Articles about Profits Interests

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2021.06.18 Equity and Equity-Based Compensation for LLCs (By Robert M. Finkel, published Jun 1, 2020; NY Society of CPAs).

2019.10.01 Phantom equity vs. profit interests: Strategic considerations (The Tax Advisor) explains why phantom equity can be designed to accomplish tax results that are favorably similar to those of profits interests, and describes the baggage from profits interests as follows:

  • There are many additional benefits of the grossed-up phantom stock strategy [over profits interests]; e.g., there are no Schedules K-1 and related W-2 problems and complications for employees otherwise not looking for ownership. No additional state filings are required for those same employees. There are also no ownership complications if employees come and go. They can be moved into and out of the plan with relative ease, while ownership remains with those committed to the business. The one primary caveat with the use of the phantom equity plan is that the primary business owners will need to have sufficient ordinary income in the year the phantom equity bonuses are paid to fully use the benefit of the ordinary tax rate deduction.

2019.09.17 Explaining Profits Interests and Their Tax Consequences (by Crowdfunding) provides likewise:

  • Q: What are the possible tax consequences to a recipient of a profits interest?
  • A: From a tax perspective, and under current Treasury Regulations1, the primary reason employers issue profits interests is that the grant of a profits interest does not result in taxable income to the recipient. … 
  • A second reason to issue a profits interest is that since the profits interest represents equity in the LLC, the later sale or redemption of the equity interest generally generates income taxable at more favorable capital gains rates. …
  • A third important difference for recipients and LLCs to consider is that upon receipt of a profits interest, the grantee recipient is no longer treated as an employee of the LLC. Instead, the recipient becomes a partner for tax purposes and will receive Forms K-1, reporting his or her share of the LLC’s fiscal year profit and loss (if any) in accordance with the LLC’s Operating Agreement and payments for services (i.e., formerly “salary”). The grantee will be solely responsible for paying periodically estimated taxes and self-employment taxes. If the profits interest is relatively small in comparison with the annual salary amounts, granting a profits interest to an employee may present a tax and compliance burden to the recipient that outweighs any benefit conferred. In those cases, an LLC should consider alternative forms of compensation such as cash bonuses.
  • However, if the change in employment status and added tax reporting burden are not deal-killers, the receipt of a profits interest has distinct advantages over other types of equity incentives of both no current taxation and a potential for capital gains treatment. Nonetheless, a grantee must be comfortable that the terms of the profits interest represent a meaningful incentive. …

2017.10.12  Options Or Profits Interests For Key Employees of LLCs? concludes as follows, reflecting the above:

  • For a company with just a few key contributors a profits interest isn’t bad. You give your employees a great tax result and what the heck, what are a few more owners among close friends? But for a company with more than a few key contributors the option is better only because it’s so much easier to keep a tighter cap table. And while the tax treatment of the employee isn’t as favorable, I’ve never seen an employee refuse an option for that reason.

2013.04.22 Options for Issuing Employee Equity in LLCs (by Venture Alley) provides more detail consistent with the above:

  • This potential for tax savings [from profits interest awards] does not, however, come without a cost.  LLCs tend to be more complicated and expensive to setup and manage, particularly for operating businesses.  LLCs can become even more tricky for businesses that want to issue equity to incentivize employees or other service providers.
  • … Where profits interests have been issued subject to vesting, the LLC agreement typically will provide that distributions with respect to unvested profits interests generally will either (i) not be distributed to the profits interest member but instead held by the LLC on behalf of the service provider pending vesting (i.e., held in escrow by the company), or (ii) be distributed subject to contractual obligations of the service provider to repay excess distributions (i.e., a ‘clawback’). [Poerio Comment: the tax distribution aspects associated with unvested profits interests adds a significant complexity.]
  • … Administrative Cost.  There is an administrative burden in managing profits interests, which increases exponentially with the number of different times the company wants to make a grant.  Following each date of a grant, the LLC must determine the value of the entity at the time of each grant of a profits interest. This is best done using a third-party valuation firm, as a corporation may do for its 409A valuations. The LLC also usually will need to account for unrealized appreciation in the LLC as of each grant date by adjusting the existing members’ capital accounts or allocation rights to ensure that the recipient of the profits interest does not inadvertently share in any pre-grant value in the LLC; the LLC generally will need to either (i) “book up” the capital accounts of the existing members in the LLC in the amount of the unrealized appreciation as of the date of the grant, or, alternatively, (ii) the company and its members may elect to amend the LLC’s operating agreement to provide for a special allocation of that pre‑grant unrealized appreciation among its existing members (“Capital Account Adjustment”). Without these Capital Account Adjustments, the intended economic deal could be frustrated.  For example, upon the LLC’s subsequent realization of unrealized gain lurking within the LLC, such as upon a sale of some of its assets having unrealized appreciation at the time the profits interests were granted.  , could be allocated to the profits interest member, effectively giving that member an interest in the value of the LLC that existed prior to their grant. Such an allocation to the profits interest member would have substantially different tax implications; it would be a capital interest in the existing value of the company rather than a profits interest. Receipt of a capital interest shifts existing value from the existing members to the new member, which is immediately subject to tax as compensation and at ordinary income tax rates.
  • Due to the above complexity with valuations and capital accounting, LLCs should avoid issuing profits interests on more than a few occasions because tracking the multiple valuation dates and making the necessary Capital Account Adjustments can quickly become an accounting nightmare.

 ​2007   The Use of LLC Profits Interests as Management Incentives in Buyouts