What Are Profits Interests and Why Should You Care?
By: Barry E. Haimo, Esq.
July 11, 2024
Let’s explore a valuable tool for partnerships: profits interests. Whether you’re looking to reward key personnel or align their interests with the company’s future growth, profits interests offer a tax-efficient way to share in the company’s success.
In this post, we’ll break down how they work, their benefits, and why they might be the perfect fit for your business.
Unlocking the Power of Profits Interests
Read Transcript
Hi, welcome back to Bite-Sized Bits of Knowledge, where we give you meaningful information in a short amount of time. Today we’re going to be talking about profits interests.
Profits interests are really cool. They’re tools that are used in the business and employment – or key personnel – context. Typically they are used in a partnership setting; you cannot use them in an S corp, C corp, or disregarded situation. It’s usually a partnership setting. And what they are is a way of giving a piece of the pie to somebody who is really important to the business with a couple benefits and – I would say – limited disadvantages.
The benefits of a profits interests are that the key person can have the rights to profits and losses of the business immediately as if they’re a partner. They will get a K-1 every year, just like the other partners. This is a good thing. In addition, they’re not going to get taxed for income tax purposes on the receipt of the profits interest. This is a key thing.
They’re not getting what’s called a “capital interest.” What that means is that they’re not getting a value as of the date of the receipt, meaning that if the company were to liquidate the next day, the profits interests holder wouldn’t get any value from the sale because not getting any value of the sale, they’re not really getting any value in that moment of the company. It’s non-capital in nature. There’s no tax.
If you get equity, you’re getting a value of that equity because you have that liquidation potential of the next day they sold it, and that’s income tax that has to be reported on your 1040, and that could be substantial. Now you can do, you know, 83(b) elections and you can defer that income tax another day, but it is income tax. Profits interests are really cool because you can give that share of the pie without exposing the person to a big tax on receipt.
Now, to just go a little bit deeper there, the profits interests holder typically will get an assigned value of the shares upon that receipt. So say for example your business is worth a million dollars. You give your profits interest holder 10%. If it’s capital, they have $100,000 dollar gain, if it’s profits interests there’s zero gain on receipt.
Say in one year the company sells for $2 million dollars. The profits interests holder will participate not in that first million, but that second million. Anything above that value that was assigned at the date of receipt they’ll participate in that as their percentage owner, or however else the partnership agreement spells it out, you know, whether the special allocations, or it’s just pro rata, that’s in the agreement. But the idea there is that they participate in the appreciation of the business after the date of the receipt.
In addition, profit interest holders can be limited in their rights. They could be limited in their vesting schedules. There’s a lot of flexibility there. You know, you can take them away, you can give them out, you can put restrictions, you can prevent transfers, you can make them partners in the sense that they have voting rights or non-voting rights. There’s a lot of flexibility here, which is really cool because it makes you able to build in key people in more flexible ways.
The downside, of course, I think, is the converse of the benefits. You’re not getting capital interest. You only get the appreciation and sometimes you might not be getting the rights that you want as a partner depending on the context of the business. But overall, I think that they are something that every partnership should consider when giving equity, or giving a piece of the pie to a key person. For all the reasons I just said, they’re really cool. The CPAs who do a lot of this kind of work really like them, and so we use them a lot.
So thank you for stopping by and stay tuned for more.
Now that we have gone into the fundamental aspects and benefits of profits interests, it’s clear that they offer a unique and flexible way to reward key contributors without the immediate tax implications of capital interests. As we move forward, we’ll explore the critical factors to consider when deciding whether to implement profits interests in your business. We’ll also provide guidance on how to assess the value and impact of profits interests from the perspective of the receiver, helping you understand what to look for and how to navigate potential risks. From understanding their value and potential risks to assessing their suitability for your specific situation, we’ll provide you with the insights needed to make an informed decision.
Profits Interest: Performance-Linked Compensation
Profits Interests, also known as carried interests or promotes, are a type of compensation that allows you to receive a share of the profits from a partnership without needing to contribute capital or pay a strike price. As a recipient of profits interests, you are treated as a partner for tax purposes from the date you receive your award. Importantly, profits interests do not trigger W-2 compensation income, which means they’re not subject to ordinary income tax.
Profits interests serve several purposes.
Incentivizing Key Employees: They motivate key employees to stay with the company longer.
Attracting Talent: They help attract new talent by offering a stake in the company’s success.
Reward and Promotion: They are used as a reward and promotion tool for those who significantly contribute to the company’s growth.
Customization and Negotiability: The economic rights associated with profits interests can be highly customized and negotiated, especially for senior executives.
To determine the value of your profits interests, consider the following:
Current Capitalization: The company may have different classes of interests, with some having priority distribution rights that could affect the value of your interests.
Future Dilution: The value of your profits interests may be impacted by new investors or additional grants of profits interests. This dilution can occur if other holders of profits interests withdraw or if new investments are made.
Participation Rights: Profits interests may participate in distributions to the fullest extent allowed for tax purposes or may have performance thresholds that affect their value.
Company Appreciation: The anticipated growth of the company before a potential sale can influence the value of your profits interests.
Make sure to consider the risk of legal scrutiny. Profits interests have faced legal scrutiny, particularly regarding the tax rates applied to hedge fund managers and senior executives. It’s essential to stay informed about any ongoing legal issues and manage risks accordingly.
Maximizing The Benefits
By understanding the intricacies of how profits interests work, from their tax implications to their impact on your compensation and overall financial strategy, you can make informed decisions that benefit both you and your business. Navigating these complexities effectively requires a clear grasp of their value, potential risks, and how they fit within your broader goals. If you need further guidance or have specific questions about how profits interests could be tailored to your situation, don’t hesitate to reach out to us. Our experts are here to provide personalized advice and help you leverage profits interests to their fullest potential.
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Author:
Barry E. Haimo, Esq.
Haimo Law
Strategic Planning With Purpose®
Email: barry@haimolaw.com
YouTube: http://www.youtube.com/user/haimolawtv
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