If you have been in the restaurant industry for a while, you have probably heard some buzz about alternative pay structures for your managers and employees, such as granting ownership, equity, or deferred compensation. While these ideas might seem tempting to attract and retain good talent, figuring out the differences and tax consequences can be overwhelming.
Offering incentives to managers/employees by structuring a portion of their pay based on the value or profits of the business can help restaurants that are already cash strapped. Restructuring pay can benefit both the owner and the manager/employee based on the expected future value that the restaurant will bring.
In this article, we hope to simplify this complex topic to help you make the right decision for your business by discussing the potential tax consequences, drawbacks, and opportunities of granting equity (either through a capital interest or a profit interest) to employees in an LLC taxed as a partnership.
A partnership has the option to issue two types of equity interests:
- Capital interest
- Profit interest
Capital Interest vs. Profit Interest
A capital interest is an interest in the assets of the company, and has immediate value. In short, if the company were to shut down immediately after granting this interest, the new owner would be entitled to their share of the company’s assets.
A profit interest is any interest that is not a capital interest. The owner of a profit interest is only entitled to future profits and appreciation of the assets (not the assets themselves). If the company were to shut down immediately after granting this interest, the new profit interest owner would not receive anything.
As an example, you decide to give Employee B a 5% capital interest and Employee C a 5% profit interest. Employee B will be entitled to 5% of your company’s assets as well as 5% of income going forward, while Employee C will only be entitled to 5% of income going forward. Assuming this interest has already vested (vesting will be explained later), if your company were to dissolve immediately after transferring these vested interests, only Employee B would receive anything (5% of the value of the assets of the company) since Employee C is only entitled to future income.
The tax consequences to the grantee (manager/employee) and the grantor (LLC) depend on whether, upon grant, the capital interest is:
- Vested; or
Vesting – or the rights to the business assets/income – may depend on a vesting period. An employee may be granted an interest that only ‘vests’ after one year, meaning that if the employee leaves before that one year is up, they do not get rights to the business. If they leave after one year, they retain rights to the business assets/income. Since it is subject to a vesting period, before this vesting period is up, the interest is considered “non-vested”.
Two conditions must be met for a capital interest to be considered non-vested:
- There must be a substantial risk of forfeiture; and
- The interest must be non-transferable.
For example, Employee B receives a non-vested capital interest in Year 1 that does not vest for 3 years. In Year 2, they decide to leave the company. Since the capital interest did not vest, then:
- they lose the full amount of interest (substantial risk of forfeiture); and
- are not able to transfer it to anyone else (non-transferable) since is still the property of the company.
If the capital is non-vested, the tax consequences of granting a capital interest depend on whether the grantee makes an election under IRC Section 83(b).
Section 83(b) Election
The Section 83(b) election gives the grantee the option to pay taxes on the total fair market value (FMV) of non-vested capital on the grant date rather than at the time of vesting. Paying the tax upfront can likely result in significant tax savings for the grantee since they would pay tax on a lower value if the value of the interest does increase, than if they wait until the capital vests. This option does require cash upfront to pay the tax. However, the risk of making this election and paying up front is that if the value of the company goes down or the grantee leaves before the capital vests, then the taxes have already been paid and are unable to be recovered.
The election documents must be sent to the IRS within 30 days after issuing the non-vested capital interest, and a copy of the completed forms must be sent to the issuer. An interest in non-vested capital where the grantee makes the 83(b) election is treated the same as if the interest was fully vested for tax purposes. For business purposes, it is still considered non-vested, meaning it is owned by the company so if the employee quits or is terminated, they do not own or receive anything, and they cannot sell or transfer it until it vests.
