Phantom equity vs. profit interests: Strategic considerations

Editor: Mark Heroux, J.D.

Consider this common client inquiry: ABC LLC wants to allocate 10% of potential profits from any future exit transaction to a pool of five key employees. The client wants to know how to accomplish this objective without the complication of giving the five employees profits interests in the LLC, while retaining capital gain treatment.

There can be no question that the significant changes to the Code enacted in 2017 by the law known as the Tax Cuts and Jobs Act (TCJA), P.L. 115-97, coupled with the implementation of the new partnership centralized audit regime beginning with tax years beginning on or after Jan. 1, 2018, have made tax filings much more complex for owners of passthrough entities. Nevertheless, the partnership or LLC passthrough remains the most beneficial entity structure for most small and midsize businesses as a consequence of the inherent flexibility of the capital structure, along with the benefit of a single level of tax.

In this landscape, it is important to challenge and reconsider conventional wisdom. For example, it has long been a foregone conclusion for most practitioners when considering employee incentive compensation arrangements that issuing a profit interest to LLC employees, with its potential for capital gain treatment, is preferable to using a phantom equity plan that yields ordinary income upon payout. Because these incentives typically seek to help retain key employees by offering the potential reward of a share of the proceeds when there is an ownership change or other exit transaction, the capital gain treatment of such a transaction remains the primary focus. In fact, it is quite common to see a nonvoting class of LLC units used for profit interest compensation.

When assisting a client with decisions of this nature, it is important to consider all aspects of the situation — not only the impact to the recipient of the award, but also the impact to all members of the business group. This is particularly true when dealing with LLCs, due to the underlying aggregate theory of taxation at play. The aggregate theory holds that a positive result for one member of an aggregation will cause an equal and opposite negative result for another member of the aggregation.

A practitioner who is a true trusted business adviser will respond to the question posed at the beginning of this item by first trying to understand what ABC’s ownership seeks to achieve with the plan. Is it a genuine ownership succession plan, or is it a compensatory award intended to aid employee retention and incentives? If it is more the former, the profit interest grant is most likely the better option, but if it tends toward the latter, the phantom equity alternative should be carefully considered.

Phantom equity plan overview

First, consider what happens in the year of sale by using simple effective tax rate assumptions uncluttered by the complexities within the new rules and the impact of Sec. 199A.

Example: ABC sells to a third-party buyer and recognizes a net cash gain on the transaction of $5 million. If the key employees had been granted a collective “catch up” 10% profit interest for capital transactions, they would be entitled to receive $500,000 of the gain on the sale. Assuming an effective combined federal and state tax rate of 25% on the capital gain, this yields those employees a net cash-in-pocket amount of $375,000. The primary owners would receive the remaining $4.5 million, for a net cash-in-pocket amount of $3,375,000.

Alternatively, what if ABC had provided the employees with phantom equity? That same $500,000 for the employees, paid out as a phantom stock compensatory bonus, would be taxed at ordinary rates. Assuming an effective federal and state net tax rate of 35% for illustration purposes, the bonus payment yields net cash in pocket of $325,000, a reduction of $50,000 from the profit interest. This is often where the analysis ends, arriving at an assumption that the phantom equity plan should be avoided for the benefit of the employee recipients, despite the complexities of their becoming K-1 partners.

It is critical to advise clients that the analysis does not stop at this point. The bonus the employees receive is an ordinary expense that is deductible by the LLC and passed through to the actual owners, with a net result of the owners’ net cash being increased by that same $50,000 (assuming comparable tax rates apply to all of the individuals). The breakdown is shown in the chart, “Profit Plan vs. Phantom Plan” (below).

This quickly leads to the consideration of what the impact might be if the phantom equity bonus is grossed up to yield the same net after-tax cash in pocket for the employees as they would have received with a capital gain profit interest. For example, the phantom equity plan might be structured to require the bonus to be grossed up to yield the same net cash-in-pocket amount of $375,000. Assuming a net effective ordinary tax rate of 35%, a bonus payment of $576,923 yields after-tax cash of $375,000.

What will be the impact on the primary owners? They will receive an allocation of and pay tax on 100% of the $5 million gain. They will also receive a deduction for compensation expense of $576,923. The capital gain tax of $1,250,000, offset by the ordinary tax reduction of $201,923, yields net cash in the primary owners’ pocket from the sale of $3,375,000 (the $5 million sale proceeds, less the compensation payment of $576,923, less net taxes of $1,048,077). The key takeaway here is to think beyond the tax amounts that would affect a recipient and consider the net result for the aggregate group.

Other complications

Sec. 199A significantly complicates tax filing for affected K-1 recipients. Furthermore, to maximize the benefit of the Sec. 199A qualified business income deduction, W-2 wages are preferable to guaranteed payments. The recipient of a profit interest grant, properly structured under the current rules, including Rev. Proc. 93-27 and related authority, will not be eligible to be a W-2 employee from the date of grant. This removes their regular compensation from the wage pool in Sec. 199A calculations.

State tax nexus issues and required filings for passthrough entity owners are also on the rise. Employees receiving regular wages or bonus payments are not subject to the additional burden of extra state filings, while a K-1 holder of a profit interest is.

There are many additional benefits of the grossed-up phantom stock strategy; e.g., there are no Schedules K-1 and related W-2 problems and complications for employees otherwise not looking for ownership. No additional state filings are required for those same employees. There are also no ownership complications if employees come and go. They can be moved into and out of the plan with relative ease, while ownership remains with those committed to the business. The one primary caveat with the use of the phantom equity plan is that the primary business owners will need to have sufficient ordinary income in the year the phantom equity bonuses are paid to fully use the benefit of the ordinary tax rate deduction.

As the author worked through this exercise with many clients prior to the newly added complexities of passthrough ownership, he was fascinated to see how many owners and their employees were extremely happy to use a phantom equity program. The incentive compensation objective sought by both parties was obtained without the complexities of ownership, where traditional ownership was not the primary objective. Now more than ever, a value-added, trusted business adviser will challenge the conventional wisdom and carefully consider the full implications of potential solutions.

EditorNotes

Mark Heroux, J.D., is a principal with the Specialty Tax Services Group at Baker Tilly Virchow Krause LLP.

For additional information about these items, contact Mr. Heroux at 312-729-8005 or mark.heroux@bakertilly.com.

Unless otherwise noted, contributors are members of or associated with Baker Tilly Virchow Krause LLP.