By Ryan Bartholomee, CPA
With the battle for talent in Texas due in large part to the thriving oil and gas industry and supporting industries, employers have to be creative in how they attract, retain and motivate experienced talent. Some employers may consider providing ownership opportunities in an affiliated entity to key employees in exchange for services contributed. In the case of an LLC taxed as a partnership, a profits interest could be provided in which the employees could share in the future profits and appreciation in value of the LLC going forward after the interest was granted (if fully vested). In general, receiving a profits interest is not a taxable event (see Rev. Proc. 93-27, clarified by Rev. Proc. 2001-43 for additional information regarding exceptions). Making an IRC section 83(b) election (discussed further below) after receiving a profits interest may still be recommended despite these safe harbor rules so as to protect against the violation that would occur from disposing of the profits interest within two years of receipt.
In contrast to a profits interest, a capital interest entitles the member to receive the proportionate share of the net proceeds of a complete liquidation of the LLC as of the grant date (if fully vested). If a capital interest is earned by the employee and a vesting period is applied, then an IRC section 83(b) election might be worth considering. This election has to be made within 30 days of receiving the capital interest even though the vesting has not yet occurred. It allows the member of the LLC to pay tax on the full fair market value of the membership interest as if it was entirely vested at this time. This is beneficial if the LLC’s assets (such as undeveloped leasehold costs) have a significantly lower value at that time than they are expected to have in the future after assets are developed.
For example, if a membership interest (a capital interest in this case) of 1 percent was granted with a five-year vesting period to an employee, the employee could make a section 83(b) election within 30 days. Let’s say the capital interest had a value of $100,000 (with assets made up largely of leasehold costs associated with undeveloped leases) after discounts for lack of marketability and lack of control. The employee would need to pay ordinary income taxes on the $100,000. If, after five years, the 1 percent capital interest was worth $500,000, then the employee would have paid taxes on $100,000 in order to eventually receive an asset worth $500,000. There are obviously significant assumptions and risks to consider when evaluating this election. Remember that time is of the essence in making an 83(b) election. The 30 days passes quickly. Consistent communication with your clients and knowledge of their plans early on could help these members make wise tax-planning decisions. This could ultimately prevent the LLC in this example from having to distribute too much cash to its members for tax purposes during a phase when capital for asset development is critical.
For definitions and a comparison of capital interests versus profits interests, please see the following link on the IRS website: http://www.irs.gov/publications/p541/ar02.html.