For example, you decide to give Employee B a 5% non-vested capital interest in connection with the performance of future services in Year 1 that will be considered substantially vested at the end of Year 3. At the time of the transfer, the interest has a FMV of $5,000. You have a non-vested capital interest agreement that says if B quits or is terminated before the end of Year 3, B will forfeit the interest. Within 30 days, B makes a valid election under section 83(b). In Year 1, B will recognize $5,000 as ordinary compensation income on his W-2 (FMV of the interest ($5,000) – amount exchanged at issuance ($0)).
At the end of Year 3, when the interest is vested, the value is $50,000. As the employee has made the Sec 83(b) election, there is no taxable event on the date of vesting, and no additional income needs to be recognized as a result of this interest in Year 3. However, had the employee not made the Sec 83(b) election (and not recognized the FMV at the date of granting), they would include $50k as ordinary income at the end of year 3.
To carry this through the cycle, let’s assume, in Year 5, B decides to sell his interest and the value is worth $70,000. Under the scenario where B made the Sec 83(b) election at the time the interest was granted, B will recognize a $65,000 capital gain (since $5,000 was already recognized in ordinary income and established his tax basis in the partnership). As you can see in the following table, assuming the highest rates, by making the election, B essentially converted $45,000 of ordinary income to capital gain, which has much lower tax rates, and saved $7,650 in taxes.
|Section 83 Election Made at Grant||No Election|
|Issuance (Year 1)||$5,000 Ordinary||$0 recognized|
|Vesting (Year 3)||$0 recognized||$50,000 Ordinary|
|Sale (Year 5)||$65,000 Capital Gain||$20,000 Capital Gain|
|Capital gain tax (20%)||$13,000 tax||$4,000 tax|
|Ordinary income tax (37%)||$1,850 tax||$18,500 tax|
The 83(b) election may seem like a no-brainer for a company that is expected to increase in value. However, there is a caveat. The example above assumes that the company generates zero taxable income during the vesting period even though the value of the partner’s equity increases by $45k. Since the grantee will be treated as a partner for tax purposes if they make an 83(b) election at the time of grant, they will need to report and pay tax on their share of the partnership’s taxable income on their personal tax returns from the grant date going forward. If the company were to generate taxable income during the vesting period, then the partner would have to pay ordinary income tax on their share of this taxable income. For example, assume that the partner’s share of taxable income from the partnership allocated during the period between the grant date and vesting date was $45k. The partner would pay ordinary income tax on the value of the shares received on the grant date plus ordinary income tax and self-employment tax on this $45k before their shares have vested and they have rights to the profits. This results in a similar yet less favorable outcome than if the election was never made. Therefore, the 83(b) election would only be favorable not only if the value of the restaurant increased significantly, but only if the value of the restaurant increased significantly while not generating considerable taxable income during the vesting period. A restaurant’s valuation is frequently driven by its ability to generate cash flow and profits, therefore this situation is unlikely. It’s important to assess whether an 83(b) election would be favorable to partners before making the election and granting a capital interest subject to vesting.
Capital Interest – Tax Effect on the Grantee
The effect on taxes for the grantee is summarized as follows:
|(Or Non-vested with 83(b) Election)||No IRC Section 83(b) Election|
|FMV of capital interest = ordinary income on W-2||At grant date||After ownership has vested|
|Partner for tax purposes||At grant date||After ownership has vested|
|Receive Forms K-1||Yes||After ownership has vested|
|Be responsible for paying self-employment taxes rather than having the LLC withhold employment taxes||Yes||After ownership has vested|
|Pay estimated income taxes rather than have income taxes withheld by the Company||Yes||After ownership has vested|
|Share in profits and losses in accordance with the agreement||Yes||After ownership has vested|
As you can see, there is no difference between the tax consequences to the grantee if the capital interest is vested or non-vested with the 83(b) election, since this election is to be treated as a partner for tax purposes, while remaining non-vested for business purposes.
