Romeo Finds a Streetlight, Steps Out of the Shade, and Says Something Like, LLC Compensation, How About It?

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Tips for Structuring LLC Incentives

by John Ludlum

On a frequent question of how to structure incentives for LLC entities, we find that many of our clients decide to use profits interests for only a few key employees (making them partners subject to partnership taxation) and a cash-based bonus plan for the majority of the employees. The issue of being treated as a partner involves receiving K-1 income, not W-2, so there is no withholding and the partners must deal with self-employment taxes, quarterly estimated taxes, and items like employer contributions to health plan premiums are taxable. But profits interests can receive capital gains treatment.

LLCs wanting to offer incentives to a broader group of employees typically do so through a cash bonus plan. These bonus plans are rights to cash only, so there is no possibility to get capital gains treatment, unlike an equity award, but they are very flexible. Cash plans have various names that typically reflect design features: phantom stock plans, performance interest plans, and change of control plans, for example. The advantages to these cash-based plans include:

  • Great flexibility in how the payment formulas are designed: the company can specify a pool of money to be divided on a change of control, include caps on payouts, or mirror the value of an equity unit.
  • The plans can be designed to pay out on specified events, usually ones that involve liquidity to pay the bonus obligations (change of control). But if liquidity is not a concern, payouts can triggered on death, retirement, disability, or termination of employment.
  • Cash plans are generally well understood for incentive purposes.
  • Cash plans do not create shareholders with any of the attendant rights (voting), and cash plans are generally not considered to have securities.
  • Cash plan recipients remain employees for tax purposes (receive a W-2, don’t have to pay estimated taxes, etc.).

There are some considerations for cash plan compliance depending on design choices with respect to Code Section 409A (the deferred compensation rules):

  • The simplest structure for Code Section 409A compliance is to make the participants continue in service to the company until such time as amounts are paid out based on an event like change of control. This structure can generally be exempt from Code Section 409A as a short-term deferral and is sometimes called “present to win.”
  • It is possible to make the right to a payment continue after termination of employment (to the extent vested), but such a structure has to be “compliant” with the Code Section 409A rules. The main consideration for the company is that compliant structures cannot be amended, modified, accelerated, delayed, or cancelled and replaced without attention to very onerous rules. So practically, if somebody terminated with a vested right to a payment to be triggered by a later change of control, the company could not choose to pay out on termination without violating Code Section 409A (it would be an impermissible acceleration).
  • The penalties under Code Section 409A include changing the time of income inclusion (to the vesting year) and a 20% additional tax on amounts included in income (all normal income and wage taxes apply too)., So Compliance or exemption from Code Section 409A is essential.