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What is a Profits Interest?August 19, 2014

You have just received an offer from a new employer. In that offer you see that they are offering to give you a “profits interest” in the company. Now, you are asking yourself, “What in the world is a profits interest?”

Very simply, a profits interest is an LLC membership interest (or partnership interest) given to you for services you perform that allows you to share in any future gains and profits of the LLC (or partnership). For example, the company might give you a profits interest that lets you share in 5% of the gains and profits of the company at a time when the company is worth $1 million. So, if the value of the company goes up to $1.5 million, the value of your profits interest will be $25,000 (5% of the $500,000 increase in value). Likewise, if the company becomes worth $2 million, the value of your profits interest will be $50,000 (5% of the $1 million increase in value). But, because the interest only shares in increases in the value of the company, if the company’s value stays the same or falls after you get the profits interest, you generally would not get anything. In this way, it is economically very similar to stock options that companies give employees.

One of the major benefits of a profits interest is that you are not subject to income tax when you receive it. Moreover, if there is a sale of the company and your profits interest is purchased, you can generally qualify for the lower long-term capital gain rate on most of that income if you have held the interest long enough. This is very different from traditional nonqualified stock options granted by employers, which result in ordinary income to the extent you have gain on the exercise or sale of the options in the liquidity event.

On the other hand, though, there are a couple of things to watch out for with profits interests. First, by holding a profits interest, you will typically no longer be an employee for tax purposes. This means that your employer will not withhold any income or payroll taxes from your salary and bonuses and will not issue you an IRS Form W-2 at the end of the year. Instead, you will be required to make quarterly estimated tax payments, you will be subject to self-employment taxes, and your compensation will show up on the Schedule K-1 you receive from the company at the end of the year.

Second, as a holder of a profits interest, you will be a member of the LLC (or partner in the partnership). As a result, you will be allocated your share of the company’s income each year and you will have to pay tax on this income. Your specific share of allocated income will depend on the terms of the LLC (or partnership) agreement. Ordinarily the agreement will provide that you will get “tax distributions” to help you pay those taxes. But, if the agreement does not say that or the company does not have enough cash to make those distributions to you, you will still be required to pay taxes on that income using your other assets. That said, if you later get that income from distributions from the company or on a sale of your interest, you generally will not be taxed again on that same amount.

Despite these drawbacks, the benefits of avoiding tax on the receipt of the interest and potentially qualifying for the lower long-term capital gain rate make profits interests attractive forms of equity compensation.

This is a very superficial discussion of some of the key characteristics of a profits interest. There are a variety of ways of structuring more complex profits interests, and there are a number of other issues and pitfalls associated with profits interests. For a more complete discussion of profits interests, please see my recent report, Practical Considerations for Issuing Profits Interests (143 Tax Notes 1157 (June 9, 2014) & 143 Tax Notes 1277 (June 16, 2014)).