLCs may use equity compensation to attract,
incentivize and reward their employees.
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S and C Corporations LLCs (Hybrid:
Corporation/
Partnership)
Share or Stock Membership interest (unit)
Shareholder Member
Shareholder agreement Operating agreement
Limited liability Limited liability
S Corp taxed as
partnership; C Corp taxed
as an entity
Taxed as a partnership

3. DECISION MAKING: ADVANTAGES and
DISADVANTAGES of EQUITY COMPENSATION
 Advantages:
 In today’s competitive environment for high achieving
key employees, the use of equity compensation is
practically mandatory;
 The use of equity compensation may be a powerful
incentive for employees to strive towards high
achievements because their economic interests
coincide with those of the business;
 By granting equity rather than cash, LLCs are able to
preserve monetary resources.
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4. DECISION MAKING: ADVANTAGES and
DISADVANTAGES of EQUITY COMPENSATION
 Disadvantages:
 Loss of control by the members;
 Issues involved in employees’ separation from the
LLC – resale restrictions;
 Members may not want to share financial information
with the LLC employees;
 Issues involved in repurchase of equity;
 Complex accounting considerations;
 Securities laws considerations
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5. FORMS of EQUITY COMPENSATION in LLCs
 Capital interests
 Profits interests
 Options (nonqualified only)
 Unit Rights and Unit Appreciation Rights (phantom
equity)
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6. CAPITAL INTERESTS
 Comparable to stock or restricted stock.
 Give the recipient the right to share in the full value of the
LLC assets through the receipt of a share of the proceeds
upon sale of the LLC assets.
 As of the grant date, the recipient has a right to share in
the capital of the LLC, as well as its profits and losses.
 May be subject to vesting requirements.
 May be restricted with regard to transferability.
 May be subject to forfeiture in case of criminal activity
affecting the company or obtaining employment with a
competitor.
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7. CAPITAL INTERESTS (Cont.)
 EXAMPLE:
 (1) Bob is employed as Vice President of Wintersport LLC and
at the time of grant in 2010 the LLC had 10 existing members
each having a capital account of $10,000, which in the
aggregate ($100,000), represents the fair market value of the
LLC. Bob as a member, receives a 5% capital interest in
Wintersport. The LLC is sold in 2014 at which time it is valued
$180,000. As such, Bob is entitled to $9,000 (5% of
$180,000). Bob receives a share of the initial capital and the
profits.
 (2) Alternatively, at the time of sale in 2014, the LLC is valued
at $80,000. Bob receives $4000. (5% of $80,000)
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8. TAXATION of CAPITAL INTERESTS
 Restricted capital interests (subject to vesting
restrictions):
 At the time the interests are fully vested, they are taxed as ordinary
compensation at their fair market value (FMV) whether the interest is sold
or not.
 Employee/recipient is not treated as a member (partner) for tax purposes
until the interests are fully vested.
 Section 83(b) election (within 30 days of grant):
 Employee pays income tax as ordinary compensation on the FMV of the
interest at the time of grant.
 Employee who later forfeits all or part of the interests is not entitled to a
refund on the taxes paid at the time of grant.
 At the time the interest is sold (after vesting), employee pays short or long-
term capital gains tax (i.e., on the increase in FMV at the time of sale as
compared to the one at the time of grant or vesting).
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9. TAXATION of CAPITAL INTERESTS (Cont.)
 Tax implications for the LLC:
 The LLC obtains a tax deduction as a business expense,
corresponding to the compensation amount claimed by the capital
interest recipient at the time of grant.
 Deductions are allocated to members pursuant to the LLC’s
operating agreement (capital interest recipients generally do not
benefit from such deductions).
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10. TAXATION of CAPITAL INTERESTS (Cont.)
 Example:
 In 2007, Sam as President of Meetingz LLC receives a capital
interest grant of 100 units valued at $500 each. Sam decided to
make an 83(b) election and pays taxes on $50,000 (100 X $500).
Sam’s interest vested in 2012. Sam sold his capital interest in 2014
for $86,000. Sam paid capital gains tax on $36,000. Meetingz got
a deduction of $50,000 at the time grant, but is not entitled to any
deduction at the time of sale of the interest.
 Alternatively, Cindy, the Vice President of Meetingz LLC decided
not to make the 83(b) election because she did no want to pay
taxes right away. She too sold her capital interest in 2014 for
$86,000. Cindy paid ordinary income tax on $50,000 (the initial
value of the units) at vesting in 2012 and capital gains tax of
$36,000 at the time of sale of the interest.
