What is a Profits Interest?
Equity compensation can be different in LLCs and corporations. LLCs have the benefit of using a special equity compensation tool called a “profits interest.”
Unlike a traditional stock option, which represents a right to buy into the company at a future time, a profits interest represents an actual current ownership interest in the LLC. A profits interest, when structured to be in compliance with applicable Internal Revenue Service “safe harbors,” is tax free to the recipient. You might wonder how it is possible to receive an actual ownership interest in a company and yet not be subject to tax on it.
Many (not all) LLCs are treated as partnerships for tax purposes. Partnership tax status means that a lot of the tax rules applicable to LLCs are different than the tax rules for corporations. A profits interest designed to comply with the IRS safe harbor represents an ownership interest in the future growth of the company but *not* an interest in the current value of the company.
For example, suppose a LLC has three owners. Each owns a third of the company. Then, the company grants a 10% profits interest to a key employee at a time when the company was worth $1 million. A few years go by, and the company is sold for $3 million. Who gets what? Of the $3 million, the first $1 million is divided equally among the three original owners. Nothing from that $1 million goes to the holder of the profits interest because that money represents the value of the company when the profits interest was granted. The remaining $2 million is distributed 30% to each of the original members and 10% to the profits interest holder, who receives $200,000 of the sales proceeds.
Profits interests can be subject to vesting in the same way as stock options. Vesting can be time-based, so that the equity is earned as the employee continues to provide services over a period of years. Alternatively, vesting can be performance-based, so that the employee vests in the equity when he/she or the company attain predetermined performance goals.
The holder of a profits interest has some ancillary consequences. As a member of the LLC, the profits interest holder is no longer a W-2 employee but rather is a partner in a partnership for tax purposes. This means that the employer doesn’t withhold payroll taxes on the employee’s income; instead the employee is subject to self-employment taxes and needs to pay quarterly estimated taxes to satisfy their income and self-employment tax obligations. This transition can be tough for some and the change should be explained to employees before a profits interest is issued. In addition, the employee will receive a Schedule K-1 reporting his/her share of the company’s profits, which he/she will be responsible for paying income taxes on. It is important for the company to have a plan to help assist employees with paying such taxes. Usually this is accomplished by making tax distributions to the LLC’s members to assist them in satisfying their tax obligations.
Profits interests can also be granted to non-employee service providers, such as managers, consultants, scientific advisors and the like. As with profits interests granted to employees, the holder of the profits interest becomes a member of the LLC for tax purposes.
Profits interests, especially those designed to comply with the IRS safe harbor, can be a very important compensation tool for LLCs. They do have complications, so it is important to consult with your professional advisors before embarking on a profits interest grant program for your LLC.
The blog content should not be construed as legal advice.