How profits interest equity grants work

Founders and early-stage business owners usually understand the value of attracting and retaining top talent. One increasingly popular strategy for achieving this, particularly within limited liability companies (LLCs), is the issuance of profits interests. This method not only incentivizes key employees but also aligns their goals with the long-term success of the company.

Let's dive into what profits interests are, how they work, the tax elements, and the benefits they offer.

What are profits interests?

Profits interests are a form of equity compensation specific to LLCs. These are not available in corporations.

Unlike traditional stock options in a corporation, profits interests give an employee a share in the future profits and appreciation of the company without conveying ownership of the company's current value. Recipients of profits interests can potentially receive a share of the profits generated by the company from the date of the grant moving forward, without having an initial capital interest or having to make a capital contribution (cash or otherwise).

How do profits interests work?

Issuing profits involves granting an employee a percentage share of the future increase in the company's value, rather than direct equity in the underlying value today. This is particularly advantageous for startups and growing companies that may not have significant current value or even companies with significant value where they do not want to give away a percentage of what they built.

As an example, if a profits interest were issued to an early employee in a LLC for 10% while the company was valued at $1M, they would only share on the appreciation above that $1M “hurdle”. This method will completely eliminate taxes at the grant for the recipient but they must be aware of the future tax treatment and ongoing taxability of their share of profits.

To implement this, an LLC must have a profits interest plan in place, which outlines the terms and conditions under which the interests are granted, vested, and eventually, possibly, redeemed.

Mechanics of issuing profits interests:

1. Establishing the plan to issue the interests: The first step in issuing profits interests is to establish a comprehensive profits interest plan. This plan should outline the eligibility criteria (such as employees or contractors being eligible), vesting conditions, valuation methodology, and the process for granting and exercising the interests. It's also important to define the rights of the profits interest holders, including their share in distributions and the treatment of their interests upon various exit scenarios, including partial changes in control.
   It is important to note in the plan if the recipient disposes of the grant within 2 years, the IRS may reclassify this as a capital interest, creating a tax liability. ‍
2. Determining your company's fair market value: Determining the current value of an LLC is crucial when issuing profits interests, as this value sets the baseline above which future profits will be shared. For startups and growth-stage companies, valuation can be challenging and sometimes expensive. However, valuations may rely on future cash flow projections, industry comparables, or previous investment rounds to get all parties comfortable with the value. Regular valuation updates may also be necessary to adjust the baseline as the company grows and issues interests to other employees.‍
3. Vesting schedules: Profits interests typically come with vesting schedules but they are not required. The usual approach we see is a four-year vesting schedule, with a one-year cliff and monthly vesting thereafter. If an employee leaves within the first year, they forfeit their profits interests; after the first year, the interests vest gradually each month.‍
4. Tax treatment: This is where it gets interesting. One of the most appealing aspects of profits interests is their favorable tax treatment for both the company and the grantee.
5. If structured correctly, the grant of profits interests is not taxable to the recipient under IRS guidelines, as there is no immediate transfer of value.
6. Instead, taxation occurs as and when the interests vest and distributions are made. A profit interest partner becomes a “K1” partner and will be taxed on their allocable share of profits. Holders should be aware of phantom income and ensure they are entitled to receive distributions to cover any tax liabilities.
7. Lastly, compliance with IRS rules is essential to ensure this treatment, particularly the requirement that profits interests have a hurdle sent to ensure there is a “floor” from which the holder is appreciating their interest from.

Legal items to consider

Before going down the profits interest path, be sure to check with legal counsel on the following items:

• Coordination with the operating agreement: The LLC's operating agreement must expressly allow for the issuance of profits interests and detail the mechanism for doing so. Amendments to the operating agreement may be required to introduce a profits interest plan.
• Securities law considerations: While profits interests are not traditional securities, they may be considered securities under certain state and federal laws, which may necessitate some additional legal compliance for the company and employee.

Strategic considerations

Issuing profits interests to early-stage employees can create a win-win incentive for early employees to help grow your company.

• Recruitment and retention: In competitive talent markets, profits interests can differentiate an LLC from other employers who may not have any equity offers.
• Financial planning: While profits interests offer tax advantages and do not require upfront cash outlays, companies must plan for the financial impact of eventual distributions at a change in control or a sale of the company. The company also needs a plan for managing future tax distributions to grantees and ensuring the grantees understand how this affects their personal financial situation.

Putting it all together

Profits interests represent a sophisticated equity compensation tool that, when used effectively, can align employee incentives with company growth, attract and retain talent, and optimize tax outcomes. Oftentimes founders are unaware this tool exists and they grant employees taxable equity. That often surprises advisors or key employees as it creates “phantom income”.

Crafting a profits interest plan in your early stages can create a long-term win if you maintain the LLC structure. The implementation requires careful planning, legal + tax compliance, and ongoing management (such as understanding your valuation at various points). Consider this tool as an alternative to standard equity grants or other phantom equity plans when you are looking to create an attractive employee benefit.

The information provided in this article does not constitute accounting, legal or financial advice and is for general informational purposes only. Please contact an accountant, attorney, or financial advisor to obtain advice with respect to your business.