You’ve probably heard of “stock options” that enable an individual to buy into a company at a future time. However, if you work for a limited liability company (LLC), you also have the option of utilizing a unique form of equity compensation known as “profits interest” which represents an actual current ownership interest in the LLC.
Tax Free Equity Compensation
A profits interest, when structured to be in compliance with relevant IRS “safe harbors,” is effectively tax free for the recipient, according to a great article published by Hutchison PLLC. This is because a profits interest basically represents an ownership interest in the future growth of the company but not an interest in the current value of the company.
Example of How a Profits Interest Works
Let’s say an LLC has three owners. Each owns one third of the company. Then, the company grants a 10 percent profits interest to an employee at a time when the company was worth $2 million. Five years later, the company sells for $5 million. Of the $5 million, the first $2 million is divided equally among the three original owners. Nothing from that $2 million goes to the holder of the profits interest because that money represents the value of the company when the profits interest was granted. However, the remaining $3 million is distributed 30 percent to each of the original members and 10 percent to the profits interest holder, who would receive $300,000 of the proceeds from the sale.
Profits Interest and Vesting
Profits interests can be subject to vesting in the same way as a stock option. Vesting can be time-based, so that the equity is earned as the employee continues to provide services over a period of years. Another option is to make vesting performance-based so the employee vests in the equity when they attain predetermined performance goals.
Who Is Eligible for a Profits Interest?
Profits interests can also be granted to non-employee service providers, such as managers, consultants, scientific advisors and the like. As with profits interests granted to employees, the holder of the profits interest becomes a member of the LLC for tax purposes.
Should You Consider Offering a Profits Interest to Your Employees?
Profits interests, especially those that are formulated to be in compliance with IRS safe harbor provisions, can be a very important compensation tool for LLCs. They do have complications, so it is important to consult with an experienced and professional business advisor before embarking on a profits interest grant program for your LLC. Contact InSight Law today to learn more.