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11. PROFITS INTEREST
 A profits interest is comparable to incentive stock in C or S
corporation.
 Holders have the right to share in both the business’ capital
appreciation and if so provided in the LLC operating
agreement or by contract, in the company’s interim operating
profits.
 Companies are free to structure profits interests consistent
with business considerations since there are no statutory
provisions governing such structures.
 The “profits” concept includes both actual profits earned during
the operation of the LLC as well the increase in FVM of
membership units upon sale of the LLC.
 Grantees do not receive capital distributions upon liquidation
of the LLC.
 May be subject to vesting restrictions and forfeiture.
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12. PROFITS INTEREST (Cont.)
 Example:
 In 2008 Mary was granted a 15% profits interest in
Techability LLC at the time the LLC has a fair market
value at $1,000,000. The LLC was sold in 2014 when it
was valued at $1,750,000. Upon the sale of the LLC,
Mary received $112,500 ($1,750,000-$1,000,000 =
$750,000 X 15% = $112,500). Operating Agreement
does not provide for share of interim operating profits.
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13. TAXATION of PROFITS INTEREST
 “Safe harbor” income tax treatment of profits interests:
 No income tax is recognized by a recipient of a profits
interest if the following three conditions are satisfied:
 Profits interest is received by an LLC member or in anticipation of becoming a
member
 The profits interest is not related to a substantially certain and predictable
stream of income
 The profits interest is not sold within two years following the date of receipt
 If the Safe Harbor requirements are not satisfied, there may be uncertainty
as to the income tax consequences arising from the initial grant
 Although Section 83(b) election is available, it may not be necessary. Profit
recipients making the election, are treated as if they have an actual equity
stake in the LLC. They will receive a K-1 statement for their share of
ownership of the LLC and will have to pay taxes on it.
 Redemption of profits interest results in short or long-term capital gains
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14. TAXATION of PROFITS INTEREST (Cont.)
 Example:
 In 2010 Jesse was granted profits interests on 100 LLC
membership interest units of Savvy LLC at their fair market
value of $150 each. In 2014, one year after vesting, the
profit interest is cashed out at $200 per unit. Jesse pays
capital gain taxes on the gain of $5000 (100 units X $50).
For each year between 2010 through 2014, Jesse receives
a K-1 statement from Savvy for his share of the company’s
earnings and pays taxes on it and the salary he receives
from Savvy is not subject to withholding. Jesse must pay
self-employment taxes on the salary. Savvy like other LLCs
of similar size agreed to “gross up” Jesse to cover these
taxes.
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15. IRC SECTION 409A and EQUITY INTERESTS in
LLCs
 IRS Notice 2005-1: Section 409A “may apply to
arrangements between a partner and a partnership which
provides for a deferral of compensation under a nonqualified
compensation plan.”
 Section 409A applies to the grant of equity in LLCs to the
extent that LLCs are taxed as partnerships:
 Restricted and unrestricted capital interests:
 Issuance of compensatory capital interest is to be treated the
same as issuance of stock – no deferral of compensation
 Restricted capital interest (vesting) may be subject to Section
409A (unless Section 83(b) election made)
 Profits Interest:
 Grant of profits interest is to be considered exempt from Section
409A since no income is recognized and as such, no deferral
 Deferral of annual distributions of operating profits from profits
interest may be subject to Section 409A.
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16. OPTIONS to ACQUIRE CAPITAL or PROFITS
INTEREST
 Options are an alternative to an outright grant of
equity interests in the LLC.
 Options give the recipient the right to purchase
equity at a future date for a price that is not less than
the fair market value (FVM) of the interest on grant
date consistent with IRC Section 409A.
 Options are subject to vesting.
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17. TAXATION OF OPTIONS
 Option grant is not taxable to the employee at the time of
grant.
 At the time of exercise, holder of capital interest pays
ordinary income tax on an amount representing the
difference in the FMV at the time of grant as compared to
the one at the time of exercise. (NOTE: Membership units
must be valued.)
 The LLC receives a corresponding deduction at exercise.
 Until exercise, recipients do not hold equity for tax
purposes.
 Holder pays capital gains tax at the time of sale of the
membership units.
 Exercise of an option on profits interest is not taxable to the
employee and it is not deductible for the LLC.
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18. TAXATION OF OPTIONS (Cont.)
