Coined by a Texas A&M University Professor, Anthony Klotz, “The Great Resignation” refers to the mass numbers of employees who have voluntarily resigned from their jobs since the beginning of 2021. As companies recover from the pandemic and layoffs, they’re hiring like crazy, and workers have their pick of opportunities. For reference, in July 2021, there were 10.9 million jobs open, and in the same month, over 4 million Americans quit their existing job. If your company wasn’t focused on retention before, you better be now. In our experience working with companies of all sizes across industries, we’ve helped build compensation packages that keep employees engaged now and in the future. One mechanism that LLCs taxed as partnerships should consider for employee compensation is profits interests. Profits interest can also work for one shareholder S-Corporations if they complete a drop down LLC reshuffle. Remember that partnership interests can be held by S-Corporations. This allows the flexibility of a partnership with the tax benefits of an S-Corp.
WHAT IS A PROFITS INTEREST AND HOW DOES IT WORK?
Just as many corporations offer stock grants as part of an employee incentive package to stand out from other prospective employers, partnerships and LLCs have a similar equity compensation tool available – granting a profits interest. Put simply, granting a profits interest allows the recipient to directly benefit from the future profits of the partnership or LLC, ideally resulting in a team member who is vested in the overall performance of the company. Providing the framework for an individual to be rewarded by the company’s success and truly be called a partner instead of an employee can be an enticing draw in today’s labor market.
An LLC profits interest differs from a capital interest in that it applies strictly to future growth. For example, a newly-hired individual who is granted a (vested) profits interest one year after the launch of a startup is eligible for distributions on the increase in value since the time of the grant, not the overall increase in value of the company. The profits interest agreement details the established value at the time of grant, which can be thought of as the “fair market value” of the interest at the time of issuance. Vesting schedules based on either time or performance are also often incorporated in the profit interests agreement to further incentivize longevity.
Depending on a variety of factors such as cash flow, company size, and overall strategic goals, LLCs can choose to structure their profits interests to pay out current distributions, liquidating distributions, or a combination of both. While current distributions (ongoing payouts from net income that follow the partner distribution schedule) are generally more appealing to prospects, LLCs that are not high-cash-flow businesses but have a strong exit strategy may find liquidating distributions (payouts from the sale of the company that subsequently terminate the interest) more suitable for their particular situation.
Profits interest example with multiple distribution structures:We recently worked with a company whose profits interest agreement was structured so that recipients received current distributions from the company’s net income over the course of 5 years; then, when the company was sold, they also received proceeds from the exit for the difference between the sale price and the distribution threshold. Highly beneficial structure for those who committed to the company and stayed through the sale! |
CONGRATULATIONS, YOU’RE A PARTNER!
For those considering an opportunity that comes with a profits interest as part of the compensation package, it’s important to note that upon receipt of a profits interest, an individual is then considered to be a partner, not an employee. Aside from the tax treatment of income related to the profits interest itself, there are additional tax-related implications to be aware of, such as the items noted below. If you are coming from a traditional employer/employee relationship, it is a good idea to speak with your accountant and be prepared for how your filing needs will differ.
- You will receive a K-1 instead of a W-2
- You will need to pay self-employment taxes (as employment taxes will no longer be withheld)
- You will need to pay estimated income taxes (as income taxes will no longer be withheld)
- Health insurance and retirement benefit contributions may need to follow a different process
There are also considerations on the part of the issuing entity such as legal costs related to updating the LLC operating agreement, additional accounting fees to track the profits interest vs. capital interests, bookkeeping changes for the treatment of the grantee as a partner versus an employee, etc. While these may seem inconvenient, we’ve recently seen clients find they need to stop accepting new business, look at short-term fixes, and give big raises to combat the effects of The Great Resignation. Creative solutions like profits interests are becoming more appealing to organizations looking to stop the bleeding.
PROFITS INTEREST TAXATION
When it comes to the tax treatment of profits interests vs. capital interests, there are notable differences. Capital interests in partnerships/LLCs generally follow a similar treatment to stock grants in corporations and are taxed as ordinary income, while profits interests are not taxable when received.
| PROFITS INTEREST | CAPITAL INTEREST | |||
|---|---|---|---|---|
| Grantor | Recipient | Grantor | Recipient | |
| Issuance (Vested / Unrestricted*) | Not a taxable event(No compensation deduction allowed) | Not a taxable event | Can take a compensation deduction (if the payment of the grantee’s services is a deductible expenditure) | Difference between FMV and amount paid is taxed as ordinary income |
| Distributions | No effect | Taxed as Schedule K-1 income
(May qualify for Qualified Business Income deduction) |
No effect | Taxed as Schedule K-1 income
(May qualify for Qualified Business Income deduction) |
*For purposes of this chart, profits interests and capital interests are assumed to be fully vested / not restricted. Capital interests granted as restricted may necessitate making an IRC § 83(b) election to permit the recipient to be taxed at the time of grant as if the interest was fully vested. Talk to your tax professional.
In order for the granting or vesting of a profits interest to be considered a non-taxable event by the IRS for both the issuer and recipient, the following conditions must be met: [1]
- Recipient must receive the profits interest in their capacity as a partner or in anticipation of becoming a partner, in exchange for the provision of services to or for the benefit of the partnership granting the interest
- The interest must not be a substantially certain and predictable stream of income from partnership assets such as income from high-quality debt securities or a high-quality net lease
- Recipient must not dispose of the profits interest within two years of receipt
- The profits interest must not be in a publicly traded partnership
- The granting entity and the recipient must treat the recipient as a “real” partner for tax purposes (i.e., Schedule K-1 income)
- Neither the recipient nor the entity granting the profits interest may take any compensation deduction in connection with the profits interest.
If you are currently looking for creative, alternative solutions for employee retention and want to understand the resulting tax implications, we’d love to help. Contact us today!
