Profits Interests: A Tax-efficient Incentive Compensation Tool

Partnerships and limited liability companies (LLCs) — particularly start-ups — often lack the financial resources to offer salaries and benefits competitive with those of larger, established enterprises. One option to help these businesses attract and retain quality talent is to offer employees, consultants or other service providers profits interests. These types of interests can provide tax advantages over capital interests and don’t immediately dilute the founding owners’ interests in the business.

What are profits interests?

A profits interest confers only the right to a share of the business’s future profits and appreciation in value. Thus, the initial grant of a profits interest generally has no current liquidation value and isn’t taxable, assuming it’s properly structured.

In contrast, recipients of capital interests have an immediate equity interest in the business. In other words, they have the right, on Day 1, to a share of the proceeds if the business’s assets are sold and the proceeds are distributed to its owners. As a result, capital interests have immediate value and, therefore, are taxable as compensation to the recipient on the grant date (or when they vest, if later), regardless of whether the business’s assets are sold.

Profit interests in action

Suppose that an LLC grants profits interests to several key executives under a properly structured plan, and the business’s fair market value (FMV) on the grant date is $10 million. The granting of the profits interests wouldn’t trigger any tax liability for the recipients. If the business’s assets were sold and the business liquidated on the day of the grant at FMV, the full $10 million in proceeds would be distributed to the existing capital interest holders, with nothing for the new profits interest holders.

If, instead, the business were liquidated five years later, when its FMV had grown to $20 million, the first $10 million would go to the capital interest holders, and the $10 million in post-grant appreciation would be split among the capital interest and profits interest holders. At that time, the profits interest holders would be taxed on their portion of the post-grant appreciation, typically at their long-term capital gains tax rates.

Setting up a plan

To use profits interests as an incentive, your business will need to establish a profits interest plan that outlines the circumstances under which such interests will be granted and the terms and conditions. Typically, profits interests vest over time based on the holder’s years of service, or, in some cases, on the business achieving performance-based goals or reaching milestones, such as launching a new product.

The business’s FMV on the grant date also must be established. Setting this threshold — and stating in the plan’s terms and conditions that profits interest holders share only in the business’s value to the extent it exceeds that threshold — ensures that profits interests have no current liquidation value for tax purposes on the grant date.

Obtaining a professional valuation of the business that will withstand IRS scrutiny is critical. If the IRS determines that the business was undervalued, profits interest recipients may face additional tax (and potentially penalties and interest) based on the corrected valuation, leading to a variety of unpleasant tax complications.

Safe harbors

IRS guidelines provide a safe harbor for profits interests, ensuring they’re tax-free when granted if certain requirements are met. (Note that the term “partner” in the safe harbor also includes a member of an LLC classified as a partnership for tax purposes.) To qualify for the safe harbor, an interest must, among other things:

Be received by the holder as a partner or in anticipation of becoming a partner, in exchange for services rendered,
Represent a true profits interest with no right to share in existing capital on the grant date,
Not be related to a substantially certain and predictable income stream from partnership assets, which may be considered disguised compensation, and
Not be disposed of within two years of receipt.

In addition, the recipient must be treated as a partner for tax purposes, beginning on the grant date. (See the sidebar for details.)

Most profits interest plans require recipients to file a Section 83(b) election to treat the interest as fully vested for tax purposes on the grant date. The reason is to help preserve the interest’s tax-favored status as it vests and support the intended tax treatment if the company is liquidated or makes capital gain allocations. There’s some debate about whether such an election is necessary. But there generally isn’t a downside because it triggers no tax liability (due to the fact that a properly structured profits interest generally has no current liquidation value on the grant date).

Moving forward with confidence

By tying compensation to long-term value creation, profits interests can be a powerful tool for aligning the interests of executives and other service providers with those of the business and its owners. But it’s important to understand what’s required to make such a plan work. Success depends on careful planning, accurate business valuation and strict compliance with IRS requirements. Working closely with tax and valuation professionals can help minimize risk and maximize the chances that the plan will achieve its intended objectives.

Treating profits interests recipients as partners for tax purposes

When considering the pros and cons of profits interests, it’s important to recognize that recipients of profits interests must immediately be treated as partners for tax purposes, regardless of any vesting requirements. Among other things, this means that:

For tax purposes, recipients can’t be treated as W-2 employees. Their compensation must be reported on Schedule K-1 (Form 1065) rather than on Form W-2. If they receive guaranteed payments for services rendered (essentially salary equivalents, except they aren’t treated as wages for tax purposes), those payments are reported on Schedule K-1 and are generally subject to self-employment tax.
Because recipients won’t be treated as W-2 employees, the business won’t withhold income and payroll taxes from their compensation. Therefore, recipients will have to make quarterly estimated tax payments to the IRS to cover income and self-employment taxes on guaranteed payments and their shares of the business’s net profits.
The business must furnish K-1 forms to recipients, reporting their shares of the business’s net profits or losses.
Recipients may be prohibited from participating in certain employee benefit plans provided by the business.