Protect Your LLC’s Earnings with Profits Interests
Profits interests are an increasingly popular form of equity compensation for LLCs that are treated as partnerships for federal tax purposes.
The profits interest is an equity interest in the LLC that entitles the holder to share only in the future income and future appreciation in the value of the LLC – not in the value and capital existing at the time of grant.
For purposes of illustration, Alan and Beth own AB, LLC on a 50/50 basis and decide in year two, when AB, LLC is valued at $100,000, to grant employee Carla a fully-vested 10% profits interest in AB, LLC. If AB, LLC is subsequently sold for $500,000 in year six, Alan and Beth would split the first $100,000 (the existing value of AB, LLC at the time of Carla’s profits interest grant) 50/50 and the remaining $400,000 would be shared as follows: 45% to each of Alan and Beth and 10% to Carla.
The popularity of using profits interests as equity compensation for key employees is due, largely, to their favorable tax treatment and their flexibility.
If structured properly to comply with applicable IRS safe harbors, the grant of a profits interest in exchange for past or future services, and in the case of unvested profits interests, the later vesting of the profits interest, is tax-free to both the recipient and the LLC. Moreover, generally, if the profits interest is held for more than one year, the distributions made at liquidation or redemption of the award are taxed at the long-term capital gains rate.
A profits interest award gives key employees a share in the future value of the company, and as such, provides a means for companies to retain and incentivize employees to continue to grow the business without doling out large cash bonuses. Retaining and motivating key employees are important, but not at the expense of founding members’ control of their business.
Some ways to tailor a profits interest award to both maximize the desired incentivizing effect and preserve the founding members’ control of the company include:
- Vesting. Time-based or performance- based vesting requirements can incentivize the recipient to remain with the company for a period of time and improve performance, respectively.
- Structure of Profits Interest Holder’s Participation in the Growth of the LLC. The profits interest holder’s participation in the growth of the LLC can be structured in different ways, including (i) fixed participation: the profits interest holder is entitled to share in a fixed percentage of future profits and growth, or (ii) catch-up participation: the first post-award gains, up to a capped amount, go to the profits interest holder, thereafter profits are shared pro-rata among all members. The latter may better incentivize enhanced employee performance because the employee is allocated all gains, rather than just his pro-rata share, up to a certain amount.
- Restrictions on Profits Interest Holder’s Membership Rights. A profits interest holder is generally considered a member of the LLC. Founding members can mitigate the adverse effects of expanding the LLC’s ownership base by eliminating or restricting certain default rights of membership by, for example, limiting or restricting the profits interest holder’s voting rights and access to company information and subjecting the profits interest to a drag-along.
- Ownership Limited to Company Insiders. The LLC’s founding members may prohibit the profits interest holder from transferring his interest to a third party. The founding members also may provide the LLC with a redemption right in the event the profits interest holder’s employment is terminated for any reason.
An experienced advisor can counsel founding members on how to fully capitalize on both the favorable tax characteristics and flexibility of the profits interest.