You Can’t Just Put “Equity” in an Offer Letter: What LLCs Must Know Before Promising Stock

It happens more often than it should: an LLC founder, eager to recruit a key hire, puts language in an offer letter promising "restricted stock," "stock options," or a percentage of equity that will vest at some point in the future—without any of the legal infrastructure in place to actually deliver it. The problem is not the intent; it is the fundamental legal architecture. An LLC simply cannot issue stock or stock options. These instruments are creatures of corporate law, available only to corporations, not to limited liability companies. Putting equity language in an offer letter without the underlying structure to support it creates an unenforceable promise at best and a significant legal liability at worst—disputes over what was promised, whether it vested, and what it was worth are among the most contentious employment matters that outside general counsel must help clients avoid.

This post provides an overview of the core legal problem, and explains why responsible counsel can’t just draft an offer letter containing equity incentives without conducting a meaningful amount of work to establish the appropriate operating infrastructure for your company.

The Core Legal Problem

Under most (if not all) states’ laws, LLC ownership is evidenced by "membership interests," not stock certificates. Because of this structural distinction, LLCs cannot have employee stock ownership plans (ESOPs), grant incentive stock options (ISOs) or nonqualified stock options (NSOs), issue restricted stock, or otherwise provide employees actual shares or rights to shares in the corporate sense. The tax laws that permit employers to issue stock options on a tax-advantaged basis—including the ISO regime under the Internal Revenue Code—apply only to corporations. An offer letter that promises "restricted stock" to an employee of an LLC is, at its core, a legally hollow promise: it references an instrument that the entity is structurally incapable of issuing. Before a company can make good on any equity promise, it must first determine which structural path it intends to take—and build the corresponding legal infrastructure to support it.

Path One: Convert to a Corporation and Issue Restricted Stock

For companies anticipating venture funding, institutional investment, or rapid scaling, converting from an LLC to a corporation may be an appropriate path. Many venture capitalists and institutional investors prefer investing in corporations, not LLCs, making conversion a practical business necessity alongside the equity compensation objective. In Texas, this process is governed by the Texas Business Organizations Code §§ 10.101–10.109, which permit a statutory conversion without dissolving the business—requiring, at minimum, a member-approved Plan of Conversion and the filing of both a Certificate of Conversion and a Certificate of Formation for the new corporation.

The conversion process, however, is only the beginning. Once corporate status is established, the company must adopt corporate bylaws, appoint or re-appoint a board of directors, and issue stock certificates. Critically, the company must then draft and adopt a formal equity incentive plan—approved by the board, with authority to approve grants typically reserved to the board of directors alone in early stages. A board resolution specific to each grant should then be passed, and a restricted stock agreement must be prepared and executed between the corporation and the employee. Restricted stock is not simply stock given to an employee—it is stock subject to a substantial risk of forfeiture, meaning the employee forfeits it upon termination or failure to meet vesting conditions, which is part of what gives it its tax treatment.

The tax implications can be complicated as well. The conversion itself may implicate securities law exemptions that must be identified and documented, and the cap table must be updated to reflect all newly issued shares and outstanding equity grants. The issuing company and the employee should also work closely with a qualified accountant to determine the fair market value of the stock at the time of grant, which will have tax implications too intricate to discuss in this blog post.

Path Two: Remain an LLC and Issue Equity-Like Rights

For companies that prefer to preserve the LLC structure—whether for tax flexibility, governance simplicity, or because they are not yet ready to convert—there are several legally viable equity-like compensation tools that an LLC can actually issue. Three of the most common instruments are (1) restricted membership interests, (2) profits interests, and (3) phantom units.

Restricted Membership Interests

A restricted membership interest grants the employee full membership interest in the LLC—including both voting and economic rights—generally subject to vesting schedules, forfeiture conditions, and buyback provisions negotiated in the award agreement. These interests are analogous to restricted stock in a corporation, but they come with significant tax complexity: the employee will generally recognize ordinary income upon grant equal to the fair market value of the interest received, unless a Section 83(b) election is timely filed. Because this type of grant creates actual membership status, it also creates partnership-level tax reporting obligations, including K-1 issuances to the employee, which many companies and employees find administratively burdensome.

