For many growing businesses, keeping talented employees and key team members can be just as important as attracting new customers. But smaller and closely held businesses may not have the resources to compete with larger companies on salary alone. One tool that can help align the interests of a business and its key people is a profits interest. Profits interests can allow certain businesses to give key service providers a stake in the future success of the company without requiring the existing owners to immediately give up a portion of the value they have already built.
What is a Profits Interest?
A profits interest is a type of ownership interest generally available to partnerships and limited liability companies taxed as partnerships. Unlike traditional ownership, a profits interest is designed to give the recipient a share of the company's future profits and growth, rather than a share of the value that already exists when the interest is granted. The IRS generally defines a profits interest as a partnership interest other than a capital interest. In simple terms, if the business were sold for its current value immediately after the profits interest was granted, the recipient generally would not receive a share of those existing proceeds based solely on the profits interest.
Consider a simple example. Assume two owners have built a company that is currently worth $1 million. They want to reward a key team member who they believe will help grow the company over the next several years. Rather than giving that person an immediate percentage of the existing $1 million in value, the company could grant a profits interest that allows the person to participate in some portion of the value created above that $1 million threshold. If the company grows to $2 million, the profits interest holder may participate in that future growth according to the terms of the company's operating agreement. If the company never increases in value, the profits interest may have little or no economic value.
Why Do Businesses Use Profits Interests?
Profits interests are often used as an incentive and retention tool. They can give key employees or other service providers an opportunity to benefit directly from the company's future success. For existing owners, this structure can also be attractive because it generally allows them to preserve the value they created before the profits interest was issued. The recipient participates primarily in what happens going forward. Profits interests can be particularly useful when a business owner wants to:
reward a key employee or service provider without requiring that person to purchase an ownership interest;
encourage a valuable team member to stay with the company long term;
tie compensation to the future growth of the business;
begin transitioning ownership or responsibility to the next generation of leadership; or
give management an ownership mindset without immediately transferring a portion of the company's existing value.
Profits Interests Can Be Subject to Vesting
A business does not necessarily have to give the entire profits interest to the recipient on day one. Instead, profits interests are frequently subject to a vesting schedule. For example, a company might grant a 10% profits interest that vests over four years. If the recipient leaves after one year, the recipient may keep only the portion that has vested and forfeit the remainder. Vesting can make profits interests especially useful as a retention tool. The business can provide a meaningful opportunity for ownership while also requiring the recipient to remain involved with the company for a certain period of time before earning the full benefit. Federal tax guidance also recognizes certain nonvested profits interests and, when the applicable requirements are satisfied, generally does not treat the initial grant or later vesting as a taxable event.
Are Profits Interests Taxed?
One of the potential advantages of a properly structured profits interest is that receiving the interest generally does not result in immediate taxable income to the recipient under the IRS safe harbor rules, provided the applicable requirements are satisfied. That does not mean profits interests are tax-free. Once an individual becomes a partner or member for federal tax purposes, the person's tax treatment may change significantly. Partnerships generally pass income and losses through to their partners, who receive a Schedule K-1 and report their share on their individual tax returns. The IRS also generally treats partners as self-employed rather than employees of the partnership for federal employment tax purposes. As a result, businesses considering profits interests should involve their legal and tax advisors before making a grant. The tax consequences can vary depending on how the interest is structured, whether it is vested, how profits are allocated, and the recipient's role in the business.
A Profits Interest Is Still Real Ownership
It is easy to think of a profits interest as simply another type of bonus plan, but it is important to remember that a profits interest is generally an actual ownership interest. That means the company's governing documents need to address more than just the percentage being granted. Among other things, the owners should consider voting rights, distributions, tax allocations, transfer restrictions, what happens if the recipient leaves the company, whether the company can repurchase the interest, and what happens upon a future sale of the business. The company's operating agreement will often need to be amended or restated to properly incorporate the new ownership structure.
Is a Profits Interest Right for Your Business?
Profits interests can be a powerful tool, but they are not appropriate for every business. They are generally used by entities taxed as partnerships, including many LLCs, and are not the equivalent of simply issuing stock in a corporation. For the right business, however, a profits interest can provide a flexible way to reward key people, encourage long-term commitment, and allow employees or other service providers to share in the value they help create. The key is getting the structure right from the beginning. Business owners considering a profits interest should work with legal and tax advisors to determine the appropriate percentage, valuation threshold, vesting terms, tax treatment, and governing-document changes before making the grant.
This article is provided for general information purposes only and should not be construed as legal advice. Those requiring legal advice are encouraged to consult with their attorney.
