Startup Tips: Issuing Profits Interests
Updated: Feb 24
You just invested money to start an LLC. Now you want to bring in partners to manage the company or help with the work and offer them some form of equity compensation. How do you go about doing that?
Unlike corporations, LLCs cannot issue restricted stock, stock options, or the like. But LLCs have an easy and tax efficient alternative called a “profits interest.” Profits interests can provide many benefits for their holders. The holder of a profits interest is a member of the company and may fully participate in the LLC (unless something lessor is agreed upon). The grant of a profits interest should not result in any taxable income (if done properly). The recipient may obtain capital gains treatment, which is may not be available with stock options. And, unlike stock options, the recipient does not have to pay an exercise price to obtain the equity interest.
This sounds great, but what is a profits interest? The IRS defines “profits interests” as an “interest other than a capital interest,” and defines “capital interest” as “an interest that would give the holder a share of the proceeds if the [company’s] assets were sold at fair market value and then the proceeds were distributed in a complete liquidation.” In other words, this means that a profits interest permits a holder to share in the future growth of the company, while the original members retain the full value of the LLC prior to the issuance of the profits interest.
The important implication of this definition is that the initial value of the profits interest must be zero dollars (hence, why there is generally no income tax associated with the grant of a profits interest). The value will appreciate as the company grows (i.e., future growth), but if there is any value associated with it upon issuance, then it is also a share of the past growth of the company, removing it from the IRS safe harbors.
For example, let’s say your capital contribution in a new LLC is $100. You immediately bring in a partner to manage the company, granting him a 50% share of the company in the form of a profits interest. If the company were to dissolve at that point, then you would take $100 and your partner would take $0 from the liquidation distributions. Now, let’s say that in the first year, the company made a profit of $50 and then dissolved. At that point, you would take your $100 and the $50 would be split 50/50: you’d take $125 in total and your partner would walk with $25.
The IRS imposes additional requirements for profits interests. For instance, the recipient may not dispose of the profits interest within two years of receipt; the recipient must receive the profits interest in his/her capacity as a member in exchange for his/her services or for the benefit of the LLC, the interest must not be tied to a substantially certain and predictable stream of income from LLC assets; and the profits interest must not be a limited partnership interest in a publicly traded partnership.
Further, profits interests can be structured in a variety of different ways to meet your specific needs, wants, and desires. They can be fully vested when granted, or they can be subject to vesting. And vesting schedules can be based on time or on performance. Profits interest can have a “catch-up” provision, so that, eventually, liquidation would approximate a 50/50 split of all assets. Or, you can “cap” profits interests, if you want to share some growth of the company, but not all of it. The list goes on.
Due to the varied structures and the multitude of IRS regulations pertaining to profits interests, it’s best to consult your attorney before issuing them. Likely, you will need to amend your operating agreement to provide for profits interests anyway.
Do you have questions about profits interests or issuing equity incentives? Don't hesitate give us a call or reach out to firstname.lastname@example.org.
This article is for general information only. The information presented should not be construed to be formal legal advice nor the formation of a lawyer/client relationship.