Founder and Equity Disputes · Memo

Phantom Equity in LLCs vs. Profits-Interest Grants: When Each Survives an Exit

Two structures dominate LLC equity-style compensation: phantom equity plans and profits-interest grants. They look similar on the recipient's term sheet. They are fundamentally different at the moment that matters. I am going to walk through which structure actually pays out.

Pass-through entities cannot grant the kind of incentive stock option that a C-corporation can. The LLC alternatives have evolved into two main structures, each with distinct tax treatment, governance implications, and exit behavior. The phantom equity plan is a contractual right to a cash payment that mirrors the value of a notional ownership percentage. The profits-interest grant is an actual membership interest in the LLC, structured to qualify under Revenue Procedure 93-27 and Revenue Procedure 2001-43, that entitles the holder to share in profits and appreciation above a defined threshold.

The two structures are not interchangeable. The choice between them has tax, governance, employment, and exit consequences that the recipient often does not appreciate when accepting the grant. I have represented recipients on both sides, including in matters where the structure that was promised verbally was not the structure that the documents created.

The basic mechanics of phantom equity

A phantom equity plan grants the recipient a contractual right to a cash payment, calculated by reference to a notional ownership percentage in the company. The recipient does not become a member of the LLC. The recipient does not receive Schedule K-1 income. The recipient does not have voting rights or other governance rights. The contract specifies the events that trigger payment (typically, sale of the company, IPO, or sometimes specified anniversary dates), the calculation methodology, and any vesting conditions.

The tax treatment of phantom equity payments is ordinary compensation income to the recipient, taxed at ordinary income rates, with the company deducting the payment as a compensation expense in the year of payment. The payment is subject to employment tax withholding if the recipient is an employee. The treatment is the standard treatment for deferred compensation under section 409A of the Internal Revenue Code, which imposes specific drafting requirements on the payment timing and form.

The structure's advantages: no membership interest issued, so no governance complication and no Schedule K-1 reporting; tax treatment is straightforward (ordinary income at payment); contractual mechanics are flexible and can be tailored to specific outcomes.

The structure's disadvantages: ordinary income rates rather than capital gains rates; payment depends on the company's solvency at the trigger event; recipient has only contractual rights, not equity rights, so the recipient's claim is a creditor's claim in any insolvency proceeding.

The basic mechanics of profits interests

A profits-interest grant is an actual membership interest in the LLC, but structured so that the recipient does not benefit from the company's existing value. The interest entitles the recipient only to a share of the future profits and appreciation above a defined threshold (the 'distribution threshold' or 'liquidation value' at the time of grant). The structure is designed to qualify under Rev. Proc. 93-27 and Rev. Proc. 2001-43, which provide that a properly structured profits interest is not taxable at the time of grant.

The tax treatment, if the profits interest qualifies under the Revenue Procedures, is that the recipient is treated as a member of the LLC. Future allocations of company income, including capital gains on a sale, flow through to the recipient as the recipient's share of the LLC's tax items. On a sale of the company, the recipient's gain is typically capital gain rather than ordinary income, taxed at the lower long-term capital gains rate if the holding period requirement is met.

The structure's advantages: capital gains treatment on appreciation; actual membership rights (subject to the operating agreement); the interest persists through the company's continued operation and can grow in value over time.

The structure's disadvantages: governance complication (the recipient is a member and may have voting or other rights under the operating agreement); Schedule K-1 reporting; self-employment tax exposure on certain LLC income allocations; the section 83(b) election issue (the recipient may need to file a section 83(b) election within thirty days to lock in the grant-date valuation, depending on the structure).

What happens at an asset sale

The first divergence between the two structures occurs at an asset sale of the company. In a typical asset sale, the buyer purchases the LLC's assets, the LLC liquidates, and the proceeds are distributed to the members in accordance with the operating agreement's liquidation waterfall.

For a phantom equity recipient, the payment trigger is typically the sale event, and the contract specifies the calculation methodology. The payment is the recipient's share of the deemed proceeds, calculated as if the recipient had been a member at the time of sale. The payment is treated as ordinary compensation income.

For a profits-interest recipient, the recipient is an actual member at the time of sale. The recipient's share of the sale proceeds flows through the LLC's liquidation waterfall, taking into account the recipient's profits-interest threshold. The recipient's gain is allocated according to the operating agreement and the membership interests held. The character of the gain (capital versus ordinary) depends on the character of the underlying gain at the LLC level.

The tax differential between the two structures at this point can be meaningful. Phantom equity recipients pay ordinary income rates (potentially as high as 37 percent federal plus state, with employment tax further reducing the after-tax proceeds). Profits-interest recipients pay long-term capital gains rates (typically 20 percent federal plus the 3.8 percent net investment income tax, plus state) on the appreciation component. The differential can be 15-20 percentage points of after-tax proceeds on a meaningful transaction.

What happens at a stock sale

The mechanics differ for a stock or membership-interest sale where the buyer purchases the LLC interests rather than the assets. In this scenario, the LLC continues to exist; the ownership changes hands.