Profits Interests

A profits interest is a commonly recommended and tax-efficient equity tool available to LLCs taxed as partnerships. Rather than granting an immediate ownership stake, the LLC sets a "liquidation threshold" on the grant date—often the company's fair market value at the time of the grant—and the profits interest holder participates only in the appreciation of the company's value above that threshold. If structured in accordance with certain IRS procedures, the grant of a profits interest is not a taxable event to the employee at the time of issuance. Like stock options, profits interests are commonly issued subject to vesting schedules and forfeiture provisions, and where vesting applies, a Section 83(b) election is required within 30 days of the grant date to prevent the interest from being treated as granted upon vesting (which could trigger ordinary income tax on appreciation that occurred while the interest was unvested). Critically, this structure is only advisable if the LLC is taxed as a partnership; LLCs taxed as S corporations or C corporations face materially different and more complicated tax consequences for issuing profits interests.

Phantom Units

A phantom unit plan grants no actual equity or ownership whatsoever. Instead, the employee receives a contractual right to a cash payout or value equivalent tied to company performance or unit value upon a defined triggering event—such as a sale, IPO, or achievement of a financial milestone. For LLCs that want to provide economic upside incentives without making employees members of the LLC (and avoiding all attendant K-1 and partnership tax complexity, or dealing with voting rights), phantom units are the cleanest instrument. Phantom unit plans must be carefully structured to comply with the tax code; a non-compliant plan can trigger immediate income taxation on the deferred amount, an additional 20% excise tax, and potential penalties—all before the employee receives a single dollar. When compliant, employees are taxed only upon payout at ordinary income rates, and the LLC receives a corresponding deduction at that time.

What the Infrastructure Actually Requires

Regardless of which path a company chooses, neither path begins—or ends—with a single offer letter clause. For Path One (conversion to a corporation), the company must, at a minimum: review and reconcile all existing organizational documents, operating agreements, tax and valuation records, and written consents; prepare and adopt a Plan of Conversion with full member approval; file a Certificate of Conversion and a new Certificate of Formation with the Secretary of State; adopt corporate bylaws and reconstitute the board of directors; draft and adopt a formal equity incentive plan; pass a board resolution specific to the intended grant; prepare and execute a restricted stock agreement; engage the company's accountant (or a separate accountant if necessary) to address fair market value, tax implications, and applicable securities law exemptions; and update the cap table to reflect all new issuances.

For Path Two (remaining an LLC), the required infrastructure is similarly substantive: the company must review and update all organizational documents and the operating agreement; amend and restate the operating agreement to accommodate the new equity-like rights, including member consent provisions and any necessary amendments to capital account and distribution mechanics; create a formal rights plan (profit interest plan, phantom unit plan, or restricted membership interest program); secure member approval of the plan and individual grants via written resolutions; draft the specific award agreement for the new employee; and engage the company's accountant to address all applicable tax implications—including the profits interest threshold valuation, Section 83(b) election timing, K-1 obligations, and Section 409A compliance for phantom arrangements.

The Risk of Skipping the Infrastructure

An offer letter that includes equity language without the corresponding legal structure is not merely incomplete—it is a source of future disputes, potential liability, and regulatory risk. Courts and employees take equity promises seriously. In some jurisdictions, vested equity awards can be characterized as wages, triggering wage payment statute claims upon termination. An offer letter referencing "stock options" issued by an entity that has no equity incentive plan, no board resolution, and no valuation is a promise the company has no mechanism to keep—and no legal basis to enforce. The prudent approach is to engage outside general counsel before equity language enters any offer letter, to ensure that the appropriate structural path has been selected, the required legal infrastructure is in place, and the applicable tax and securities law obligations are understood and documented. Equity is a powerful recruiting and retention tool—but only when the legal foundation beneath it is sound.

This post is for general informational purposes only and does not constitute legal advice. For guidance specific to your company's situation, contact Elkhoury Law PLLC.