What Are the Implications of Selling the Company on Incentive Compensation by LLCs Taxed as Partnerships?

Bravo on arriving at the 11th segment of our incentive compensation series! Your unwavering commitment has brought you to a pivotal discussion - the impact of selling a partnership-taxed LLC on its members’ incentive compensation plans. In this engaging read, we’ll explore the various ramifications on profit interests, capital interests, options on capital interest, phantom equity, and additional cash-based incentives.

Capital Interest

Upon the partnership taxed LLC’s sale, the effect on capital interest will vary based on the sale, as detailed below:

  • Capital interests sale: In this scenario, holders’ share of returns will be subject to capital gains tax depending on their ownership duration. Short-term capital gains tax applies if they’ve held the interests for under a year, while long-term capital gains tax is applicable for holdings exceeding a year.
  • Asset sale: Holders will receive profit shares corresponding to their ownership percentage. Capital income assets, such as real estate, will face capital gains tax, while ordinary income assets, like patents and copyrights, will be subject to ordinary tax.

Options on Capital Interest

Following the partnership taxed LLC’s sale, members with options on capital interest must first exercise these options. Once they contribute cash to exercise their options, they become company owners and are eligible to receive a portion of the returns.

At this stage, the LLC’s FMV must be accessible, necessitating a valuation if recent data is unavailable. If the FMV exceeds the exercise price, the difference incurs ordinary income tax. The returns upon sale of the capital interests are subject to short-term capital gains tax, if the ownership duration is under one year.

Profit Interests

Upon the LLC’s sale, the effect on members’ profit interests hinges on the distribution hurdle, ensuring profit interest holders receive their share only after capital interest holders have been allocated theirs. If this threshold is satisfied, holders obtain the residual returns, subject to taxation, as detailed below:

  • Sale of Profit Interests: Proceeds are subject to short-term or long-term capital gains tax, depending on the duration between grant and sale, assuming the team member made an IRC Section 83(b) election at grant time.
  • Asset sale: Proceeds from capital asset sales face capital gains tax, with the holding period dependent upon how long the LLC held the assets, while earnings from ordinary asset sales are subject to ordinary tax.

Phantom Equity and Other Cash Incentives

A partnership-taxed LLC’s sale usually prompts payment obligations for phantom equity and other cash-based incentive holders. These cash rewards are subject to ordinary income tax, necessitating a company tax deduction and the payment of employment taxes.

Wrapping Up

We hope this article has been informative and useful for your business. If you have any questions or comments, please contact us at info@wilkinsonlawllc.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. You are welcome to join us tomorrow as we divulge the different consequences on incentive compensation once a member exits the partnership-taxed LLC.

Join us tomorrow as we explore how the termination of team members affects 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.