What are Profits Interests?
Profits interests are a form of equity compensation available to entities treated as partnerships by the IRS (including LLCs). Profits interests give the recipient a share of an entity’s future profits and appreciation in value, but none of the partnership’s existing value, and are easily the most common device used by partnerships/LLCs for incentivizing service providers. Similar to other equity compensation, profits interest are often structured with vesting.
If issued correctly, profits interests have the added benefit of yielding no tax liability for the recipient at the time of grant and/or vesting. This arises if the recipient is providing services in exchange for profits interests that aren’t tied to a substantially certain stream of income, the partnership is not publicly traded, and the recipient doesn’t dispose of the profits interest for at least two years.
Still, profits interests touch the notoriously troublesome partnership tax regime and require careful consideration in how their structured to avoid tax liability.
For one, it is potentially perilous for an employee of the partnership to receive a profits interest because per IRS guidance an employee of a partnership cannot also be an owner of the partnership. This means that any employee who receives profits interest is now considered an owner/partner who is now subject to the self-employment tax regime, as well as subject to the liabilities of owners (e.g. in a general partnership, the employee is now considered a general partner and is liable for actions of the other partners). In response, many partnerships will set up a tiered structure to delineate between ownership interests and operating interests, but this require careful consideration and legal advice.
Second, profits interests could subject the recipient to phantom income, which arises when the partnership experiences a profit though does not distribute adequate cash to cover a person’s tax liability for such profit. If the profits interests are illiquid, then the recipient will need to still cover its share of partnership taxes. This is also addressable via provisions in an operating agreement providing that the partnership will distribute enough cash to cover the partner’s tax liabilities in a given year.
