Unlocking the Power of Equity-Based Incentive Compensation: Basics of Profits Interests

This article is the fifth in our series on equity-based compensation intended to assist employers with answering a common question: What type of equity compensation award is best for our company and our employees? The first article is available here, the second article is available here, the third article is available here, and the fourth article is available here.

This article will provide an overview of profits interests. As such, this article will address only certain key aspects of profits interests. It is not intended to be a comprehensive discussion of every issue or consideration that applies to these types of awards. For the purposes of this article, all discussion of taxes is limited to U.S. federal income tax.

What Is a Profits Interest?

A profits interest is an interest in a partnership, granted in exchange for services, that gives the recipient the right to future appreciation or profits of the company. Unlike a capital interest, which provides a right to share in the current value of the company, a profits interest entitles the recipient only to the company’s future gains. For example, if the company were to liquidate or experience a change in control the day after granting the profits interest, the recipient would not receive any proceeds, as there would have been no appreciation in the value of the company yet.

Similar to restricted stock (discussed in a prior article), profits interests are often subject to restrictions, meaning they are typically non-transferable and at risk of forfeiture until they vest (i.e., the restrictions lapse).

Who Can Grant Profits Interests?

Only partnerships and limited liability companies (LLCs) that are taxed as partnerships for U.S. federal income tax purposes can grant profits interests. Corporations or LLCs taxed as corporations are not permitted to grant profits interests.

Tax Treatment of Profits Interests

Are profits interests taxable upon grant or vesting?

When properly structured under the guidelines outlined by the Internal Revenue Service in Revenue Procedures 93-27 and 2001-43, profits interests are not subject to taxation at the time of grant or vesting, even if the recipient does not file an election under Internal Revenue Code Section 83(b). Because no income is triggered at these stages, the company does not receive a corresponding tax deduction.

To qualify as a profits interest, the following conditions must be met:

1. The interest must be granted in exchange for services benefiting the partnership.
2. It cannot provide the recipient with an interest in the current capital of the partnership.
3. It must not relate to a predictable stream of income from assets like high-quality debt securities or net leases.
4. The recipient must hold the interest for at least two years.
5. The interest cannot be tied to a publicly traded partnership.

How is the recipient of a profits interest treated during ownership?

A recipient of a profits interest is considered a partner in the partnership as of the time the profits interest is granted (even if not yet vested), and partnerships are treated as pass-through entities for income tax purposes. This means the partnership itself generally does not pay income taxes, but rather the owners report their share of income or loss on their personal tax returns.

The recipient will be allocated profits and losses from the partnership and must report these on their individual tax returns.

Employment Tax Implications

Once someone becomes a partner, they can no longer be a W-2 employee of the company. Without careful structuring, recipients of profits interests will be treated as self-employed for tax purposes. Salary and bonus payments will be classified as guaranteed payments to the partner. The partnership will not withhold income, Social Security, or Medicare taxes on these payments; instead, the partner must make quarterly estimated payments for income and self-employment taxes.

Additionally, partners cannot participate in company-sponsored cafeteria plans (e.g., health insurance plans) on a pre-tax basis and must pay for these benefits with after-tax compensation. However, they may be able to deduct part of these costs on their personal tax returns. Partners may be able to continue participating in tax-qualified defined contribution retirement plans as long as the plan terms allows for such participation.

How are profits interests treated at sale?

If the recipient holds the profits interest for at least one year, the sale of the interest typically results in long-term capital gains, which are currently taxed at lower preferential U.S. federal tax rates (up to 20%) compared to ordinary income (up to 37%). However, the sale of any partnership interest may result in some portion of ordinary income regardless of holding period.

This combination of no income at grant or vesting and preferential capital gains rates makes profits interests an attractive option for partnership equity compensation.

Advantages of Profits Interests

Profits interests offer several potential advantages:

• The recipient is not taxed at grant or vesting.
• The sale of a profits interest generally results in long-term capital gains, taxed at lower rates.
• Profits interests offer flexibility in structuring how recipients share in future profits.
• Recipients do not need to make a personal financial investment.
• For companies, the risk of forfeiture helps retain key personnel if the recipient leaves before restrictions lapse.

Disadvantages of Profits Interests

There are also potential disadvantages to profits interests:

• Without proper structuring, employees who receive profits interests become partners, which can complicate tax reporting and filings.
• Due to the flexibility in designing profits interests, the structure can become complex and confusing.
• Other partners may perceive that recipients are receiving “something for nothing.”

Other Considerations

Securities Laws

Profits interests are considered securities under U.S. federal and state securities laws, meaning grants must comply with the Securities Act of 1933. Generally, securities must either be registered with the Securities and Exchange Commission (SEC) or qualify for an exemption. One commonly used exemption is Rule 701, which applies to securities offered and sold to employees, consultants, or advisors under a written compensatory benefit plan, provided certain conditions are met.

In addition to federal laws, grants of profits interests must also comply with state securities laws, often called “blue sky” laws. These laws vary depending on the recipient’s state of residence at the time of the grant, and some states may require a filing or fee. Companies should ensure compliance with applicable state regulations before issuing profits interests.

Documentation and LLC Agreements

Profits interests are typically documented in a written plan that outlines the main terms and conditions, with individual award agreements specifying details such as the number of units granted and vesting schedules. The company’s board of managers typically adopt the plan and approve each grant, though authority may sometimes be delegated.

Additionally, grants of profits interests are subject to the company’s LLC agreement, which governs ownership of the company. The LLC agreement can impose restrictions, such as limiting transfers, requiring the sale of interests back to the company under certain conditions, or mandating participation in mergers or other transactions approved by the other members.

Conclusion

This article provides an overview of key aspects of profits interests, but is not exhaustive. If you have questions or wish to explore other equity compensation options, stay tuned for future articles in this series or contact your Foley attorney for more information.