Congratulations! You’ve been offered employment as an executive of a promising up-and-coming limited liability company (LLC). The LLC has been operating for a few years, and it appears to be on the cusp of “taking off” and becoming profitable. In order for the LLC to preserve one of its most precious commodities, cash, you are offered a below-market salary; however, to make up for the below-market cash compensation, the LLC has agreed to grant you a 3% ownership interest in the LLC. You are inclined to accept this employment opportunity, as you believe the 3% ownership interest has tremendous upside potential. But, as you might expect, ownership in an LLC (especially in lieu of cash compensation) can be tricky, and there are potential pitfalls everywhere.
Before we get started, it is important to note that like most other forms of compensation, the receipt of ownership interests in an LLC, unless structured as a “profits interest” as described below, will result in taxable income to you equal to the “value” of such ownership interests. To limit tax liability, many LLCs issue ownership interests intended to qualify as “profits interests.” If structured properly, a profits interest is not taxable to the recipient at the time of issuance. If you are to receive “profits interests,” it is imperative that you engage a tax professional to ensure that the profits interests are structured properly such that you do not have an immediate tax liability as a result of their issuance and to ensure that any other tax issues, particularly the ones described below, are properly addressed.
Typically, there are two documents that are critical to understanding your rights with respect to your ownership in the LLC. The first is the award agreement, pursuant to which the LLC issues the interests to you, which can either be a separate stand-alone agreement or is occasionally included in your employment agreement with the LLC. The second is the LLC’s operating agreement, which specifies the rights of ALL of the owners of the LLC, including your rights, should you accept employment and become an owner. It is common for an executive to be able to negotiate the terms of the award agreement, but it is uncommon for an executive to be able to negotiate the terms of the LLC’s operating agreement since it governs the rights of ALL owners of the LLC and not just the executive. Depending on your relative bargaining power, however, you may be able to negotiate some changes to the operating agreement (or use your award agreement to override certain provisions in the operating agreement). Both documents should be reviewed carefully, particularly the provisions set forth below.
Most award agreements provide that the interests vest over time, e.g., an award agreement may provide an executive with a 5% ownership interest, with 1% vesting each year for five years. The vesting feature typically requires you to be employed with the LLC (or, possibly an affiliated entity), such that, upon termination of your employment, your “unvested” ownership interests will be forfeited. It is certainly crucial for you to negotiate the length of the vesting period; however, it is just as important for you to try to limit the types of terminations that would cause a forfeiture of your unvested interests. If your employment with the LLC is “at-will” or can be terminated by the LLC at any time, you should try to limit the forfeiture of unvested interests solely to cases where you voluntarily quit or if the LLC terminates your employment “for cause."
Further, there is nothing preventing you from negotiating the award agreement to provide that you have the right to receive distributions (and to vote, to the extent you are granted voting interests) with respect to all interests, even those interests that have not yet vested.
Virtually all operating agreements include provisions governing how the LLC’s cash flow is distributed amongst its owners. Many operating agreements contain different types of distribution “waterfalls” depending on the source of the cash flow, e.g., one “waterfall” for cash flow from operations, a different “waterfall” for cash flow from capital and/or an extraordinary transaction, etc. Many operating agreements include distribution “preferences” for owners who have invested money or property in the LLC. At a bare minimum, you need to understand what distribution preferences there are and where you stand in the “waterfall” of distributions. You should do your best to ensure that you are entitled to participate in ongoing distributions of operational cash flow.
Further, most operating agreements give management broad discretion in deciding when to make distributions (and how much cash to distribute). LLCs are typically “pass-through” entities for federal income tax purposes. This means that instead of paying income taxes on its profits, the LLC allocates the profits to its owners (typically, based on relative ownership) who are then responsible for paying the taxes on the profits allocated to them. As such, you need to ensure that the operating agreement includes a provision requiring the LLC to distribute sufficient cash to cover any taxable income that may be allocated to you.
Most operating agreements contain a myriad of (sometimes confusing) transfer restrictions with respect to ownership interests. It is not uncommon for these provisions to include some or all of the following:
- A general prohibition on all transfers (except for certain estate-planning transfers) without management approval.
- A right of first refusal to the owners of the LLC prior to an owner selling his or her interests in the LLC.
- A “drag-along” right mandating that should a certain number of owners desire to sell their interests in the LLC, they can “drag” all other owners along and force them to sell as well.
- A “tag-along” right allowing minority owners to “tag” along with the sale of a majority of interests in the LLC.
- Buyouts on the death or dissolution of an owner.
As an employee-owner of the LLC, you should pay particular attention to any transfer requirements that would apply to employee-owners that do not otherwise apply to the ownership group as a whole. For example, the operating agreement could include a provision requiring you to sell back your interests to the LLC (or the other owners) at a steep discount should you no longer be employed by the LLC for any reason.
Gross Up of Cash Compensation
A person cannot be both an “owner” and an “employee” of an LLC for federal income tax purposes. As such, once you become an “owner” of an LLC, any compensation that would otherwise be reported on a W-2 as salary, should, on a go-forward basis, be reported as self-employment income to you, such that you are responsible for what would otherwise have been the LLC’s portion of FICA (if you were just a non-owner employee). You should insist on a provision in the award agreement (or your employment agreement) that any such compensation will be increased by the amount that would have been required to be paid by the LLC as a FICA tax if you were treated as an employee of the LLC for tax purposes. It is important to note that many LLCs incorrectly continue to treat all compensation of employee-owners as “compensation,” as opposed to self-employment income. Regardless of how the LLC treats it, you should still insist on adding the aforementioned provision.
These are just the most common provisions that can render your 3% ownership in the LLC worth a lot less than 3% of the LLC. If you are considering receiving equity ownership, especially in lieu of cash compensation, you should engage an experienced professional to assist you in navigating all of the potential pitfalls.
For more information, please contact a member of Taft's Business & Finance group or Tax group.