Looking to incentivize a key employee who lacks cash for a buy-in? Consider a “profits interest.”
By : Charlie Wittmack
If you own a partnership (or an LLC that is taxed as a partnership), you may divide your partnership interest (or membership interest in the case of an LLC) into a capital interest and a profits interest. Every business owner understands the value of their “capital interest,” which represents their ownership in the partnership in a similar manner to stock in a publicly traded company. The capital interest gives the holder a share of proceeds if the partnership’s assets were sold at their fair market value and the proceeds distributed in a complete liquidation of the company. A capital interest is typically granted to a partner in exchange for a contribution of cash or other property.
The “profits interest” works a little differently. A profits interest is a right to receive a percentage of future profits from the company (but not existing capital or accumulated profits). Most commonly, a profits interest is granted to a key employee in exchange for a contribution of services. In many cases, the service partner is an executive or senior manager in the partnership.
Unlike the owner of a capital interest, the owner of a profits interest has no current capital at risk in the venture and usually, has no obligation to contribute funds in the future. Therefore, all that can be lost by the owner of a profits interest are profits earned after the grant date of the profits interest (with some exceptions).
There are many tax benefits to granting a key employee a profits interest, including:
- It allows the key employee to defer income until a gain is realized by the company; and,
- It allows the key employee to pay taxes on the income as a long-term capital gain, rather than ordinary income.
Profits interests can be structured in a variety of ways and are commonly granted with a vesting schedule that allows the interest to increase over time, either with the passage of time, or as the service partner reaches certain performance levels. This type of profits interest structure tends to better align the service partner’s economic interest with the long-term interests of the partnership.
ABOUT CHARLIE WITTMACK
Charlie Wittmack represents high-growth companies ranging in size from small start-ups to large multinational companies. His practice is focused primarily on helping companies pursue strategies that increase total revenue, increase net profit, and increase scalability. You can read more about him here.
