Profits interest offers a popular solution to a question we often receive: As an LLC owner, how can I incentivize employee performance and share some of the company’s success without having to provide individuals management or voting rights?
Read on to learn more about the benefits of profits interest agreements and important points to keep in mind!
For the purposes of this post, we will refer to the LLC granting the interest as a partnership and assume that the entity did not elect to be taxed as a C- or S-Corporation.
What are profits interests?
A profits interest is an equity interest or right that awards the granted party (such as an employee) a portion of future profits, as well as appreciation of the partnership’s assets, in exchange for their services to the partnership.
This is a popular form of equity compensation, particularly for cash-poor startups that want to pay employees down the line when the company is more profitable. It can be a good alternative to issuing stock for LLCs that don’t actually have stock to give.
Although granting profits interest does technically grant some ownership, since the grantee becomes a member of the LLC, it has important distinctions and limitations:
- The grantee does not assume any of the company’s debt.
- The grantee typically does not have company voting rights (there are exceptions on certain issues depending on state laws).
- The grantee is typically not entitled to the tax benefits provided by distribution of losses.
This infographic illustrates how profit interests work on a basic level:
As you can see, employee Joe gets no benefit from his profit interests agreement if the company liquidates before any appreciation (profit) occurs. He only receives a portion of the increase in the company’s value.
Profits interest vs capital interest
A capital interest is different than a profits interest in that the holder of a capital interest is entitled to a portion of the company’s value at the time the interest was granted as well as a portion of the appreciation.
Here’s an example of a simple capital interest agreement:
Notice how employee Joe, when granted a capital interest, benefits even if the company has no increase in value.
Vesting interest with a profit interests agreement
A profits interest can also be a form of vested interest, just like a capital interest. Here’s a simple example of how the benefits can increase over time:
Profits interest taxation
There are 2 important things to keep in mind when it comes to profits interest taxation:
- Profit interests normally aren’t taxed upon receipt; the tax is deferred until payout.
- In some cases, the holder of a profits interest becomes a partner in the business (typically a Class B partner) and must file U.S. taxes as a self-employed individual.
Profit interests are typically non-taxable at the time they’re granted, since they aren’t actually worth anything at that time. There are some exceptions to this rule under IRS Rev. Proc. 93-27.
Profits interest and self-employed taxes:
Before entering a profits interest agreement, both employers and employees should be aware of the potential tax implications. When an employee is granted a profits interest (we’ll refer to this employee as the “holder”), they may become a partial owner/partner of the company depending on the existing business structure and other factors.
When the holder becomes a partner, in some circumstances they will no longer be taxed as an employee or have taxes withheld from their paychecks. The holder will receive a K-1 each year documenting their portion of the company’s profits.
Some employees may not want this extra layer of responsibility. However, if the holder is taxed as a self-employed worker, they will receive the benefit of being able to write off business expenses. (See our Top 10 Self-Employed Tax Deductions.)
The holder should be aware that they may have to start paying self-employment taxes, which are approximately 15% of income. They may also be required to pay quarterly tax estimates; not doing so can rack up hefty penalties.
However, the agreement can sometimes be structured so that the holder is still an employee who has taxes withheld from paychecks; the holder could even be an employee and a partner at the same time.
Profits interest agreements can be structured in countless ways and there are many nuances to consider from a tax and legal standpoint. If you need help structuring your agreement, give our startup lawyers a call!
Need help with your profits interest agreement?
The attorneys at Gordon Law Group assist companies with profits interest agreements and capital interest agreements on a routine basis. If your partnership is interested in incentivizing and retaining key employees this way, contact us today and connect with an experienced business attorney!