In most cases if you intend to offer equity to employees then you should probably organize or reorganize your company as a corporation. It makes things simpler in terms of documentation, internal tracking and HR management. However, if you have a good accountant (see final paragraph of this post) and a good reason to operate as an LLC (see post here), offering employees equity in the LLC is a totally viable, possibly advantageous, option.
Like a corporation, LLCs (along with any other entity taxed as a partnership) can grant equity and options to acquire equity, the practical difference (for an equity holder) just being that LLC equity is called "membership interests" (or sometimes "units" but there's no legal distinction) and corporate equity is called "stock." FN1
As a matter of law, however, membership interests do not fit within the portion of the IRS tax code that applies to employee incentive stock options. From a implementation standpoint this means LLCs cannot simply have their lawyer draw up a standard Stock Option Plan and concommitant Stock Option Agreement (to be signed by each participating employee), make the necessary accounting adjustments (a certain portion of company stock - the stock option pool - will have to be reserved) and call it a day.
Instead, the LLC has to set up a mechanism (usually in the Operating Agreement) to grant employees "membership interests". The implementation of this may be a little tricky but it's not conceptually complicated. The upshot is that somewhere in the LLC Operating Agreement terms and provisions will have to be inserted that a) distinguishes between the "members" (i.e., partners/founders) and the "employees" and the kind of membership interests being received by each, b) describes any applicable vesting requirements and c) identifies (usually as an exhibit) the employees receiving the equity and how much and the vesting schedule (if any). FN2
As a threshold matter, however, an LLC has to choose what KIND of membership interest to grant, and this is where the complexities start.
In essence, while a corporation typically grants employees common stock options, an LLC has a choice to grant employees "capital" interests or "profits" interests. The capital interest is effectively like common stock - it carries the right to a proportionate share (whenever distributed) of the a) existing capital base, b) future profits and c) future appreciation of the company. The profits interest, on the other hand, is only 2/3 of this. It incorporates future profits and appreciation but not existing capital value (which makes it a bit like a stock appreciation right, which is also similar in that (unlike a stock option) it doesn't have a strike price and the employee would at time of distribution just receive the amount of the appreciated value without having to pay anthing). Thus, the profits interest starts out with zero dollar value (since it doesn't share in the capital base of the company) and grows in value as the LLC grows in value.
An example: imagine an LLC grants a new employee a 5 percent profits interest and that the LLC is valued at $10 million. If the LLC later sold for $14 million, the new employee would be entitled to $200 grand, which represents 5% of the $4 million appreciation. The remaining partners would be entitled to 100 percent of the $10 million and 95% of the $4 million appreciation.
The big benefit of a profits interest (and why it exists) is that under current tax law the grant of it does not impose any taxes on the recipient at the time of the grant. FN3 It's not taxable because, as noted, it does not grant the employee a share of the capital base; all the value is forward-looking, thus at the time of grant there is no value being transferred. With a grant of capital interest, by contrast, the employee will have to pay (in the year of the grant) tax on the difference between the value of the capital interest being received and the amount of money that the employee contributes (if any), which partially undermines the value proposition to the employee (or, depending on the value of the LLC, might be flat out cost prohibitive to the employee). FN4
Three administrative issues also merit mention: First, LLCs face a special problem that corporations don't in so far as under tax law a member of an LLC will not be treated as an employee of that LLC by the IRS. He'll be treated as a partner. This means any wages paid to the employee by the LLC won't be subject to taxes by way of a W-2. FN5 Instead, the employee, if paid any wages, would be subject to self-employment taxes (at a rate of 15.3 percent) rather than a share of FICA (at a rate of 7.65 percent) (as is the corporate case).
Second, employees should file what is called a 83(b) election when being granted any membership interest. The 83(b) election ensures that the employee will be taxed only at the time of grant (for the excess between price paid (if any) and value receive in the case of the capital interest and for nothing in the case of the profits interest) and not taxed incrementally over time as the value of the interest goes up or, if any vesting requirements are put on the interest (as usually in the case) the vested portion of the interest.
Third, and most importantly, when an employee is granted a membership interest or leaves the company prior to full vesting, your accountant is required by tax law to "book up" or "book down" the capital accounts of the members. Generally, each member's capital account is adjusted to reflect the member's share of any gain or loss that would be triggered if the LLC had sold all of its assets at the time of the adjustment. This activity can be difficult and expensive (basically because book-ups must be based on a fair market value of the LLC's assets and require special tax allocations afterwards). Accordingly, any compensation program that requires multiple book-ups (employees are coming and going with regularity) might not be practical.
FN1
Because the majority of the strategic issues around equity incentives relate to tax law and LLCs are partnerships according to the IRS, most of this discussion also applies to limited liability partnerships.
FN2
If the employees are receiving "profits" interest, it will also probably require a separate profits interest grant agreement (pursuant to the LLC agreement) with that employee.
FN3
The specific "safe harbor" rules here are that there is a tax exemption so long as (1) the interest represents an interest in profits and value accretion (not current capital), (2) the interest is being received for the provision of services, (3) no transfer is made within 2 years of receipt, (4) the interest is not related to a substantially certain stream of income of partnership assets (such as income from debt securities), (5) the partnership is not publicly traded. Revenue Procedure 93-27.
FN4
Note that in very newly formed companies this difference tends to be very small (since the capital of the company will likely be valued at a very low price) and thus not a concern.
FN5
There are creative ways to handle this. A company, for example, could have an operating arm that is a corporation and that pays the employees and a holding arm (which is the LLC). The employees could be given membership interests in the LLC and receive a salary from the corporate entity.
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