Save your employees big bucks using profits interests instead of options

Many goodcounsel clients start off in businesses as limited liability companies, enjoying the flexibility and tax-efficiency that this type of entity offers. A lesser known but quite significant advantage of LLC’s is the ability to provide incentive equity in the form of “profits interests.”

A profits interest allows an LLC to give service providers option-like equity without the need for those individuals to put money at risk in order to obtain favorable long-term capital gains tax treatment. Consider the following example:

A corporation issues options to a new employee, priced at the company’s then-fair market value of $1 per share. Issuance of the options has no current tax impact, however, if the employee exercises the options when the company is later acquired at a price of $3 per share, the gain or “spread” of $2 per share will be taxed to the employee at short-term capital gains rates – above 35 percent for high income filers (same rates as ordinary income). This is because the holding period for the equity starts upon the exercise, not the issuance, of the options.

Wouldn’t it be better for the employee to exercise the options and hold the underlying equity for a year in order to receive long-term capital gains treatment at the time of sale? Of course. But this requires the optionholder to come out of pocket and pay the exercise price and take the risk that the equity declines in value – or worse, that the company goes under. Few employees of an early startup will take that risk, and will instead hold the options until a profitable exit is at hand, swallowing the significantly higher tax rate as the cost of reducing risk.

A profits interest is economically equivalent to an option. If a unit of LLC equity has a value of $1, a profits interest issued at that moment comes with a right to participate only in those proceeds of a liquidity event that are in excess of that dollar. (This “hurdle amount” is the economic equivalent of an option’s exercise price – both serve to ensure that the optionholder participates only in the economic value he or she helps to create.) But unlike an option, which is not “property” (in the view of the IRS), the profits interest is property, and therefore the capital gains holding period begins to run upon issuance – and the employee never has to come out of pocket to exercise anything. Using the previous example, when the company sells for $3 per share, the profits interest holder would receive his or her share of the proceeds above the $1 hurdle amount, or $2 per unit, and (assuming at least a year had elapsed between issuance and the sale) these proceeds would be taxed at much lower long-term capital gains rates.

What should you consider before issuing profits interests? First, you have to be an LLC, so you have to be comfortable that this is the right entity for you, your business, and your investors. Next, consider that profits interests are not the easiest form of incentive equity to explain. The typical employee understands what an option is; odds are they’ve never heard of a profits interest. But my view is that if their incentive equity grant is significant, their tax savings from a profits interest stands to be worth a great deal – enough for them to take a few minutes to understand how this works for their benefit.

The most significant negatives arise from the fact that a profits interest holder in an LLC is an equity owner, and therefore is technically ineligible to be paid as a regular W-2 employee. Instead, the company must report all compensation on a form K-1, which the partnership issues to its partners annually. This has negative ramifications regarding the employee’s responsibility for self-employment taxes. These are issues that should be discussed with tax and legal advisors before making a decision about the proper form of incentive equity to use.

Categorised as: Lawyering

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