Considering a Profits Interest for Key Employees

If you have a high performing employee, perhaps a general manager you can’t do without, you have probably initiated or will initiate an ownership conversation at some point. Key employee retention and motivation is important and using the incentive of ownership can be a very effective retention tool. If you have a limited liability company and are planning on offering an ownership position to an employee, a tax effective strategy could involve using a profits interest issuance instead of a capital interest issuance.

Profits Interest Issuance vs. Capital Interest Issuance

Let’s get to the basics on what the differences are between the two. Issuing a capital interest represents immediate ownership in the liquidation rights of the company and the right to participate in the future profits and losses of the company. So, if you have a company with net book value of $1MM of which you issue a capital interest of 10% to a key employee, then you liquidate the next day, that key employee receives $100,000 as their rights to the capital of the company. Now consider the issuance of a profits interest. This represents only the immediate right to participate in the profits of the company and its future appreciation in value. Using the same example above, with a properly structured profits interest, the key employee would receive zero as part of the liquidation since the employee would not participate in the initial $1MM of value.

Why is this important? There can be steep tax consequences to the issuance of a capital interest. The receipt of a capital interest is considered a taxable event and is considered income to the recipient. Depending on the fair market value of the company, the resulting taxable income to the key employee could be significant. If your key employee cannot afford the tax liability upon the issuance, you may need to consider additional compensation to the employee to fund the tax cost as well as of the issuance of ownership.

Why else would you consider the profits interest? You can get the best of both worlds. On the one hand you motivate the key employee to generate higher profits so that they can build their capital account. You also have the ability to keep the equity that you created in the company, as there isn’t a transfer of capital with the issuance of the profits interest.

IRS Safe Harbor guidelines

As for the caveats, you want to make sure that the issuance of the profits interest falls within IRS guidance and accomplishes your goals. As long as the ownership interest issued has no liquidation value and is not transferred within a two-year period then the ownership at inception should not be taxable. The IRS issued Safe Harbor guidelines (see Revenue Procedure 93-27) to effectively transfer a profits interest on a tax-free basis. There are other items to review, such as your operating agreement, so a careful analysis of the regulations, IRS guidance, as well as the facts and circumstances for your company is recommended by you and your tax advisor.

If you have any questions about issuing a profits interest, please contact Jon Paul Davis at jpdavis@hhmcpas.comor 423.756.7771.