Many entrepreneurs opt to structure their startups as limited liability company (LLCs) for several reasons. Some of these reasons are the relative ease of registering the company, pass-through taxation (which eliminates the double taxation presented by C corporations), and management flexibility. But, similarly to entrepreneurs operating in other entity structures (i.e., corporations) they often need to find a way to provide equity or equity-like incentives to their key employees. However, one of the most commonly used tools to provide equity incentives to key employees (i.e., incentive stock options) is not available to LLCs. Thus, entrepreneurs operating through LLCs often seek other alternatives for incentives.
One of the requirements that entrepreneurs require in connection with the issuance of such interests is that the issuance be made in a “tax-free” manner (and that the key employee not be required to “come out of pocket” and pay for the interest). In such a case, a “profits interests” or a profit interest plan can be a good solution to consider. In this article, we’ll explain how profits interest work and some of the pros and cons associated with them.
Profits Interests, Generally.
A profits interest can be issued to employees of (or other service providers to) an LLC for no additional consideration and in a tax-free manner (i.e., the recipient doesn’t have to pay anything for the interest and doesn’t recognize income as a result of receiving the interest). The profits interests must be structured such that the recipient will participate in the future growth of the company.
In order for the issuance of the profits interest to qualify as a tax-free transaction, it must meet certain criteria, including (but not limited to):
The interest is being granted in connection with the recipient’s services to the LLC; and
The recipient will have an initial capital account balance of $0 and, if the company were immediately liquidated at its fair market value, the recipient of the profits interest would not receive any consideration from the liquidation.
Benefits of Profits Interests Plans to Holders
The benefits of issuing profits interests to a key service provider include the following:
The service partner can receive the interest in a tax-free manner. In the context of a corporation, issuing a key service provider stock (without payment from the recipient of the fair market value) would yield an income tax to the service provider. In the LLC, we are able to issue the interest without the service provider having to recognize income for receiving it.
The service provider is aligned with the other owners of the company. They will be focused on driving profit and growing enterprise value (as those will drive the value of his or her profits interest). The service provider would (likely) receive allocations of profit from that point forward and would participate in the future enterprise value growth of the company.
Disadvantages of Profits Interests Plans to LLC Members
The biggest disadvantage to issuing profits interests to service providers is that it can substantially change the way in which the recipient is taxed. Once the service provider receives the profits interest he or she becomes a “partner” in the LLC and is treated as such for tax purposes. Partners in an LLC can’t be paid using traditional W-2 compensation. Instead, they often receive “guaranteed payments”. The payments made to the partner are made without tax withholdings.
Thus, the recipient of the profits interest (who may be most comfortable receiving a paycheck where taxes have been withheld) must now make quarterly state and federal tax payments (and, more importantly, need to plan and budget to make such payments). Thus, it can add a lot of complexity to someone’s tax life if they aren’t prepared for it. In addition, the recipient will also be receiving allocations of profits and losses (through K-1s) and have to pay taxes based on those allocations as well.
Some clients have steered clear of profits interest plans simply because of this compensation complexity. Instead, they may choose a Phantom Equity Plan. Read more about that here.
The next disadvantage is that, depending on how the profits interest plan is structured, it may require the company to conduct periodic third-party valuations prior to issuances of profits interest. This can be a significant expense. The reason for this is that, because the profits interest holder can only participate in future growth of the company, a “baseline” value of the company may need to be established from which to measure the increase in value. However, as you may note, I have indicated that this may be needed. Whether or not it is needed is largely a function of the capital structure of the company (e.g., whether there are multiple classes of units/membership interests, liquidation preferences, waterfalls, or other economic terms to consider).
Example of Profits Interests Plan
Let’s say an LLC has a current valuation of $750,000. The members want to keep a certain key employee they hired, who has worked tirelessly day and night to keep the company afloat in its delicate first few months. So, they offer her a 5% profits interests stake. She accepts. In a simple plan, from that point on, she would receive an allocation of 5% of the company’s profits (and pay tax on that allocation if there are profits reported). Let’s further assume that after five years that the members decide to sell the company for $5 million. In that case, she will receive 5% of $4,250,000 (i.e., $5,000,000 – the initial value of $750,000) or $212,500.
If you have just started a limited liability company, your hands are not completely tied when it comes to offering equity to your important team members. Profits interests plans can be a tax-efficient way to retain key talent and incentivize future growth and profitability. But, as discussed, there are unique tax and legal considerations to these plans.
Contact Doida Law Group
We can help you with these situations for your business; our unique fixed-fees approach to your relationship with our legal team allows us to fully concentrate on your case while giving your certainty on cost. Please reach out to our firm soon so we can get started on a consultation and see how we can add value to your startup or small business – in the immediate and long-term future.