Thinking About Granting Profits Interests to Your Employees? Four Reasons You May Want to Think Again

We are often asked by owners of limited liability companies (LLCs) to help them issue “profits interests” to service providers of their LLCs. At first glance, profits interests seem perfect — after all, they offer a low-cost, tax-savvy way for LLC owners to incentivize their employees and consultants (at capital gains rates and with no immediate tax consequences) while retaining control of their LLCs. 

The reality is that, although profits interests can be a great way to motivate service providers, they can also create tax and administrative headaches for LLC owners who do not understand exactly how they operate, underestimate the compliance demands involved, and/or fail to appreciate the long-term consequences of expanding their capitalization tables. That can lead to “surprise” tax complications for everyone involved, increase the likelihood of disputes between the parties, and may even give future buyers pause about acquiring your LLC.

In this article, we will provide four questions you should ask yourself before including profits interests in your LLC’s incentive compensation program. Depending on your answers, you might want to consider an alternative approach to incentivizing your employees.

Background

LLCs taxed as partnerships are one of the most popular forms of business entities in the U.S., especially among small and mid-size organizations. LLCs combine the benefits of both partnerships and corporations, because they are treated like partnerships for tax purposes (i.e., as pass-through entities), while, as corporations, they provide owners with protection from personal liability for the company’s debts.

The dual nature of LLCs provides owners with significant flexibility when determining how best to reward top performers. LLC owners are increasingly issuing “profits interests” to their key talent, both as a long-term incentive compensation strategy and as a means for aligning the interests of management and owners. 

Profits Interests 101 

A “profits interest” is an interest in an LLC taxed as a partnership that is: 

1. granted in exchange for services
2. gives the recipient the right to share in future appreciation or profits of the LLC.¹

Unlike a “capital” interest in the LLC, a profits interest only entitles the recipient to share in the company’s future profits or earnings.² 

Profits interests can be used as a means to incentivize and retain LLC employees and consultants. Typically, profits interests are non-transferable and subject to vesting requirements.

When properly structured (in accordance with IRS Revenue Procedures 93-27 and 2001-43, which impose requirements on profits interests beyond those discussed herein), profits interest recipients will not be subject to tax when their profits interests are granted or when they vest, even if the recipient fails to file a timely election under Internal Revenue Code §83(b) (an 83(b) election). As discussed below, however, there are good reasons for requiring profits interest recipients to file a “protective” 83(b) election.   

For more information, check out our prior article, which covers the advantages and disadvantages of profits interests in much greater depth.  

Do You Really Want the Profits Interest Recipient to Be Your Partner?

If you grant a profits interest to a service provider (including to an existing employee), that person will immediately become a partner in your LLC for federal tax purposes — even if the profits interest is subject to vesting.³ This may come as a surprise to LLC owners thinking about offering profits interests to their service providers.

The immediate change in a profits interest recipient’s tax status from employee to partner has a number of practical consequences, including, but not limited to, the following:

When thinking about issuing profits interests, LLC owners should consider the sophistication of their work force, and the difficulty profits interest recipients may face if they suddenly find themselves treated as partners. Can they navigate the more complicated tax issues applicable to partners, including the required quarterly income tax filings? If not, an LLC owner should consider other ways to incentivize its employees (more on this below).⁵

If an LLC owner decides to issue profits interests to its employees, but continues to treat them as employees, that is going to be a problem. For one, the grant may fail to qualify as a profits interest, and could be treated as taxable compensation at grant (or upon vesting, if applicable).⁶ Even if the LLC continues to withhold taxes from the recipient’s compensation (as though the recipient was still an employee), if the LLC’s withholding does not reflect the recipient’s share of the LLC’s profits and losses, that withholding likely will not be sufficient, leading to the recipient’s potential underpayment of required taxes (leading to the penalties and interest).

Can You Get the “Hurdle” Right?

In order to provide the recipient with the right to share in future profits/appreciation of the LLC occurring after the grant date, a profits interest must include a “hurdle” or threshold amount tied to the LLC’s fair market value (FMV) on that date. Profits interests, by definition, have no intrinsic value if the LLC is liquidated on the grant date.⁷ If the LLC sells for more than the hurdle after the grant date, profits interest recipients may participate in the LLC’s value above the hurdle.⁸

Determining the FMV of a privately held LLC is not easy. If the IRS determines on audit (or a potential buyer discovers during diligence) that the profits interest’s hurdle was set too low, the recipient may be forced to recognize income on the profits interest, retroactive to the grant date. This could require the LLC to issue corrected W-2s, and the recipients to file corrected personal returns, among the possible “parade of horribles.”

