Profits interest is an intangible form of incentive for employees, like shares (stocks) or options in company. It is one of the kind of the partnership interests given to the company's holders which gives the easy and tax efficiently granted equity for running the companies' activities.
The main purpose
Profits interest refers to an equity right based on the future value of a partnership awarded to an individual for their intangible contribution like service. The award consists of receiving profits (interests) from a partnership without having to monetary contribute capital. Thus, it is a form of equity compensation and is used as a way of motivation workers. Most commonly, a profits interest is given to a stakeholder in exchange for their contribution to company's revenue. They are distincted from capital interests, which allow a stakeholder gives the possibility to have share until the date of planned liquidation. It could be called as the appreciation of the way of contribution to the company. It should be reminded that the profits are counted only when the interests are reached in future from the profit.
The primary goal of issuing profits interests is typically to give a service provider the ability to participate in the growth of the enterprise without paying added tax on the receipt of the interest. What is more, it can allow participating in some long-term capital gain treatment (instead of ordinary income treatment) on continuation when they receive on a sale of the LLC or partnership company.
The profits interest and their taxation
There are some rules which should be gone by the book in order not to pay the tax, which are written below:
Vested profits interest
It is the lawful right of stakeholder to gain access to tangible or intangible ways of investments for providing services:
- recipients should be treated like companies’ partners or they should be going to become partners in anticipation so they can receive the interest for their services;
- this source of income cannot be alike the profit from partnership assets, such as high-quality debt securities,
- the holder has to leave the profits interest in two years after receiving it (it is not allowed to sell them during that period),
- the profits interests have not been taken from “publicly traded partnership” if they are limited partnership interest.
Unvested profits interest
- all the requirements for the vested interests have to be fulfilled and
- the recipients have to treat the recipient as the partner who could pay the taxes with taking the according to the entire income from,
- none of the holders cannot receive any money deduction from having the profits interest.
It should be noticed that both of these categories are fully vested and unrestricted. Moreover, many politicians view the use of profits interest as the way of averting paying the taxes and it should be stopped in order to make each profit and benefit for employees on the same level of taxation.
A company may reward workers with equity rights instead of paying them in cash. That solution is used e.g. in start-ups where funds are limited, partnership and limited liability companies (known also as LLC). Profits interest could be the form of benefits. It can affect on increasing motivation of employees. The awareness of possibility to involve on the level of company's revenue will drive the staff to work more efficiently. However, it could be the case only if workers are sure that the company will grow. In other case employees can be disappointed, as they predict that value of shares in future will drop. What is more, entrepreneurs alike often use a profits interest grant (an equity-based incentive award) as a means to encourage employees and protect the companies liquidity.
Profits interest can be beneficial for the company to incentivize staff. The company, which considering profits interests, should take careful steps to prepare their structure (some documentation) and the way of giving them to employees in order to ensure the whole program being successful and check if it is profitable for the organisation.
- Elhauge, E. (2005), Sacrificing corporate profits in the public interest. NyUL Rev., 80, 733.
- Panter B. (2016), The basics of profits interests, Business Insights
- Paz S. (2018), Profits interest grants – basics, Dla Piper Accelerate, Attorney Advertising
- Prisk S. H. (2018), Corporate Matters: Profits Interest Basics, Ruchelman PLLC
- Roskam K. K. (2016), Keeping Your Team Motivated: A Profits Interest as an Equity-Based Incentive, Varnum Attorneys at Law, Startup Blog Spot
Author: Beata Mertyn