Utilizing profits interests as equity incentive compensation

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Given the tax advantages for grantees and flexibility provided to grantors, a profits interests program can serve as a useful tool for companies looking to incentivize key employees and service providers.

What are profits interests?

Businesses that are structured as partnerships or limited liability companies (LLCs) taxed as pass-through entities have a number of options when it comes to compensating and incentivizing their workforce and service providers. In addition to cash bonuses and employee benefit plans, these businesses can also offer equity incentive compensation, such as restricted capital interests, phantom interests and profits interests.

Profits interests may be awarded to employees and service providers as a form of compensation. Unlike capital interests, which represent interests in the current value of the company, profits interests represent ownership interests in the future growth and profits of the company. The holder of a profits interest (referred to in this article as the “grantee”) benefits from (1) profits generated by the employer or service recipient (referred to in this article as the “grantor”), and (2) appreciation in the value of the grantor, both after the date on which the profits interest is granted.

Profits interests offer unique advantages in that they are generally tax-free to grantees upon issuance and receive capital gains treatment upon the later sale or redemption of the interests. However, profits interests can have significant repercussions for both the grantor and the grantee, and we have briefly noted some of these considerations below.

Advantages of profits interests

Tax-free upon issuance

If structured properly, profits interests are tax-free to the grantee upon issuance. This is a significant benefit over capital interests incentives, which subject the grantee to an ordinary income tax in an amount equal to the then-current value of the capital interests minus the amount the grantee paid for such capital interests. The Internal Revenue Service (“IRS”) provides a safe harbor, if certain conditions are met, regarding the taxation of profits interests upon issue. IRS Revenue Procedure 93-27, as clarified by IRS Revenue Procedure 2001-43, provides that, subject to certain exceptions, the IRS will treat the issuance of profits interests for the provision of services to or for the benefit of a grantor as a non-taxable event.

Capital gains treatment on appreciation

In addition to being tax-free for grantees at the time of issuance, profits interests are beneficial in that appreciation, to the extent the grantee satisfies the applicable holding period requirement, is eligible for long-term capital gain taxation (subject to certain exceptions for “hot” assets) upon the sale or redemption of the interests. This long-term capital gain treatment is a key distinction from phantom equity awards, which are subject to ordinary income taxation.

Extended holding period requirement for long-term capital gain treatment

Under general income tax rules, subject to certain exceptions for “hot” assets, gains realized on the sale or redemption of partnership interests receive long-term capital gain treatment if a grantee held the partnership interests for more than one year. However, the 2017 Tax Cuts and Jobs Act enacted a new holding period requirement for certain partnership interests (including profits interests) in certain businesses (i.e., a business that engages on a regular, continuous and substantial basis in (1) raising or returning capital, and (2) investing in, disposing of, or developing certain specified assets, such as real estate, cash or cash equivalents, securities, commodities, or derivative contracts). This requirement primarily effects profits interests granted in hedge funds, private equity funds and real estate funds.

Under Section 1061 of the Internal Revenue Code of 1986, as amended, a grantee of profits interests in certain applicable partnerships will only be eligible for long-term capital gain treatment if such profits interests are held by the grantee for at least three years. Profits interests held for less than three years are treated as short-term capital gains, notwithstanding Code Section 83 or any election made under Code Section 83(b).

Flexibility

Profits interests provide grantors with significant flexibility in setting the terms of the award and the rights of the grantee as an equity holder in the business following the issuance. Profits interests are issued through a grant agreement which establishes the terms and conditions of the award. The grant agreement will contain the vesting schedule, if any, the value of the company as of the grant date (used to determine the grantee’s share of appreciation), restrictive covenants and other contractual rights and obligations.

Additional Considerations

Before implementing a profits interests program, a company should consider a variety of key factors and implications relating to issues such as corporate governance and tax reporting obligations.

Corporate governance

As discussed above, profits interests holders are equity holders in the business and are therefore entitled to the rights, privileges and obligations set forth in the partnership or operating agreement and under applicable law. Prior to making a profits interest grant, a grantor should review its existing governance documents and consider whether amendments are needed to restrict or modify the rights of the grantee.

If profits interests are issued from the same class of equity held by the other partners or members of the company, grantees will have the same rights and obligations held by the other company equity holders. This would include, for example, requirements to make capital contributions and rights to receive distributions.

A stand-alone equity class is often created for the profits interests with rights and obligations specifically tailored by the issuing grantor. In doing so, grantors can limit the grantee’s non-economic rights, such as limiting access to the company’s books and records and removing any pre-emptive rights held by other equity holders. Modifications can also negate or ease administrative burdens that may arise from granting certain privileges, such as voting rights or distribution rights, to grantees.

Employment status and tax reporting burdens

An individual who receives a profits interest grant cannot simultaneously be treated as an employee of the company and a partner of the company for tax purposes. Thus, as soon as a grantee is granted a profits interest, the grantee is no longer treated as an employee for tax purposes. From a practical standpoint (1) the grantee’s salary is converted into a guaranteed payment that is subject to self-employment taxation, (2) employers will no longer collect and remit the employer portion of any FICA taxes to tax authorities and, thus, the grantee must remit quarterly tax payments to satisfy the grantee’s tax obligations, (3) the grantee will receive an IRS Form Schedule K-1 (rather than an IRS Form W-2), and (4) the grantee may be disqualified from participating in certain employee benefits programs.

Phantom income

Partnerships and LLCs taxed as pass-through entities are generally not subject to U.S. federal income tax; instead, their equity holders are taxed on the company income. Equity holders in pass-through entities, including holders of profits interests (grantees), are taxed on the entity’s income, regardless of whether the equity holders receive an actual distribution of cash. Operating and partnership agreements may (but are not required to) provide for mandatory tax distributions to cover such tax obligations in excess of the distributions made by the company.

Size of the grant

Prior to implementing a profits interests plan, a grantor should consider the size of the grant(s) compared to the employee’s compensation. If the grant is small compared to the other compensation paid to the employee, the benefits of issuing profits interests may be outweighed by the corresponding burdens and costs, including the complexities that arise from the grantee automatically becoming a K-1 partner upon the profits interests grant. In such instances, other forms of incentive compensation, such as issuing phantom interests, restricted interest or providing cash bonuses, might be more appropriate.

Conclusion

While a profits interests program has unique advantages, a company should carefully consider the implications of such a program prior to its implementation.

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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