 Example:
 In 2009, Marilyn who is Vice President of Marketing for Eat What
You Kill LLC, receives an option equal to 200 membership units
valued at $100 per unit. They fully vest in 2014 at $225 per unit.
Marilyn pays ordinary income tax on $25,000 (200 X $125) and the
LLC gets a corresponding tax deduction.
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19. PHANTOM EQUITY: UNIT RIGHTS and UNIT
APPRECIATION RIGHTS
 Unit rights are comparable to phantom stock and unit
appreciation rights are comparable to stock appreciation rights.
 Grants of phantom equity imitate equity from an economic view
point, however, holders do not participate in the governance of
the LLC.
 Recipients of unit rights obtain the cash value of a specified
number of membership units, but not the units themselves.
 Unit appreciation rights entitle the recipients to receive the
increase in value of the LLC units in cash.
 Unit rights and stock appreciation rights are subject to vesting.
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20. TAXATION OF PHANTOM EQUITY
 Phantom equity awards are taxed like nonqualified
deferred compensation and as such Section 409A
implications must be addressed:
 Section 409A :
 If the grant is compliant with 409A, the recipient is subject to
ordinary income tax at the time at vesting, and the LLC gets a
corresponding deduction.
 If the grant is not compliant with 409A, at the time of vesting, the
amounts received by the employee are taxed as ordinary income,
plus 20% penalty tax, plus interest
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21. TAXATION OF PHANTOM EQUITY (Cont.)
 Example:
 In 2010, Miriam is hired as President of Linguability, LLC. Her
contract provides for her to be awarded units rights representing
600 membership units at $275 per unit. Her unit rights fully vest in
2014 at a $395 per unit. Since her deferred compensation plan is
409A compliant, Miriam pays ordinary income tax on $237,000
(600 X $395) and Linguability receives a corresponding deduction.
 In 2009, Jackson is hired as COO of Prospero LLC and pursuant to
his executive employment agreement, he is awarded unit
appreciation rights on 300 units with a value of $300 per unit.
Jackson’s unit appreciation rights vest in 2014 with a value of $450
per unit. Since Jackson’s plan is not 409A compliant, he pays
ordinary income tax on $45,000, plus 20% penalties tax, plus
interest for the deferral period.
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22.  Issues that need to be addressed:
 Consider whether the employee (executive)
should have real ownership or virtual
(phantom) ownership:
 Employee’s/executive’s contributions to the
organization (how valuable is the employee to the
success of the organization;
 Executive’s possible role in planning leadership
succession of the company;
 Whether the employee should have legal ownership
right and how this would affect the rights of the other
members
ESTABLISHING an EQUITY
COMPENSATION PROGRAM

23. ESTABLISHING an EQUITY COMPENSATION
PROGRAM (Cont.)
 Consider the amount of total equity available
for distribution:
 Percentage of total membership interest in play – 10%
is rather common, but it depends on company
size/worth:
o Employees are incentivized by amount of
compensation as opposed to percentage;
o Employer prefers decreasing amount of cash
compensation (salaries);
o Employer’s need to share the equity after it is earned
leads to a gradual approach as to how much equity is
available each year commensurate with the
company’s growth in equity.
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24. ESTABLISHING an EQUITY COMPENSATION
PROGRAM (Cont.)
 Eligibility and allocation:
 Eligibility criteria:
o Key employees
o Broad-based plans need to be considered when it is
critical that as many employees as possible be
incentivized to perform at their highest levels.
 Allocation standards are purely a business
decision:
o Commensurate with fulfillment of certain performance
targets;
o Commensurate with the value of the individual employee
to the organization as reflected by the employee’s salary;
o Commensurate with how much the organization wants to
retain the particular employee (particularly when the
employee is highly sought after by competitors)
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25. Vesting criteria:
Length of time:
oDuration
oStaggered or all at once
Performance targets
At the time of sale of the LLC (may be attractive to
capital interests holders who had not made a Section
83(b) election, but not recommended as an employee
incentivizing vehicle)
ESTABLISHING an EQUITY COMPENSATION
PROGRAM (Cont.)

26. For More Information
“Equity Interests in Limited Liability Corporations” available
for download at:
http://www.greensfelder.com/bio/239/daniel-n-janich.aspx
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27. Disclaimers
 These materials, and the oral presentation
accompanying them, are for educational purposes only
and do not constitute legal advice or create an
attorney-client relationship.
 Any information in this presentation is not intended and
cannot be used for the purpose of avoiding any
penalties that may be imposed on any person under the
Internal Revenue Code.
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