A profits interest grant gives partnerships and LLCs that are taxed as partnerships a flexible way of providing incentive-based compensation to their workers. Profits interest grants are a type of equity compensation but differ from traditional equity compensation in both what the worker receives rights to and in tax treatment.
What is a profits interest grant?
A profits interest grant is an interest in future profits. This includes both income statement profits and increases in the company’s market value. Note that an interest in income statement profits does not necessarily mean an entitlement to cash distributions of those profits. This is determined by the grant conditions or the partnership agreement.
Example: A company is worth $1,000,000 and has $100,000 in annual profits. A worker receives a 10% profits interest grant. The worker has no interest in the current value of the company but does have an interest in $10,000 of the annual profits. If annual profits increase to $200,000, the worker’s interest in the annual profits increases to $20,000.
How is this different than stock options?
There are two key differences from stock options. First, a profits interest grant doesn’t require the holder to exercise an option.
Second, unlike shares of stock, there is no immediate right to a share of the existing capital of the company. This means that if the company goes out of business or is sold immediately after the grant is issued, the future profits interest-holder has no right to receive any share of the company’s assets.
Example: A company is worth $1,000,000 and is later sold for $2,000,000. A worker who receives 10% in stock immediately owns $100,000 of the company’s value and receives $200,000 when the company is sold. A worker who receives a 10% profits interest grant owns $0 of the company’s value upon receiving the interest. When the company is later sold, the worker would receive 10% of the $1,000,000 increase in value ($2,000,000 – $1,000,000) or $100,000.
What’s the difference between vested and unvested interests?
A profits interest grant can be either vested or unvested. Vested means that the worker immediately receives all rights provided by the grant. Unvested means that the worker must meet certain conditions before receiving full rights. An example of an unvested interest is a grant subject to remaining with the company for a certain period of time and/or meeting certain performance benchmarks.
Are profits interest grants taxable?
- The recipient is a partner or becomes a partner upon receiving the grant;
- The interest is not tied to a substantially certain and predictable stream of revenue such as high-quality debt securities or a net lease;
- The recipient may not sell or dispose of the interest within two years; and
- The interest is not a limited partnership in a publicly traded partnership.
Unvested partnerships must meet two additional conditions:
- The interest recipient is treated as a real partner for tax purposes; and
- No compensation deduction is taken for the profits interest.
Does a profits interest grant recipient have to be a partner?
A Profits Interest Grant recipient must be a Partner or become a partner. A profits interest recipient must be treated as a partner and cannot be treated as an employee. This means that the recipient cannot receive W-2 wages or participate in employee benefits programs not available to partners. If the recipient receives payments for services, the recipient must pay self-employment tax on those payments. In addition, the recipient must report and pay tax on his or her share of partnership profits even when not receiving a cash distribution.
As partners, grant recipients may also be entitled to inspect the company’s books and records and receive full voting rights as a partner. The recipient may also take on personal liability as a general partner if the partnership is not an LLC or other limited-liability entity. The rights and obligations of each partner may be modified by the partnership agreement and/or the terms of any grants, but any such agreements must comply with the IRS regulations outlined above.
Are there other tax consequences?
When a worker ceases to be an employee upon receiving a profits interest grant, the partnership loses the ability to deduct that worker’s wages. This would result in the partnership as a whole having a higher net profit. However, since the profits interest results in dilution of the ownership of the pre-grant partners, the taxable income allocated to the pre-grant partners might be no more than without the grant of the profits interest.
The new partner would face a 7.65% tax increase from having to pay full self-employment taxes instead of only one half of employment taxes. However, the new partner’s allocation of partnership income (other than guaranteed payments) would potentially be eligible for the 20% qualified business income deduction under Section 199A.
Where should I go with other questions about profits interest grants?
There are clear business advantages to offering incentive-based compensation, but you must carefully comply with IRS regulations to avoid unexpected tax consequences. Connect with a Warren Averett advisor for help properly structuring your profits interest grants to comply with the law and to ensure that the after-tax value of the grant is what you expect it to be.