Until the advent of LLC company structures, the only way to combine limited liability with pass-through taxation was to form an S corporation. Entrepreneurs were advised to go public through a C corporation if they dreamed of a major exit or liquidity event.
What are equity interests? #
An LLC with more than a single member is classified as a partnership for US federal tax purposes unless it elects to be classified as a corporation. LLCs taxed as partnerships have two types of equity:
Capital Interests #
A capital interest is similar to what a share of stock in a corporation as it represents a part of existing company value. In other words, if the LLC were to liquidate by selling its assets, paying off its debts, and distributing out the remaining proceeds before making any profit, the recipient of a capital interest would be entitled to receive a share of the liquidation proceeds or capital.
Profit Interest #
A profits interest, on the other hand, represents only a right to share in future growth of the entity, that is, income or appreciation that will be generated after the profits interest date of grant.
Historical reasons why equity interests have become common? #
One limitation is that partnerships cannot grant Incentive Stock Options (“ISOs”). Only corporations can issue ISOs.
Before the advent of LLC company structure, the only way to combine the benefits of limited liability with pass-through taxation was with an S corporation. Entrepreneurs were told that if they dreamed of a major exit or liquidity event, going public through a C corporation was the way to go.
In the past, forming an S corporation was the only way to combine limited liability and pass-through taxation. C corporations were recommended for entrepreneurs who envisioned a major exit or liquidity event.
All 50 states have well-developed LLC statutes; the IRS has enacted “check the box” regulations that simplify the process of obtaining pass-through tax status; and increased regulation on the public markets and the growth of private equity have made IPOs less attractive. As a result, LLCs are now the most common form of business organization for emerging companies.