This post is the fourth in a series exploring techniques to attract and retain key employees, directors, and other service providers of privately held companies through equity-based compensation arrangements and alternative arrangements that provide cash payments tied to the value of the company’s stock or ownership interests.

Previously, I provided an overview and discussed the tax treatment of various equity compensation arrangements typically used by corporations, such as stock options, restricted stock, phantom stock, and stock appreciation rights. In this post, I’ll discuss a popular technique, called a “profits interest,” which is available to entities taxed as partnerships, such as limited liability companies (or “LLCs”). Profits interests can provide a tax efficient way to reward key service providers. Since LLCs are the most popular type of entity taxed as a partnership, for the rest of this post, I will assume that the entity in question is an LLC.

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A “profits interest” in an LLC is an interest in the LLC’s future profits but none of its existing capital. That is, a service provider who receives a profits interest starts with a capital account of $0 and the capital account increases as future profits are allocated to the recipient in accordance with the LLC’s operating agreement. If structured properly, a profits interest will not be taxed to the recipient at grant. However, the holder of the profits interest will incur taxable income for his share of the company profits. If the service provider later sells the profits interest at a price in excess of its value when the profits interest is granted (adjusted upward for any income allocated to the service provider along the way), then gain from such sale would be taxed as long-term capital gains. Therefore, it is hoped that the potential for these economic benefits to the service provider will retain or incentivize him to help the LLC achieve its financial goals.

Considerations in structuring a profits interest include the following:

  • The profits interest must not result in the recipient receiving an interest in the LLC’s capital at date of grant. This is tested by doing a hypothetical liquidation analysis in which it is assumed that the LLC’s assets are sold at their fair market values immediately after the date of grant and the proceeds are then immediately distributed to the LLC members in accordance with the liquidation provisions of the LLC’s operating agreement. If the recipient would receive $0 upon this hypothetical liquidation analysis, then the recipient is deemed to have received no interest in capital and there will be no tax at the date of receipt of the profits interest. Capital accounts of the existing LLC members (those other than the recipient of the profits interest) can be “booked up” to achieve this result.
  • The profits interest can be vested or unvested at date of grant. Frequently a profits interest is granted which vests over some period of time (e.g. 20% per year for five years). However, whether the interest is vested or not, the service provider should be treated as the owner of the interest from the date of grant for income tax purposes (i.e. the service provider will receive his or her pro rata share of income, loss, etc. under the LLC’s operating agreement). Therefore, a mechanism to deal with taxes due on phantom flow-through income to the recipient needs to be established, such as having the company make distributions to the service provider to assist him in meeting his increased tax burden. In addition, the recipient will generally want to make an 83(b) election for any unvested interests so that the interest is taken into account for tax purposes at date of grant (when the value for tax purposes is $0) instead of later upon vesting when it would generally have value.
  • An employee who receives a profits interest will thereafter be deemed a partner for tax purposes and thus “self-employed”. Therefore, the new partner/former employee will be subject to self-employment taxes and will no longer be able to participate in certain employee only benefit plans. This may be one negative associated with a profits interest granted to an employee of the LLC as opposed to a phantom unit or unit appreciation plan. A potential solution to this problem is to create tiered structure in which a second LLC owns an interest in the operating entity, and then the employees are granted interests in the second LLC. The result would be that the employees will remain employees (and not partners/members) of the operating entity.
  • The granting LLC and its existing members will want to have the profits interest recipient sign on to and be bound by the operating agreement. In addition, it may be necessary to amend the operating agreement to set forth transfer restrictions, drag along rights, repurchase rights of the LLC or the existing members (e.g. upon termination of employment), and other rights or restrictions.

Granting a profits interest to an employee or existing member of an LLC (or other entity taxed as a partnership) is fairly complex, but can be a great way to align the interests of the entity and its key employees or members.