A growing number of limited liability companies (LLCs) are now offering employees profits interest plans: executive incentive compensation plans that offer design flexibility and potential income tax savings for U.S. participants. They have become more attractive primarily because:
- The growth in the number and value of private equity portfolio companies, often formed as partnerships, has led to increased competition for executive talent and creativity in aligning compensation with investors’ interests.
- Changes by the Tax Cuts and Jobs Act of 2017 to capital gains and income tax brackets and rates made profits interest plans even more favorable than they were before the passage of this law.
When structured carefully, profits interests combine the leveraged growth opportunity of corporate stock options, the design flexibility of a performance-based stock plan and the long-term capital gains tax treatment of outright equity ownership.
What are profits interests?
A profits interest agreement provides the recipient the right to receive a share of the LLC’s future profits or equity value gain. Like traditional stock options, profits interest units have no taxable value when they are granted and only gain value based on future profits and appreciation in partnership value. Unlike traditional stock options that specify vesting dates and exercise schedules, profits interests can be far more flexible; earning potential, vesting provisions and payment schedules can all be set by the company in a way that meets its strategic needs.
For example, a profits interest agreement can distribute a fixed percentage of the company’s profits or value gain — but only once the general or limited partners achieve their internal rate of return goals. In contrast, a stock option’s value would only be based on increases in value of company stock.
Can my company grant profits interests?
To grant profits interests, the company must be a partnership or an LLC that is taxed as a partnership. Publicly traded companies, private C corporations and LLCs that are taxed as corporations cannot grant profits interests. Profits interest plans are most popular among profitable private equity-owned portfolio companies, but other partnerships could potentially adopt a profits interest plan. Subsidiaries of a larger company and joint ventures can also use this structure, if the profits interest units themselves are established for an entity that is taxed as a partnership.
What are the potential tax savings for granting profits interests versus other compensation?
Compensation earned via profits interests can be subject to long-term capital gains rates, currently up to 20% at the U.S. federal level (2023). This is a potentially significant tax savings compared with compensation from more common forms of private company long-term incentives (e.g., phantom shares, phantom appreciation rights or performance cash plans), which are considered ordinary income and subject to a marginal federal income tax rate of up to 37% for the highest individual earners under U.S. federal tax law. State taxes may also be lower for gains on profits interests versus regular compensation.
However, profits interest payments are not tax-deductible for the company, because earnings from the profits interests are partner income and not considered employee compensation under the tax code. In contrast, a stock option exercise or restricted share vesting would be deductible to the company at the same rate taxed to the individual.
What is the typical setup for profits interests?
Profits interest arrangements tend to share several key features:
- Limited participation. Typically, awards under these plans can be granted only to “real” company partners; private companies tend to limit the number of partners. Also, the potential income tax advantages are greatest for those with the highest earnings with the highest individual tax rates.
- Participants become partners of the firm but work for a wholly owned subsidiary. While the tax benefits of a profits interest plan are profound, recipients are not employees and would not otherwise receive company-provided benefits. To avoid this result, most companies create a C corporation as a wholly owned subsidiary of the partnership/LLC so that company employees and participants in the profits interest plan can receive benefits from the C corporation.
- Participants file an 83(b) election with the IRS at the grant of their profits interests. To fully ensure capital gains taxation, participants typically file an 83(b) election with the IRS when granted, meaning that the grant date value is taxed as ordinary income. As noted earlier, because the profits interest typically has zero value based on tax code valuation principles, most often no taxes are payable. Once a tax basis of the profits interest is established at grant, any payments resulting from future appreciation in value are taxed as capital gains.
- Timing and determination of payments. While companies could elect to distribute profits to partners at any time, a profits interest plan is typically designed to compensate for increases in the company’s equity value upon the occurrence of future events. Typically, the gain in equity value is determined only when the partnership dissolves (e.g., through a sale of the company or a conversion to a C corporation in conjunction with an initial public offering [IPO]) or has a recapitalization or other permissible liquidity event. For participants who terminate employment before the conclusion of the plan, the plan’s terms typically give the board flexibility to decide whether to allow those employees to retain their vested units to the plan’s conclusion. The board can either cancel those units and pay the terminated participants their current value, cutting off the ability to earn more from future growth in the business, or take no action so the vested units can continue to grow in value until all plan participants receive their payments.
What other design features could be included with profits interests?
The number and scale of unique structures that can be included in profits interest plans are endless. Here are some examples of features that we have seen in practice:
- Different classes of profits interest units. Suppose an employee joins the firm after the initial profits interest grant, and the company does not want the new hire to receive the same full value of the interest when settled in the future as the employees with longer tenure. The company can create different classes of partnership units to distribute to different groups of employees who have different earning potential. For example, original employees have B-1 Units worth 5% of the company’s value gain, and new employees get B-2 Units worth 3% of the value gain.
- Different vesting provisions. Like stock options or restricted stock units at public companies, profits interests can also include different vesting dates for different executives. Profits interests also can vary in the performance vesting terms; for example, a CEO only begins to earn value on his or her profits interests once the value of the company triples, while other executive officers begin to accumulate value on their interests when the value of the company doubles.
- Different cash-out options. While it’s most common for profits interests to be valued and paid out in cash upon a company sale or IPO, the plan terms can require that in the case of an IPO, those units convert to shares in the new company. Alternatively, a portion of the proceeds payable must be deferred in the case of a corporate takeover. Some plans may also allow for partial payments before the company is sold or conducts an IPO. Regardless of the transaction, conversion of the profits interest into a new interest should maintain its capital gains tax treatment when settled at a future date.
- Different voting rights. While typically partners have the right to vote their shares, profits interest units can come with or without voting rights.
- Different participants. “Non-employees,” such as directors, consultants or advisors, can also be granted profits interests and are sometimes provided profits interests in lieu of other compensation.
So, should we offer profits interests?
You can consider four questions when determining if these plans are right for your firm. If you answer “yes” to each of these, profits interests may be an important vehicle to add to your executive rewards structure.
- Is your company a profitable partnership, or an LLC taxed as a partnership, that plans to sell or convert the company to a different corporate structure in the future? (Note that the company needs to sell or convert for the plan to fully pay out.)
- Do you compete for executive talent with publicly traded companies that can offer equity incentives, such as stock options or restricted stock units?
- Would your executives elect to defer short-term income in exchange for long-term opportunity that can be taxable at a long-term capital gains rate?
- Is your executive team comfortable with a significant portion of their potential earnings being delivered in a vehicle whose value is not immediately measurable or understandable?
Overall, we find that companies that adopt profits interest plans have a high tolerance for navigating the legal nature of these agreements, recognizing that eligible executives are true, valued partners in the future success of the business. Once a company decides to go this route, it embraces seeking a solution customized to the circumstances of its executive talent and strategic business objectives.