Docschi #5270-v1-nceo 2014-presentation1

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

Transcript of Docschi #5270-v1-nceo 2014-presentation1

Page 1: Docschi #5270-v1-nceo 2014-presentation1

Presented by

Compensating and Incentivizing LLC Employees Through Equity Compensation: An Attractive

Alternative to ESOPs

Daniel N. JanichOfficer, Greensfelder, Hemker & Gale, P.C.

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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

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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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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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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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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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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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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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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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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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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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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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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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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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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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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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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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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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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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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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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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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

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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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ESTABLISHING an EQUITY COMPENSATION PROGRAM (Cont.)

Eligibility and allocation: Eligibility criteria:

o Key employeeso 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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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.)

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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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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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