Although profits interests are not typically treated as “deferred compensation” subject to Internal Revenue Code §409A, we typically recommend that LLC owners take a page out of the Code §409A compliance handbook and engage an independent third-party appraiser to determine the LLC’s FMV as of the profits interests’ grant date. Using the LLC’s appraiser-determined FMV will provide you with a defensible hurdle for any profits interests you issue. The upfront cost of an independent third-party appraisal will almost always be less than the time and cost of defending a profits interest hurdle (and the LLC’s FMV) against an IRS audit or explaining it to a potential buyer during diligence. 

Will Profits Interest Recipients Be Required to Make a “Protective” Code §83(b) Election?

If a profits interest is subject to vesting, the timing of income inclusion turns on whether it is “substantially nonvested” within the meaning of Treasury Regulation §1.83-3(b). In general, absent of a timely 83(b) election, an equity award holder (including a profits interest recipient) will recognize ordinary income as each portion of their equity award vests. 

Rev. Proc. 2001-43 provides, however, that if a profits interest is properly structured, neither the profits interest’s grant nor its vesting will be a taxable event. Further, the profits interest recipient will be treated as if they had made a timely 83(b) election (even if no such election is filed). Even so, LLC owners often require profits interest recipients to make a “protective” 83(b) election with respect to their grants, especially if the award is subject to vesting. If the profits interest’s hurdle was appropriately set, there will be no cost to the recipient to make the election — the value of the profits interest at grant will be $0. However, filing a protective 83(b) election can safeguard a profits interest recipient if, for any reason, the profits interest fails to meet the requirements of Rev. Procs. 93-27 or 2001-43. 

For example, under Rev. Proc. 93-27, a profits interest will not meet the safe harbor for tax-favored treatment if the recipient disposes of the interest within two years of receiving it. However, if the profits interest recipient makes a protective 83(b) election, the award’s tax-favored status will be preserved as the award vests. If the award fails to qualify as a profits interest, income will be recognized on the date of grant, when the value of the award is likely to be at its lowest. Further, making a protective 83(b) election will ensure the profits interest recipient’s capital gains holding period begins to run as of the grant date (regardless of whether the award actually qualifies as a profits interest).

Given these benefits, it often makes sense to require profits interest recipients to make a protective 83(b) election as a condition of receiving their awards.   

Are You Comfortable with Complexity? 

While profits interests provide recipients with “a piece of the pie” (i.e., a piece of your LLC), they are complicated equity arrangements subject to complex tax and reporting requirements. They require both specific actions by LLC owners when they are granted, as well as ongoing corporate and tax compliance. Accordingly, it is imperative you understand what will happen to your LLC when a partner (including a profits interest recipient) quits, is terminated (with or without “cause”), becomes disabled, or dies. You must also be prepared to deal with the implications of expanding your LLC’s capitalization table. 

At a minimum, your LLC’s operating agreement should address how profits interests will be handled upon a sale, merger, IPO, and/or recapitalization of the LLC. It should also clearly describe how profits interests fit into your waterfall. Ambiguity on these points can lead to disputes among the LLC’s partners at the most inopportune time (often when you are trying to sell the LLC). 

You will need to put processes and procedures in place to ensure the profits interests you issue comply with federal tax law. Among other items, you must also retain documentation showing that you:

•  obtained accurate and timely FMV determinations
• took all required corporate actions
• obtained timely and valid §83(b) elections from profits interest recipients
• properly allocated profits and losses’ and issued timely K-1s. 

And did we mention profits interests must comply with state and federal securities laws? (They do!) Multi-state filing nexuses, equity interest recharacterization, and other securities law requirements can follow, all of which are (thankfully) beyond the scope of this article, but which can require substantial attention from the LLC owner. 

If You Answered “No” to Any of the Four Questions: Consider Possible Alternatives

If all of this sounds like too much, you may want to consider a simpler equity or equity-like vehicle to align your interests with that of your employees and consultants. An excellent overview of equity alternatives can be found here, while information about appreciation-type equity awards and full-value equity awards are discussed here and here, respectively. 

You might also consider establishing a cash-settled equity award plan or even a phantom equity plan. While these plans may not provide award recipients with capital gains tax treatment when settled, they can still provide recipients with considerable value and incentive (plus, they are often simpler to administer and raise fewer tax complications.) 

The Bottom Line 

In the right circumstances, profits interests offer LLC owners a tax-advantaged way to incentivize their service providers, aligning everyone’s interest in the LLC’s continued success. However, the perceived advantages of profits interests come with real legal, tax, and administrative costs that can only be realized through thoughtful structuring and disciplined compliance efforts. Hastily prepared or improperly maintained profits interest can result in costly compliance problems down the road. 

Bottom line: implementing and maintaining a compliant profits interest program is not impossible — but it is not easy, either. Before you promise profits interests to your service providers, be sure you are comfortable with the inherent complexity of these awards and are willing to invest the upfront and ongoing costs and effort necessary to properly structure and maintain them.