How Can I Give an Employee Ownership in MY LLC

Hi, welcome to Counselor Chronicles with CapEx Legal. Today we're going to talk about delivering employees equity compensation, specifically in limited liability companies. There are a lot of reasons that a company might want to give its employees equity. It could be because you're delivering under market compensation, like with a startup.

In other cases, established companies might want to deliver equity to employees as a form of keeping them around and making sure they don't jump ship to a competitor. In either case, there are a few factors that we need to balance when thinking about how to deliver equity to employees. We have to make sure tax obligations make sense, that legal compliance is in place, and that overall company and owner goals fit the solution that we're intending.

As an initial starting point, we need to talk about company value. The IRS says that all companies have value. Now, for a startup that was started 15 minutes ago, there's really not going to be that much value. But in a company that's been around for a few years, a company that has assets, including intangibles like goodwill and brand recognition, there is absolutely going to be company value.

And the IRS says that you cannot give away equity in a company. It either has to be purchased at fair market value, or it's delivered as compensation. If delivered as compensation, that compensation is immediately taxable on the date of the grant. So in terms of a real world scenario, let's say we've got a company that's worth $2 Million.

If you want to give an employee 10% of the company, either they have to purchase it at $200, 000 or it's delivered as compensation. And the IRS will say, okay, you just gave this employee $200, 000 in compensation in the form of equity. And now the employee has tax liability on that income as though they received cash.

That tax liability will probably come out to somewhere around $65,000 or $70,000, that would be immediately payable to the IRS. In either case, it's not really a great incentive for an employee to stick around or to join a company. In one case they're paying out taxes, and in another case they're purchasing the company at a very high price point.

In lieu of that, what the IRS has said is that we can create something called a profit interest. Before I get into that, I kind of want to talk about LLCs for just a moment and how they work. LLCs are one of the newest kind of entities that exist. The New York State did not even recognize the limited liability companies until 1995.

They're so new that the federal government does not have a tax classification for LLCs. Instead, LLCs have to work with a default tax classification or an elective tax classification. For a multi member LLC, a LLC's default tax classification is going to be as a partnership, a pass through tax entity.

Now, one of the cool things about LLCs is that they have a bundle of rights, and each of those rights can be separated. There's three primary groups of rights that we're looking at within LLC. Capital rights, profits rights, and management rights. Capital rights are rights to the existing value and assets of the company.

So in the case of the $2 Million company, rights to that $2 Million in value. Profits rights are rights for future profits in the company, rights and profits that don't really exist yet. And management rights are pretty much self explanatory. When it comes to LLCs, when we want to talk about delivering equity to employees, what we can do is we can separate out the capital rights and focus on the profits right, or maybe just the profits and management rights, and focus on delivering those.

And the mechanics for doing this is called a profits interest and what we do is we look at different classes of shares and bundle separate rights to each of the classes. So the existing owners of that company that has a $2 Million value, they might get class A membership interest and class A membership interest will have rights to all of the existing capital, the whole $2 Million plus profits and management rights.

Then for employees, we can create a new class of ownership, we can create class B membership interests. And what we can do is we can specify that all capital rights, all rights to that $2 Million are with class A and none of those rights go to class B. But class B gets rights in the future profits of the company and maybe some management rights.

Because we're creating a new class of units that has no relation to the existing value of the company, the par value or the value of interest being delivered is zero. Because it's zero, the employee doesn't really have to buy anything, and the employee doesn't really have any kind of taxable income on it.

And so we're kind of getting around this whole concept of company value and the buy in or the tax basis. Another great thing about profits interest is that we can create what's called a hurdle. So let's say you have, company A that you want to give equity to in 2024. And we have this $2 Million valuation in 2024 Let's say in 2025, you want to give employee B company equity, there's going to be some kind of change in the value of the company, some kind of appreciation.

And we don't want to have to create a new class of membership interests each time and for each employee, where are you trying to get membership interests and where are you trying to give some kind of ownership. And so what we do instead is we create a hurdle, and each employee in Class B can get a different hurdle.

And that kind of simplifies and streamlines the delivery of equity, and this whole bundle of rights that we're delivering. But when we're structuring a profits interest plan, it's really important to focus and think about termination. There are a lot of ways that the employment relationship might get terminated over time.

Maybe an employee is stealing from you, or maybe they're just no longer a good fit, or maybe you have to downsize. On the other hand, maybe the employee wants to leave because they have a life change or a change of focus. In each of these cases, you want to be able to decide whether or not the employee gets to retain that equity that they've built up over time, these Class B membership interests, let's say, or whether they get bought out.

In some cases, for example, if they're stealing from the company, maybe they get bought out for nothing because they're stealing from the company. In other cases, we might want some kind of fair market value so that they actually feel like they're earning something over time. You are actually properly incentivizing them.

Whatever the case, all of these factors need to be thought out, but there's one really important point that needs to be disclosed to the employee, where the employee needs to have a kind of mental buy in, and that's a function of tax status. Now, for anyone that's received a W 2 paycheck before, you've noticed a line on there for FICA.

It's a 7.65% tax for Medicaid, Medicare, and other similar things. And what a lot of employees don't realize is that FICA is a dual sided tax. 50% is paid for by the employee, and the other 50% is paid for by the employer. It's a total tax of 15.3%, but the employee is used to just paying 7.65%.

When it comes to LLCs, the IRS says you cannot be dual status. You cannot be both employee and owner. You cannot save that 7.65%, you have to pay both sides of it. And not only that, you have to pay both sides of it for any kind of compensation you receive. This extends to benefits like health care or gym memberships.

So the moment that you deliver a profits interest or other form of equity to the employee, their tax rate for any money they make from the company is going to jump up by 7.65%, if not more in the case of benefits. In most cases, this is going to be counterbalanced by the distributions and other incentives that they receive as company owners, but it's something that you do have to disclose to the employees so that they're aware and so that your accountants also know, uh, that their tax basis is going to be changed moving forward.

There are a lot of great reasons to deliver equity to employees in a company, but all of it should be thought out and well planned in advance to make sure that you're not running into tax implications or legal compliance issues that you're not expecting. If you have any questions, always reach out to a lawyer.

And if you need a lawyer, reach out to us at Capex.Legal. Thanks for joining me at Counsel Chronicles with CapEx Legal.