Insights

Employee Equity Incentives: The Beauty and the Beast of LLC Profits Interest

By Steven Keeler

Limited liability companies (LLCs) and partnerships have one executive-favorable equity incentive tool that is not available to corporations – the mysterious “profits interest”. Venture capital and private equity fund managers have been receiving “carried interests” for years, and profits interests have now become very popular in private operating company LLCs. In our experience, profits interests can be one of the best ways to incentivize growth company employees and they are now very common in private equity-backed companies.

The Beauty of a Profits Interest

• Economic Upside. A profits interest is a grant of shares or units of equity ownership in an LLC (or partnership) that is designed to restrict the recipient’s return from the profits interest to the future profits and gains from the company. For this reason, a profits interest is economically similar to a stock option with a fair market value exercise or strike price.
  

• Employee Tax Benefits. Unlike corporate stock or  LLC options, or corporate stock or LLC “capital interest” awards, profits interests can be granted (a) with no current tax impact to the recipient, (b) no requirement that the recipient pay for the profits interest, and (c) to afford the employee capital gain treatment on future appreciation in value.
  

• Real Equity Ownership. Despite the misleading name, unlike certain types of “phantom equity” like share appreciation rights (or “SARs”), a “profits interest” is real company equity.
  

• Future Capital Gain Versus Ordinary Income. The biggest tax advantage to a profits interest is that gain on any future sale of the profits interest will be taxed as capital gain in most instances, and not as ordinary compensation income (in contrast to an option or SAR).
  

• Company Tax Trade-Off. However, profits interest are advantageous to the employee, but less advantageous to the company than options and SARs, which provide the company with a tax deduction for the amount of compensation income recognized by the employee.
  

• Future Capital Gain Versus Ordinary Income. The biggest tax advantage to a profits interest is that gain on any future sale of the profits interest will be taxed as capital gain in most instances, and not as ordinary compensation income (in contrast to an option or SAR).
  

• Employee K-1s. And, the holder of the profits interest receives allocations of taxable profits and losses and may receive distributions from the company (including, hopefully, distributions for taxes that may be owed on profit allocations), including prior to “vesting” or a sale of the profits interest or the company. The employee’s ownership of a profits interest will also result in the employee not being treated as an employee for tax purposes, but some of the drawbacks of this can be avoided with multiple entity planning.
  

• To Vest or Not. Most profits interests “vest” either over a period of time or subject to company performance milestones, but they don’t have to in order to provide the employee tax benefits. “Vesting” means that, if the holder-employee leaves the company prior to the specified vesting dates or achievement of the performance goals, he or she will not receive the full future value of the profits interests shares, but rather will forfeit them for their cost or no money. Upon vesting, the holder usually becomes entitled to receive the full value of the profits interest on a termination of employment (other than, perhaps, for “cause” or retirement without “good reason”) or a company sale.
  

• Skin in the Game. To avoid the complexities of a profits interest, the company might choose to grant a “capital” interest” (similar to restricted corporate stock) for a cash payment by or promissory note from the employee. But this is less common in our experience.
  

The Beast in a Profits Interest

In addition to being more favorable to the employee than the LLC company and its owners, profits interests can be complicated to explain and to manage.

• Economic Risk. A profits interest is possibly one of the most difficult things to explain to company management or an employee-recipient. We first point out that they will only receive benefit from the profits interest if they remain with the company long enough for it to vest, and then, only if the company’s total equity value has increased well beyond its current value after subtracting out debt and the current value of the common and any preferred LLC shares.
  

• Lawyer and CPA Work. In properly designing and administering profits interests (which are typically just a different class of “common” shares, units or interests in the LLC), it is critical that the LLC’s operating agreement and the profits interest award agreement prohibit the holder from receiving any company distributions (or “dividends”) derived from the company’s “capital” or value existing on the date the profits interest is granted. To achieve this objective, most profits interests provide for a “hurdle” rate such that the profits interest holder is not entitled to receive any distributions until the prior LLC owners have received distributions in an amount equal to their capital accounts as of the award date. See how easy this is to explain?
  

• “Hurdle Rate, or Not. Although popular, a “hard-wired” hurdle rate in the legal documents is not required to achieve the tax advantages of a profits interest. We have also drafted profits interests without a set “hurdle rate” with operating agreement provisions that clearly state that the profits interest holder will only be entitled to distributions from the company that are attributable to company profits or gains occurring after the award date.
  

• Catch-Up to Full Ownership Percentage. With or without the hurdle rate concept, the profits interest can also be designed with a “catch-up” provision that entitles the profits interest holder to ultimately receive his or her full share percentage of the proceeds from cumulative distributions or a company sale. In this way, if the company’s profits or sale gain are sufficient, the profits interest holder has the opportunity to receive extra profit or gain allocations to support “full” distributions of the profits interest “percentage” in the company. Suffice it to say that the drafting requires competent legal counsel and the involvement of the company’s tax accountants. The hurdle rate concept makes the accountant’s job easier and is perhaps easier to understand.
  

• Annual CPA Compliance. We have had several experiences where properly drafted profits interests were not followed-up with coordinated and advisable tax return preparation. The company’s tax accountants should read, review and comment on the operating agreement and profits interest award agreement terms to ensure that they will understand how to determine all of the owners’ capital accounts in connection with the company’s tax returns. Most important, the capital accounts of the existing owners should be restated to current fair market value upon the grant of the profits interest, and all capital accounts should be restated in connection with various transactions and events in the future. The moral of the story is that companies operating as LLCs and granting profits interests should engage experienced tax accountants who understand the partnership tax rules and requirements for profits interests. One more recommendation – it is a common best practice to have a “vesting” profits interest recipient file a so-called “83(b)” election within 30 days after the grant to provide some extra protection in the event of a tax audit.
  

Take Aways

From the employee’s or executive’s perspective, an LLC profits interest is arguably the best equity incentive alternative because he or she does not have to pay for it, is not taxed upon its receipt, and may eventually receive capital gain (versus ordinary, compensation income) tax treatment on the sale of the profits interest, including in connection with a sale of the company. The company and its existing owners should determine whether the less favorable tax impact of a profits interest on the company is justified by providing the employee with real equity and beneficial tax treatment. As with many aspects of the tax flexibility and advantages (i.e. the “beauty”) of LLCs (as compared with corporations), these benefits come at the cost of some complexity, competent legal and accounting support, and the need for ongoing tax review and compliance efforts. And if your company is a corporation, there may be ways to create an LLC subsidiary to own the business and allow for the grant of profits interests to key executives.