What Is a Profits Interest?
Profits interest refers to an equity right based on the future value of a partnership awarded to an individual for their service to the partnership. The award consists of receiving a percentage of profits from a partnership without having to contribute capital.
In effect, it is a form of equity compensation and is used as a means of incentivizing workers when monetary compensation may be difficult due to limited funds, such as with a start-up limited liability company (LLC).
- Profits interest is a way for partnerships to reward and retain employees in lieu of having equity to grant.
- Profits interest gives key employees a share in the future growth in value of the partnership in return for their efforts in making that happen.
- Profits interest makes an employee a partner in the practice and will trigger some other changes in terms of tax filing and some benefit programs.
Understanding Profits Interest
When starting a business, many entrepreneurs choose to structure their entity as an LLC taxed as a partnership, because such a structure allows them to use pass-through tax treatment and provides for the personal use of losses. But one option not available to entrepreneurs using this structure is the ability to issue equity stock options to motivate, reward, and retain key employees. That's where the profits interest comes in.
A profits interest represents an actual interest in the ownership of a partnership. As such, it differs from a stock option (another form of awarding an ownership stake), which grants to the holder a right to buy into a company at a time in the future.
A profits interest may be tax-free to its recipient if structured to be compliant with Internal Revenue Service (IRS) safe-harbor rules for partnership profits interest, as it represents an ownership interest in future growth of an LLC or partnership, rather than an interest based on its current value.
A profits interest serves as an incentive for partners to become more proactive in pursuing greater profitability, thus contributing to the companies' growth. It also provides a tax benefit to recipients, as all appreciation in value is taxed as long-term capital gains rather than as ordinary income.
Profits Interest Versus Capital Interest
Equity in an LLC that is taxed as a partnership may be treated either as a capital interest or profits interest. A capital interest is an interest based on the current value of a company. For example, if the company were to liquidate soon after the grant of capital interest was made, then the grantee would be entitled to a share of the proceeds from the liquidation.
Meanwhile, a profits interest is treated as a right to share in the future growth of a company or, put another way, value created after the profits interest was granted. This differs from existing LLC equity holders whose stake is based on the current value of the entity. If the entity were to shut down, the existing LLC equity holders would share in the value of the LLC while the profits interest holder would get nothing.
Profits Interest in Practice
Profit interest stakes may be subject to vesting rules in the same way stock options are treated. Vesting may also be based on time of service so that the profit interest holder's continued service is required for them to be able to earn their interest. It also may be based on meeting a certain predetermined performance goal or threshold.
Once an employee accepts a profits interest offer they become a partner. This means they have to convert their salary to self-employment income and pay quarterly estimated income taxes, as well as leave some employee benefits programs.