For a phantom equity recipient, the analysis depends on the contract. If the contract treats a change of control as a trigger event, the payment is due. If the contract requires actual asset liquidation or company dissolution, the membership-interest sale may not trigger payment, leaving the recipient holding a contractual right against the new owner, whose obligations are governed by the unchanged contract.

For a profits-interest recipient, the recipient must affirmatively sell the membership interest to the buyer (or roll over into successor interests) to participate. The standard membership-interest sale closing involves the recipient executing transfer documents and receiving the recipient's share of the consideration. The transfer is a sale of the membership interest, taxed as the disposition of a capital asset.

The drafting question that matters: does the phantom equity contract trigger on change of control, and does the operating agreement permit the profits-interest holder to participate in a sale on terms equivalent to other members? The answers to these questions determine whether each recipient actually receives the payment they were expecting.

What happens at a recapitalization or restructuring

Recapitalizations are the most underweighted scenario in equity-substitute compensation. The company restructures, perhaps to admit a new investor, perhaps to convert from an LLC to a corporation in preparation for an IPO, perhaps to reorganize for tax or operational reasons. The equity-substitute holders may or may not participate, depending on the structure.

For a phantom equity recipient, a recapitalization typically does not trigger payment under the standard contract. The recipient continues to hold the contractual right against the (restructured) company, whose obligations may have been transferred to a successor entity or whose terms may have been modified by the restructuring. The recipient's contractual protection depends on the contract's successor-and-assigns clause and on any change-of-control language.

For a profits-interest recipient, a recapitalization may trigger a deemed sale or exchange under partnership tax rules. The treatment depends on the specific restructuring and on whether the recipient's interest is converted, exchanged, redeemed, or otherwise modified. Conversion from an LLC to a corporation, for example, may be a taxable event for the profits-interest holder unless the conversion qualifies as a tax-free reorganization under section 351 or section 368.

The drafting moves that protect against recapitalization disruption: the phantom equity contract should require contractual succession in any restructuring and should treat any meaningful structural change as a trigger event for vesting and payment, even if not for actual cash payment; the profits-interest grant should be paired with an operating agreement that addresses the restructuring scenarios (continuation, exchange, redemption, conversion) with defined economic outcomes.

The 409A overlay on phantom equity

Section 409A of the Internal Revenue Code imposes specific requirements on nonqualified deferred compensation, which most phantom equity plans constitute. The requirements include limits on payment timing, restrictions on payment acceleration, and specific drafting requirements for the payment events and forms.

A phantom equity plan that does not comply with section 409A imposes severe tax consequences on the recipient: immediate income recognition of the accumulated value, plus an additional 20 percent penalty tax, plus interest on the unreported amount. The penalty applies to the recipient, not the company; the company's only direct exposure is to the under-withheld employment taxes.

The 409A compliance check is the most critical operational element of phantom equity drafting. The drafting moves: payment only on permitted events (separation from service, change in control, fixed date or schedule, death, disability, or unforeseen emergency); no acceleration of payment outside the limited permitted circumstances; specific form-of-payment language (lump sum or annuity); careful drafting around the 'short-term deferral' exception. A phantom equity plan drafted by counsel unfamiliar with section 409A is a malpractice risk.

The recipient's diligence checklist

A recipient evaluating an LLC equity-substitute grant should ask:

1. Is this phantom equity or a profits interest? The term sheet may not be clear. Read the underlying plan document or operating agreement.
2. If profits interest, what is the distribution threshold? A high threshold (above current company value) is required for the favorable Rev. Proc. 93-27 treatment.
3. What triggers payment? Asset sale only? Stock sale? Change of control? Liquidation? Each trigger has implications.
4. What is the vesting schedule, and what happens to unvested portions on termination?
5. For phantom equity, is the contract section 409A compliant on its face?
6. For profits interest, has the section 83(b) election been made or considered?
7. What happens in a recapitalization?
8. What governance rights, if any, attach to the grant?
9. What confidentiality and non-compete obligations are imposed?

The grant document should answer each of these. If it does not, the recipient should negotiate clarification before accepting.

What I would not assume

The tax treatment of profits interests under Rev. Proc. 93-27 has been stable since 2001, but the IRS retains the position that interests substantially similar to capital interests may not qualify. The 2024-2025 enforcement environment has not produced significant published guidance changes, but counsel should treat the area as one where the IRS could shift its position. The phantom equity section 409A landscape is more settled but is also strict; the drafting requirements are detailed. The two structures look similar to the recipient; they produce dramatically different outcomes at the exit. Counsel representing recipients should evaluate the actual structure against the recipient's expectations before accepting the grant. Counsel representing companies should think carefully about which structure aligns with the company's compensation philosophy and capital structure. Outcomes in specific matters depend on the operating agreement, the plan document, the exit event, and the recipient's particular circumstances.

Sergei Tokmakov, Esq., CA Bar #279869. This memo is attorney commentary on legal questions and is not legal advice. Reading it does not create an attorney-client relationship. Past matter outcomes depend on facts and the responding party; nothing here is a prediction of result.