Before making the 83(b) election and paying the tax upfront on a business interest expected to appreciate, the grantee (employee) should consider the related cons of unfavorable partner tax treatments. Partners frequently must contend with taxes on phantom income, self-employment tax on guaranteed payments, pre-paid estimated taxes, and the administrative burden of K-1 reporting. For the grantee, the main benefit of making an 83(b) election would be to include a protective measure that any increase in overall equity valuation (not just profits) from the date of grant to the later sale date of their interest is treated as capital gains, which is taxed at the lower capital gains rate. If the value of the restaurant is expected to go up substantially through the years beyond reasons due to profitability and cash flow, then this could be a huge tax saving to the grantee.
The effect on taxes for the LLC are summarized as follows:
|(Or Non-vested with 83(b) Election)||No IRC Section 83(b) Election|
|Value of interest granted will be considered as wages paid to the manager/employee and subsequently contributed back into the company||At grant date||After ownership has vested|
|Trigger gain, loss, and deduction in the LLC, which will flow through to the other LLC owners||Yes||After ownership has vested|
|Compensation deduction reported on W-2||Yes||After ownership has vested|
Granting a profit interest as an incentive can also be very appealing, especially since it is less likely to create a taxable event. Just like for a capital interest, the tax effect of a profit interest to a grantee depends on whether it is vested or non-vested. The LLC and any existing members will not recognize gain, loss, or deduction upon the grant or later vesting of a profit interest regardless of whether it is vested or non-vested.
Taxation of a Vested Profit Interest
The IRS takes the position that the receipt of a vested profit interest to the grantee in consideration for services provided is not a taxable event, if:
- The grantee does not sell their interest within two years of receipt.
- The LLC issuing the interest does not hold property producing a certain and predictable stream of income (i.e. – stable rental income, interest income, etc.).
- The grantee becomes a partner upon receipt of the interest and is allocated income and gain per the LLC agreement after ownership is granted.
For example, Employee C receives a profit interest in a restaurant in Year 1. C is recognized as a tax partner upon issuance. C does not sell their interest until Year 3. Since (1) the grantee held the property for two years, (2) income is not predictable or from a publicly traded partnership, and (3) C becomes a partner upon receipt, this is considered a non-taxable event. Only the income received after the interest was received will be taxable. If C were to sell the interest in the middle of year 2, or the interest was in predictable income, then this would not satisfy the requirements and would be considered a taxable event.
Taxation of a Non-vested Profit Interest
In general, neither the receipt of a profit interest by the grantee for services to the LLC nor the later vesting of the profit interest is taxable to the grantee if the grantee is treated as owning the profit interest from the date of grant, including for the purposes of making allocations of income, gain, or loss.
A profit interest is generally viewed as something other than property for purposes of IRC section 83, unlike a capital interest. While the section 83(b) election does not technically apply, it is recommended by many practitioners to make a protective IRC section 83(b) election in case the interest is later determined to be a capital interest. If the grantee forfeits their profit interest (quits or is terminated), the grantee’s basis in the partnership will also be forfeited and will be reallocated to the remaining partners.
Additional Considerations – Capital and Profit Interests
Holders of vested capital interests and profit interests in LLCs are not treated as employees for tax purposes. This means that:
- They are not issued a Form W-2 (except for the year the equity was granted).
- Income is generally not subject to withholding.
- Payments for services may be guaranteed payments reported on Schedule K-1. And,
- The tax treatment of fringe benefits differs.
It is highly recommended to have a repurchase agreement in place so when the employment ends, the grantor can buy the interest back at FMV, or at less than FMV if there are violations of non-disclosure or other reasons for “cause.”
Due to all the complicated factors discussed above, determining appropriate and attractive compensation to retain key employees can be incredibly difficult. Both capital and profit interest offerings have the benefit of tying manager/employee compensation to the future profitability of your restaurant but come with the challenge of partner-style tax implications. If you’d like to discuss your specific situation or have additional questions regarding capital interest and profit interest options, we can help! Feel free to contact us to speak with a client advisor about your restaurant and compensation offerings.
By Marisa Parker, CPA | Published on 12/08/2021