It is important for the company to have a plan to help assist employees with paying such taxes. 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. If you have questions or want more information, please comment below, email me or connect with me on LinkedIn or Twitter. Sweat Equity. Podcast Blog News Library Events. View All Blog Posts Tax. Furthermore, unlike a stock option, the service provider does not have to pay an option exercise price to receive this favorable treatment.
As a result, profits interests can be structured to have the benefits of stock options, but also be more favorable to key service providers.
By receiving a profits interest grant, the recipient will be entitled to i receive distributions of future profits of the LLC and ii participate in the increase in the enterprise value of the business which occurs following the date of grant.
However, recipients do not share in any value created before the grant date. Profits interests, like stock options, can be granted subject to vesting provisions. Businesses often structure a stock option or profits interest grant to vest over a three-year period, or longer, in order to induce the recipient to maintain his or her employment until, at a minimum, such time as the stock options or profits interest has become fully vested.
As with stock options, a profits interest vesting schedule can, and typically does, accelerate upon a liquidity event such as a sale of the company. A business can but is not required to structure all profits interests as non-voting membership interests, thus enabling the primary owners to maintain full voting control. Profits interests have several distinct advantages as compared to stock options, particularly when viewed from the perspective of the service provider, including:.
When selling a business, maximizing return is the primary goal of most owners. With increasing…. Bronfman, Synthetic Equity Sagemark Consulting, Photo courtesy of PeterBeers. THE Profits Interest. Pictured above: Price Tower, Oklahoma, featuring the innovative "upside" design by Frank Lloyd Wright Profits interest is a cantilevered approach to equity transfer.
The power of the profits interest Encouraging key executives to feel and act like co-owners in a privately held business is the holy grail of executive compensation planning. Nevertheless, many owners of partnerships, and their trusted advisors as well, are unfamiliar with one of the most powerful and flexible tools that US tax law currently allows for achieving that goal.
This tool, which is available exclusively to LLCs taxed as partnerships and other partnerships, is the profits interest. The profits interest enables owners to give key employees a stake in the future of a partnership without simultaneously transferring any portion of the underlying value of the firm. The grant of a profits interest has a distinguishing feature in current US tax law: It is a transfer of true equity without the typical buy-in or tax friction associated with most equity transfers.
Among other things, a profits interest must be granted based on or above the then fair market value of the partnership, generally referred to as the threshold value, notionally similar to a strike price for a stock option.
The threshold value is the signature characteristic of a profits interest: if the partnership was liquidated the moment after a profits interest is granted, then the profits interest has no value. Thus, unlike many other kinds of executive incentive plans, the grant of a profits interest requires no buy-in, carries no immediate tax consequence and qualifies for capital gain treatment at liquidation or sale if held for the required time period.
To borrow a concept from architectural engineering, the profits interest is a cantilevered approach to equity transfer. Architects design awe-inspiring buildings, like Frank Lloyd Wright's Fallingwater, by cantilevering a portion of the superstructure into space without visible means of support.
Similarly, profits interests extend a stake in the economic future of a company without requiring payment for the underlying capital interest foundation. The profits interest is a powerful type of strategic incentive limited by choice of entity.
C corporations and S corporations, the historical choice for middle market entities, are not permitted to use profits interests. As middle market LLCs and partnerships rise in popularity, profits interests are becoming a mainstream choice as a strategic incentive. The upshot: The demand for and use of profits interests among middle-market companies is in its early stages and likely to increase rapidly for years to come, subject to changes in US tax law.
The growth of pass-thru entities has triggered the growth of partnerships. Pass-thru entities have a fundamental advantage over C corporations. Pass-thru entities pay only one level of tax. C corporations can "check a box" and elect to be taxed as a pass-thru S corporation. Conversely, it is unusual for a corporation to convert to a partnership because doing so generally results in a taxable liquidation of the corporation.
Accordingly, LLCs are typically natively formed, or "born", as partnerships. LLCs taxed as a partnership also avoid many of the restrictions of S corporations, such as single class of stock, pro-rata distributions in accordance with stock ownership, the number and nationalities of owners, financing structure, and administrative requirements. That is why, starting in the late s, more and more owners of new companies began to choose the more-flexible LLC structure over the S corporation.
Since then, LLCs taxed as a partnership and partnerships have exploded in popularity. According to Wall Street Journal article on February 8, , by , fully Three compelling advantages of profits interests Three characteristics can make profits interests a superior, high-performance incentive for partnerships.
Specifically, profits interests are accretive, they are taxed as property and they are especially flexible. Taken together, profits interests can be especially effective tools for achieving the "jobs-to-be-done" in middle-market partnerships.
Profits interests are accretive The value of a profits interest accrues from the future success of the business. It has no value when issued; its monetary value is generated only after it is granted—when profits and upside equity value are allocated. Hence, owners and founders can be assured that they are only giving away a portion of the upside growth of their companies.
When designed correctly, a profits interest creates added value for both the underlying capital-interest founders and new profits-interest owners. Profits interests qualifications The capital gains safe harbor granted by the IRS to profits interests Rev.
There must be no guarantee of income from the profits interest. In other words, a profits interest cannot relate to a substantially certain and predictable stream of income. The recipient may not dispose of profits interest within two years of receipt. The profits interest must pertain to a privately-held partnership.
The recipient of the profits interest must provide services to, or for the benefit of, the partnership, as a partner or in anticipation of becoming a partner.
Because a profits interest has no financial value when issued, it also requires no investment on the part of the recipient.
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