Companies are always looking for creative ways to compensate their top executives. They want to be able to attract top talent as well as retain the knowledge and experience they already have. One tool for doing so is profits interests, which are an option for businesses taxed as pass-through entities.
A profits interest is an equity right that can be granted to any individual for their service to a partnership or limited liability company. This grant includes an interest in a percentage of profits from the business even though the individual did not contribute any capital to the business. It is a way to share profits and incentivize executives without sharing ownership.
- Tax-Free Issuance: Profits interests are generally tax-free on issuance, a huge advantage over capital interests that are immediately subject to income tax. The IRS provides a safe harbor, subject to certain conditions and exemptions, to treat profits interests as a non-taxable event.
- Long Term Capital Gains Treatment: In addition to being tax-free when issued, any appreciation, so long as the holding requirement is satisfied, is taxed at the same rate as long-term capital gains. In order to qualify for this treatment, profits interest must be held for a period of one year or longer, with an exception for “hot” assets. The Tax Cuts and Jobs Act included a new holding period focused on profits interests granted in hedge funds and other investment businesses where the interest must be held for three years before it is eligible for taxation at long-term capital gains rates.
- Contractual Flexibility: When designing a profits interest program, companies have a fair amount of flexibility in setting the terms for the grant of interest as well as the rights of the recipient as an equity holder. The grant agreement establishes terms and conditions, a vesting schedule, and the value of the company.
- Corporate Governance Documents: An individual that holds a profits interest is considered an equity holder in the business. As such, they are entitled to the same rights, privileges, and obligations any other partner would be obligated to. Therefore, it is important to make changes to the company’s governing documents before you add additional equity holders such as those with a profits interest. In many companies, a stand-alone equity class is created for the profits interest’s holders with rights and obligations appropriate for the situation.
- Employment: Executives receiving profits interests rights cannot be both an employee and owner for tax purposes, so they are treated as an owner for tax purposes. This means the employee’s salary is converted into a guaranteed payment subject to self-employment taxes and quarterly tax payments. They may also lose access to certain benefits programs.
The experienced benefits attorneys at Hall Benefits Law can help your business design and implement profits interests as part of an executive compensation package. To learn more, call 678-439-6236 today or visit the Hall Benefits Law website.
Hall Benefits Law, LLC
