Profits Interests Explained
What is a Profits Interest?
Profits interests are the most well-known and commonly used form of equity compensation used by partnerships and limited liability companies that are taxed as partnerships to incentivize key service providers to remain invested in the success of the company. Profits interests are granted to service providers or key employees in exchange for their contribution of services to the partnership (as opposed to cash or other property).
They are similar to stock options in a corporation context, although profits interests are not ‘options’. For purposes of this article, we will refer to “partnership” as an entity, including LLCs, that are taxed as partnerships for federal income tax purposes.
A profits interest is an equity interest in a partnership that gives the holder the right to a share of future profits and appreciation of the partnership, but the holder is not entitled to participate in the capital and accumulated profits or value of the partnership as of the day of the grant of the profits interest. While a profits interest legally constitutes a form of equity (i.e. the holder is deemed an owner of the partnership and receives annual K-1s), it is not a “capital interest”.
For example, if a partnership was valued at $1mm on the day of grant of a 5% profits interest to a grantee and later sold for $10mm, the grantee would receive 5% of $9mm ($10mm sale price minus $1mm value on grant date, multiplied by 5% (i.e., $450,000). In other words, unlike a capital interest (based on actual cash or other tangible value contributed to the partnership), a profits interest has only the right to “post-grant” partnership income and gain.
Key Considerations in Granting Profits Interests
Following are a few key issues that typically need to be addressed in structuring profits interests:
Determination of Profits Interest Distribution Threshold
In order to satisfy federal tax law requirements, the value of the capital interests in the partnership should be determined as of the date the profits interest is granted, and this valuation should be included in the profits interest recipient’s grant agreement.
This amount, sometimes referred to as the “hurdle”, must be paid to the capital interest holders upon a complete liquidation of the partnership’s assets before any proceeds of such liquidation are paid to profits interest holders. This ensures that the value of the profits interest is $0.00 as of the date of grant.
Another way of stating this is a fair market value determination of the partnership must be established at the time of each grant of a profits interest (to do otherwise would mean the partnership could not ensure that the value of a profits interest at the time of its grant is actually $0.00).
Profits interests can be fully vested upon grant or can vest over time. Whether or not to require vesting differs for each partnership and transaction. Profits interests that vest over time are used in order to incentivize the key employee or service provider to remain aligned with the partnership over a longer timeframe. A couple of key differences between the treatment of vested and unvested interests are laid out below:
- Distributions. Vested profits interests receive distributions as other owners of the partnership receive distributions, subject to the distribution threshold discussed above. With unvested profits interests, a partnership could choose for distributions to be distributed to the other owners such that the holder would not receive any distributions with respect to their unvested profits interests, or for distributions to instead be held in a separate account to be distributed to the profits interest holders once the profits interests vest.
- Forfeiture and Repurchase. Unvested profits interests are typically forfeited by the holder upon certain events, such as separation of service, whereas vested profit interests would typically be subject to repurchase by the partnership under those same scenarios.
- Allocations. If a partnership contemplates profits interests that vest over time, the partnership or operating agreement will often include a provision that allocations from prior years (when the profits interest percentage was lower) will be re-allocated to the holder of the interest upon full vesting.
Company Repurchase Rights
Profits interests are generally subject to repurchase by the partnership on certain events, most typically on discontinuation of providing employment or services to the partnership by the profits interest holder. A “put” right of the profits interest holder, which is the right to force the partnership to buy the holder’s profits interest on certain events, is rare and would only be included in an individual grant agreement negotiated specifically by the partnership and the applicable recipient.
Other Rights of the Profits Interest Holder
Often, profits interests are designated as a separate class of interests under a partnership or operating agreement. By structuring the profits interests in this manner, different rights can be set with respect to those interests, and it is almost universal that the rights attributable to profits interests are much more limited than the rights attributable to capital interests.
Among other things, profits interests are rarely entitled to vote, to be involved in management, or to have preemptive rights or rights of first refusal, etc. (which rights are typical for capital interests or interests held by founders).
Depending on the circumstances, it may be advisable for the profits interest recipient to make what is known in the startup world as an “83(b) election”. Under Section 83(b) of the IRS Code, a taxpayer that receives property subject to vesting as compensation for services (like a profits interest) may elect to include in gross income the fair market value of the property at the time of the grant, rather than in a later year when the property becomes vested.
An 83(b) election also allows the recipient to be taxed at a capital gains rate and not an ordinary income rate down the line (if more than one year from the grant) when and if the profits interest becomes valuable. To be valid, an 83(b) election must be filed with the IRS within 30 days of the profits interest grant date.
Example: You are granted 100 profits interest units in a startup (based on a deemed valuation of $0.00 per unit on the grant date). There is a three-year vesting period. The units are worth $500.00 per unit after 3 years and become vested. You didn’t file an 83(b) election. At the time of vesting, you will be deemed to have income of $50,000 (whether or not you have been able to actually monetize the units) and you will be required to pay ordinary income tax on that amount.
Applying a 39.6% ordinary income tax means writing a check to Uncle Sam for $19,800. Had an 83(b) election been made, no tax would be payable at the time of vesting and tax would only be payable at the time you actually monetize the units – such as on a sale of the business and then the tax is at the capital gains rate (say a cap gains rate of 20% x $50,000 = $10,000, or savings of $9,800 for this example).
The filing or non-filing of an 83(b) election is highly important with tax consequences and is a decision that recipients should determine only after consulting with a qualified attorney or certified public accountant.
Profits interests can be an effective way for partnerships to align the economic interests of key employees and service providers with those of the partnership. However, the legal considerations associated with profits interests can be complex and need to be thought through carefully by both the issuing partnerships and recipients alike.
At Linden Law Partners, we have represented hundreds of partnerships with formation, capitalization and partnership agreement considerations, including the structuring and implementation of profits interest plans and all their associated agreements. Contact us here today to let us know how we can help you.