Many people are familiar with stock options and how those operate, but for those businesses organized as an LLC and taxed as a partnership, profits interests are another tool in the toolbox to recruit, retain, and motivate your employees. However, I often need to provide more explanation about profits interests and how they work than stock options after offering them as a suggestion. Business owners and management should be aware of all the potential possibilities they have for compensating employees because attracting and keeping talent is a key issue faced in all industries.
What are profits interests?
A profits interest is an equity interest in the future growth of a partnership (or an LLC that is taxed as a partnership); it is a tool that can only be used by those entities and not corporations or S corporations. Note that the term “profits” here means the growth in the overall value of the business from the day the profits interest is granted; it does not mean the more typical annual profits that one might think. Another key point to emphasize is that profits interests are a current grant of equity now, meaning the recipient will become a partner in the business for tax purposes on the date the interests are granted. There is no requirement to exercise or pay a strike price, although some kind of vesting schedule is customary. This would come with all the same rights that a normal partner would have (voting, right to information, etc.), so careful consideration should be given to those issues before structuring a grant of profits interests.
How do profits interests work?
In order to be considered a profits interest, they must be structured so that the recipient essentially starts at a $0 liquidation value and only shares in the growth from there. So, the business must set what is known as a “hurdle rate”, which must be the fair market value of the company if it were to be liquidated. What the hurdle rate does is require that all that value that was built before the profits interests were issued be allocated to the non-profits interest owners first before the owner of the profits interest receives any cash.
An example is probably the easiest way to understand this concept. If a company issues a 5% profits interests to an employee and sets the hurdle rate at $1 million, this means that the prior owners must receive the first $1 million in distributable cash, and the holder of the profits interests receives 5% of all distributable cash greater than $1 million. This ensures that recipients of profits interests are only receiving the growth and are not sharing in the previous value of the business. This is no different than stock options and the concept of the strike price and is required to get the tax benefits of profits interests. Partnerships are extremely flexible with how distributions are made, so certain catch-up allocations can be made if you had something different in mind in how the profits interests are structured.
How are profits interests taxed?
As mentioned above, profits interests are designed to start at $0 of value to the recipient at the time of grant. This means that there is no tax effect at that time. That is often very important to recipients since nobody wants to take a tax hit without cash actually changing hands. Another benefit of profits interests is that there is no obligation to exercise or pay a strike price, which is not the case with stock options as those often comes with a tax obligation on the difference between the strike price and the fair market value at exercise. And because profits interest are a grant of equity right now, the capital gains clock starts at the moment of grant, which potentially leads to lower tax obligations in the event of a sale.
One important aspect, and potential downside, to discuss for profits interests centers around the recipient’s employment status. A partner in a partnership (or an LLC taxed as a partnership) is not able to be a W-2 employee and is instead considered to be “self-employed”, turning all employment compensation from salary into “guaranteed payments”. A recipient of profits interests will now receive a Schedule K-1 each year instead of a W-2 at tax time, and there may be obligations to pay quarterly estimated taxes. This can often be a brand new frontier for someone used to just being a W-2 employee their whole career, so it is definitely worthwhile to have that discussion with the recipient and make sure they understand what this means for their personal income taxes. The benefits of profits interest may end up not worth the headache for personal tax reporting, but it should be explored either way.
Conclusion
Profits interests have become an attractive option for businesses today given their favorable tax treatment and the flexibility provided by partnerships. But understanding how they work and what their effect is on the recipient is necessary for any business considering new ways to motivate its employees and recruit new talent. If your business is interested in coming up with solutions to the eternal need for good employees, reach out to William Daniel or your BrownWinick attorney with any questions you may have. BrownWinick is here to assist you in structuring these transactions in the most advantageous way for your business and your employees.
