What Is the Role of Vesting in Incentive Compensation by LLCs Taxed as Partnerships?
We’ve reached the big 1-0 in our exhilarating incentive compensation series—a milestone that calls for a celebration! In this article, we’ll shine the spotlight on vesting and unravel its crucial role in sculpting diverse compensation plans for partnership-taxed LLCs. You’ll be armed with the knowledge to create a compensation blueprint that catapults your organization towards new heights of success!
Unraveling the Concept of Vesting
If incentives are the vehicle used to motivate team members, then vesting is the roadmap that guides them. It dictates the conditions for eliminating all, or https://www.irs.gov/businesses/small-businesses-self-employed/what-is-taxable-and-nontaxable-incomesubstantially all, of the risk of forfeiting the ownership rights or other entitlements. Here are the two primary approaches::
- Time-based vesting- under his vesting structure, the recipient earns the rights to the compensation gradually over time, usually expressed in years, quarters, or months, or in full after a certain amount of time has transpired (“cliff vesting”).
- Performance-based vesting- The team member must achieve specific performance milestones to earn the right to the incentive under this vesting structure.
Vesting in the Granting of Profit Interests
Vested and unvested profit interests are typically taxed similarly. Granting or vesting of a profits interest generally does not result in taxable income, particularly if the recipient makes the IRC Section 83(b) election. However, if a team member sells their unvested profit interests to a third party, they may have taxable income. The LLC may choose to allocate income on its books as if the unvested interest is fully vested, although the operating agreement may limit actual distribution of that income until the interest is fully vested.
Vesting in the Granting of Capital Interests
Vested capital interests are taxable upon grant. The team member pays tax on the difference between the FMV and the amount, if any, the team member paid for the capital interest. However, when the company issues unvested capital interests, by default, the recipient pays tax when the interests vest and are no longer subject to a “substantial risk of forfeiture.” However, if they file an IRC Section 83(b) election, they can recognize income upon grant, resulting in potentially lower tax liability.
Vesting in the Granting of Options on Capital Interests
Unvested options on capital interests are usually not subject to taxation when they are issued. Additionally, vesting of these options does not typically trigger taxation. The taxable event usually occurs only when the team member exercises the options. At that point, the difference between the fair market value (FMV) of the capital interests and the exercise price is treated as ordinary income for tax purposes.
Vesting in Phantom Equity and Cash-Based Incentives
Phantom equity and other cash incentives that are unvested are not subject to taxation upon grant, nor is there a taxable event upon vesting. The tax consequences arise only when the recipient receives the cash payout. At that point, the proceeds are treated as ordinary income and are subject to federal income tax. If the recipient is an employee, the payout is also subject to employment taxes.
We hope this article has been informative and useful for your business. If you have any questions or comments, please contact us at email@example.com. We plan to answer general questions in an upcoming FAQ series. If you need legal advice specific to your situation, please ask to schedule a consultation with an attorney to discuss your company’s goals.
Gear up for our next thrilling installment, where we’ll lift the veil on the implications of selling a partnership-taxed LLC on existing incentive compensation plans.
This article is for informational purposes only and should not be relied upon as tax advice. Please consult your tax professional for advice tailored to your specific situation. The author and publisher assume no responsibility for any errors or omissions or for any actions taken based on the information presented.