Restricted Equity vs. Phantom Equity: Incentive Plans for LLCs
A privately held company organized as a limited liability company (LLC) often wants to offer to key employees the right to participate in the financial success of the business through an equity incentive plan that provides participants with a capital and profits interest in the LLC.¹ These plans may be structured in a number of ways.
A common structure is a restricted equity plan, under which the LLC grants employees equity interests in the LLC that vest over time or when certain benchmarks are met. But is it ideal for an LLC to grant actual equity to its employees? After examining LLC governance and tax issues related to restricted equity plans, an LLC may find it more desirable to grant an employee “phantom equity.”
A phantom equity plan is a contractual arrangement between an employee and an LLC granting the employee rights to future payments once certain events occur. The plan ties the economic benefits of an actual equity interest to that of the phantom equity interest. For example, if the owners of an LLC sell all of their equity interests for cash, a 5% phantom equity interest holder would generally be entitled to a cash payment equivalent to the payment received by a 5% equity interest holder. The plan may also require cash payments to phantom equity holders in the event that the LLC makes distributions to its members.
Although the economic rights for phantom equity and actual equity holders are similar, the non-economic rights are quite different. When an employee obtains an equity interest in an LLC, he or she becomes a member of the LLC, which entitles him or her to all rights afforded to members under the company agreement and the relevant state law. The company agreement may create separate classes of equity for employees that curtail certain member rights such as voting.
However, under state law, certain membership rights like access to LLC books and records may be guaranteed. Importantly, managers owe fiduciary duties to the LLC. If that is the case, an employee who becomes a member through a restricted equity plan could sue a manager for breach of those duties. This uncertainty may burden management when important decisions need to be made.
On the other hand, as long as the phantom equity plan is properly drafted, a phantom equity holder’s rights are derived solely from the plan. The holder does not become a party to the company agreement and, thus, is not given any membership or ownership rights.
Therefore, management does not have to comply with a phantom equity holder’s request for access to books and records, including financial statements, or a demand to hold or participate in an owner meeting, because they have no such rights. For this reason, an LLC may prefer establishing a phantom equity plan for its employees, rather than a restricted equity plan.
Tax considerations advance the conclusion that phantom equity plans may be preferable to restricted equity plans for an LLC that is classified as a partnership for federal income tax purposes. The tax considerations favoring phantom equity plans include:
- Typically, phantom equity plans avoid significant accounting complexities and tax-filing requirements associated with restricted equity plans. Each time additional equity interests vest or are retired, the LLC must recalculate all equity owners’ capital accounts, sharing ratios and tax basis allocations. Further, an award of equity may create added state tax filing requirements for the LLC and the new member.
- Because the IRS has ruled that an LLC member cannot also be an employee of the LLC,² employees holding restricted equity in their LLC employer must have their regular compensation reported as a guaranteed payment on a Schedule K-1 issued by the LLC. The Schedule K-1 will also report their distributive shares of the LLC’s income or loss and other tax items, including state tax items.
- This can be confusing to the employee, generate complexity for the employee’s personal tax filings and give rise to state tax filing requirements that the employee would not otherwise have. In contrast, an employee’s participation in a phantom equity plan has no effect on reporting the employee’s regular compensation on Form W-2, does not cause any allocation of LLC tax items to the employee or give rise to any independent state tax filing requirements. Payments made under a phantom equity plan can be treated as bonuses and reported on an employee’s Form W-2.
- All phantom equity payments by the company are immediately deductible. In contrast, any payment made to retire restricted equity is generally not immediately deductible, but must instead be added to the basis of undistributed company assets and recovered through depreciation or other basis recovery provisions.
A phantom equity plan is also subject to several potential tax disadvantages compared to a restricted equity plan. However, considering all of the tax issues, a phantom equity plan will likely be preferable to a restricted equity plan for both the employee and the LLC. Taking tax and governance issues into account, compared to restrictive equity plans, phantom equity plans can reduce the risk of management/member conflicts and provide tax benefits to the LLC, while providing significant upside to the key employee.
Restricted equity plans and phantom equity plans take many forms, and variations within a plan may affect the foregoing analysis.