Profits interests are a strategic alterative for providing equity compensation to service providers at startups structured as limited liability companies (LLCs).

Startups typically have limited financial resources, which means they often struggle to compete with established companies in terms of offering high salaries and comprehensive benefit packages. Instead, startups use equity incentives as a strategic tool to attract and retain talent, align interests, and manage cash flow, all of which are critical for their growth and success.

Though startups structured as corporations qualify for certain statutory benefits and equity incentive plans, a business entity treated as a partnership for tax purposes — commonly structured as an LLC — cannot issue incentive stock options.

Regardless of the industry in which you operate, your business can offer employees equity while still taking advantage of all the benefits of an LLC. Incentives used for an LLC taxed as a partnership can include partnership options, forfeitable interests and phantom equity plans, but a profits interest is by far the most common structure.

What is Profits Interest?

Partnership interests in an LLC taxed as a partnership can be divided into capital interests and profits interests.

A capital interest represents a share of the partnership’s capital. It’s created when a member of the LLC contributes capital in exchange for ownership interests. Starting on the day of their contribution, a member with a capital interest has a right to a share of the proceeds if the LLC assets were sold at their fair market value and the proceeds were distributed in a complete liquidation of the LLC.

A profits interest is sometimes called a profits-only interest or mere profits interest. It’s a partnership interest that gives its owner the right to receive a percentage of future profits without a buy-in. Most commonly, a profits interest is granted to a service partner in exchange for their contribution of services. In many cases, recipients are an executive or senior manager at the LLC. Unlike the owner of a capital interest, the owner of a profits interest has no investment at risk in the venture and no obligation to contribute funds in the future. Therefore, the owner of a profits interest can only lose profits earned after the date it was granted.

Profits interests must be granted with a restriction on rights to the then-fair market value of the LLC — generally referred to as the threshold value — to prevent the grant from having a liquidation value upon issuance and creating a taxable event. It also means that if the LLC was liquidated the moment after a profits interest was granted, the profits interest holder would receive no share of the liquidation proceeds.

To give a practical example: Assume a company’s equity value — and therefore liquidation threshold — is $5 million on the date you grant profits interest units to a service provider. If the company sold its assets and liquidated on the grant date, the full $5 million must be distributed to the existing equity holders, with no exit proceeds for the newly granted profit interest units. Now imagine the same company liquidates at a future date when it has a fair market value of $15 million. The first $5 million would go to the existing equity holders. The $10 million increase would be shared among existing equity holders and the holders of the profits interests.

How Are Profits Interests Structured?

Similar to other types of equity compensation grants, an LLC needs to provide a profits interest grant agreement or profits interest unit grant agreement that provides the recipient with the right to receive a share of the LLC’s future profits or equity value gain.

Like traditional stock options, profits interest units (which comply with the $0 liquidation upon grant requirement we have discussed) have no taxable value when they are granted and only accrue value based on future profits and appreciation in the LLC’s value. Also similar to stock options, profits interests are typically subject to vesting schedules or forced repurchase upon the occurrence of certain events, such as termination of the service relationship. The vesting can be time-based, where an individual must provide services for a period of time. Vesting can also be performance-based, where the company or individual must achieve certain performance criteria, such as an earnings before interest, taxes, depreciation and amortization (EBITA) threshold or personal performance goal.

Profits are computed and allocated among the partners annually and proper drafting of a vesting schedule can be complex. Typically, recipients of profits interests will make a Section 83(b) election to treat the interests as fully vested for tax purposes upon grant.

Often, investor partners (generally partners who contribute cash or property) are guaranteed a return of contributed capital plus a fixed rate of return before any allocation of profits to service partners. This is called the hurdle rate. Careful drafting of the LLC’s operating agreement and the profits interest agreement must account for the possibility that the partnership’s profits will exceed the hurdle rate in some years but not in others.

What Are the Rights and Obligations as an Owner of Profits Interest?

It is crucial to understand that a profits interest is a partnership interest in the LLC for tax purposes. The owner of profits interest has all the rights and obligations that flow from having membership interests in the LLC as set forth in the applicable operating agreement. Membership can be structured as voting or nonvoting, depending on how company founders want to share decision-making authority. In addition, the owner of profits interest typically has rights provided by applicable state law to members of an LLC, including in many cases the right to inspect the company’s books and tax returns.

Employee Status With Profits Interest

Under the current IRS guidance, when an LLC employee accepts their equity grant, they take an ownership stake and become a new partner. They cannot simultaneously be treated as an employee. This results in some tax implications both for the business and for the member. 

Members of an LLC taxed as a partnership can no longer be classified as W-2 employees. Instead, they receive “guaranteed payments,” which are generally subject to self-employment tax. If they are paid as an employee, they must report quarterly self-employment income and make estimated tax payments to the IRS. The LLC must so provide K-1 tax forms that provide information on the member’s share of earnings, losses, deductions, and credits for each member at the end of the year. An employee’s right to participate in certain company benefits plans will also be affected by their status as a partner in the LLC.

Profits Interest Tax Treatment

A capital interest received for services may be taxable as compensation upon grant. However, where the company complies with the $0 liquidation requirement discussed above, the IRS provides guidance confirming that the amount of the compensation income in a profits interest is equal to $0 upon grant. Where profits interests are subject to a vesting schedule, the interest may not be required to be taken into income until a future date when the interests are fully vested. However, upon that future date, the value of the profits interests would likely have risen. Accordingly, most profits interest recipients file a timely Section 83(b) election upon grant. This election requires the recipient to take the profits interest into income in the year of grant, regardless of vesting requirements. This is beneficial to the recipient because the IRS agrees that upon grant, the profits interest has a value of $0. A profits interest is also subject to capital gains tax if sold at a later date. Capital gains rates are more favorable than ordinary income rates where the owner has held the capital asset for greater than one year prior to sale. Finally, profits interests provide for potential capital gain treatment upon distributions to them, which makes them favorable to other structures.

John Hodnette and Niloofar Zarei Henzaki are attorneys in the firm's Corporate Department and Emerging Companies & Venture Capital Practice. John can be reached at jhodnette@foxrothschild.com or 704.384.2632. Niloofar can be reached at nhenzaki@foxrothschild.com or 424.285.7092.

National Emerging Companies & Venture Capital Practice Chair Elizabeth Sigety can be reached at esigety@foxrothschild.com or 215.918.3554.