What is a Profits Interest?
The equity compensation tools available to LLCs and corporations are different. In particular, 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 immediate ownership interest in the LLC. A profits interest, when structured 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; it almost seems like magic.
How the Magic Happens
Most (not all) LLCs with multiple members are treated as partnerships for tax purposes. Partnership tax status means that many of the tax rules applicable to LLCs are different than the tax rules for corporations. One of these is that tax partnerships can grant profits interests. A profits interest designed to comply with the IRS safe harbor rules represents an ownership interest in the future growth of the company but *not* an interest in the current value of the company. The fact that the profits interest does not participate in the current value of the company – and the corollary that for it to have value, the worth of the underlying company must increase over time – is what makes the magic. The IRS deems that this interest in future growth has no readily determinable value at the time of grant and thus that the grant is tax free.
How Does this Work?
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. (This is a simplified example and events during the course of years after the profits interest is issued and before the company is sold can make a big difference.)
Profits interests can be subject to vesting in the same way as stock options or the grant of restricted stock can be subject to vesting. Vesting can be time-based, so that the equity is earned as the employee continues to provide services over a period of years; a typical time-based vesting schedule provides for 25% of the grant to vest on the first anniversary of the grant with the remaining 75% vesting in equal monthly increments over the next three years. Alternatively, vesting can be performance-based, so that the employee vests in the equity when the employee or the company attain predetermined performance goals based on metrics such as revenue growth, number of sales, making key government filings, etc. Vesting may also accelerate on the sale of the underlying company, depending on the terms of the grant.
Complications with Profits Interests
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 (determined in accordance with the company’s operating agreement), 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.
Not Just for Employees
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. Remember, however, that this means that your non-employee service provider is now a member of the company, with the rights that entails under the company’s operating agreement and applicable statutes.
Consult with a Professional Advisor if You Are Thinking About Profits Interests
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.
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The blog content should not be construed as legal advice.