Since we're on the subject: aren't there restrictions for LLCs about principles/members taking W2 wages? I know there's a way around this, but I'm curious about what the best practice is for issuing equity to employees at LLCs.
If early-stage LLCs want to adopt equity incentives, they can mimic what a corporation does with a little custom drafting to the operating agreement. Instead of defining ownership in terms of percentage ownership as set forth in a schedule (the typical LLC pattern), LLC owners who want to issue equity to employees can define the ownership in terms of "units" of ownership. They define a number of authorized units in an operating agreement (e.g., 10M units) and then reserve a grouping of them for an equity incentive pool. These can then be used to support unit option grants (like stock options, albeit always NQO and never ISO) or restricted unit grants (akin to restricted stock grants in a corporation). If this is all done in the early stage, the units can be priced at nominal pricing so as to avoid adverse tax consequences to the employees. There is still the problem of option holders being taxed on the spread on the date of exercise (as with NQO options in a corporation) but, otherwise, such grants may be made very much as they would be in a corporation (made subject to vesting, etc.).
The key to an effective plan is to do this early in the LLC's existence and, if done in that way, this is pretty comparable to what happens with a corporation (except for the absence of ISO-like options). As long as this is all done right, there are no special restrictions on issuing equity incentives to employees in an LLC.
LLCs are state-specific and it might be that there are special restrictions in Illinois or other states that don't exist in California where I practice. But the above sums up the essence of how it is done here.
The obligation to be 1099 is the default case for single-proprietor LLCs but can be overcome as I described above. It is not necessarily the case for multiple-member LLCs.
FYI:
I am not a lawyer, but I have done all this before.
Right, that's what an 8832 election I referred to in the original comment is.
Generally speaking, LLCs are not appropriate entities for a highly fluid, ever-changing shareholder picture. If you want to be able to easily add or drop employees--and for that matter, institutional investors--as partners, don't choose a pass-through entity. Choose something that is structured as an appropriate vehicle for that kind of thing, i.e. a C-corp with a share pool.
There are ways to get around this, of course. The simplest idea I can think of if you are an LLC is to create a separate C-corp as a holding company, and have it own some (presumably non-trivial) percentage of the LLC. You can then issue shares in the Inc. holding company to your senior employees. The Inc. would of course be entitled to the highest liquidation preference, be dilution-proof to whatever extent desired, etc.
Edit: You can also do what grellas said above and make some sort of accommodation for an equity pool in an operating agreement. But if you want to actually write any employees in as partners, you'll have to amend your articles of organisation every time you do it. So, it's still by far not the most flexible entity type for that.