Many small business clients find granting employees or key service providers a stake in the business an attractive concept as a tool for encouraging employee retention and quality work product. However, stock options and other grants of equity in small businesses often meet significant tax challenges that derail business owners’ good intentions.
One traditional type of equity grant, a grant of stock options, is used in many startup-friendly industries to help fledgling businesses compete with their more-established, full-pocketed competitors that offer higher salaries. But one hurdle is that stock options, when vested or when exercised, are often considered taxable income to the recipient.
A generally tax-free alternative to a stock option is the grant of a profits interest in a business. A profits interest in an LLC is a legal form of equity and will make the recipient a partner or member of the LLC for tax purposes. What differentiates a profits interest from a full membership interest (“capital interest”) is that a capital interest entitles a recipient to participate in the capital and accumulated profits or value of the LLC, while a profits interest is forward-looking, giving the holder no right to previously accumulated value or capital of the company, only to future gains and profits.
Unless clearly and specifically spelled out within the LLC’s operating agreement or other documents, any provision that would lead to a different distribution result could have unforeseen tax consequences. The IRS has created a safe harbor (Rev. Proc. 93-27 and Rev. Proc. 2001-43) for profits interests, provided they comply with certain criteria:
- The profits interest must pertain to a privately-held partnership.
- The recipient may not dispose of the profits interest within two (2) years of receipt.
- There must be no guarantee of income from the profits interest (i.e. the interest cannot relate to a substantially certain stream of income such as rental income from real property held as an investment);
- The recipient must provide services to, or for, the benefit of the LLC.
In order to ensure compliance with the IRS guidance, corporate governance, and other legal issues and effectively make a profits interest grant, a business has a few key considerations.
“The Hurdle.” As of the date of the grant, the company should determine its value, and thus what the value of a capital interest would be. That number is often referred to as the “hurdle,” after which, during a liquidity event, a profits interest holder would begin to realize a profit. For instance, if the company was valued at $1 million at the time of a profits interest grant of 10%, and later sold for $5 million, the value as of the date of the grant ($1 million) would be the hurdle, and the profits interest holder would share in the value of the $4 million of the sale price above that hurdle. The hurdle should generally be clearly spelled out in writing and documented through financial records or valuations in the granting instrument or operating agreement.
Company Repurchase Rights. Most often, a company will want to structure repurchase or other rights of the company triggered if the recipient of the profits interest discontinues service to, or employment with, the company. Often, that involves the company having a buy-back option at a value either predetermined or with the process for ascertaining such value predetermined.
Vesting. As with most equity grants, a profits interest can either be granted all at once or vest over a schedule the parties see fit. If the LLC chooses to use a vesting schedule, it will need to determine and adequately document what will occur with distributions related to unvested portions of profit interests (i.e. whether to distribute distributions on unvested interests to other members or to hold them aside for future benefit of the profits interest recipient), how to allocate profits for tax purposes (and whether to “catch up” allocations once the full interests are vested), and how to structure repurchase or buyback rights, including whether or not unvested interests should be forfeited rather than bought back.
83(b) Elections. If the profits interest will vest, to avoid some stickier issues with vesting and value, upon making a grant of a profits interest, it may be advisable for a recipient to make what is known as an 83(b) election. That election would allow the recipient to elect to include in gross income the fair market value of the property at the time of the grant, rather than in a later year when the property becomes vested. Since the fair market value of a profits interest in the year of the grant should be $0, as it should not include any existing value or capital in the company, an 83(b) election could mean the recipient can avoid future income tax in the years of vesting.
Voting Rights. As the grant of a profits interest will make the holder a partner in the LLC for tax purposes, it is important to differentiate any underlying membership rights, such as voting, meeting, record access, and other rights in the LLC’s operating agreement if the LLC intends to treat holders of profits interests differently than holders of capital interests.
Employee Tax Returns. One negative to a profits interest (which would also be present in just about any other equity grant) is that the recipient’s tax returns will become a bit more complicated. Often, members in LLCs do not receive W-2 compensation, as the employee might be used to, but rather receive guaranteed payments or distributions from the LLC, which would be made without tax withholdings and may require the employee to make quarterly state and federal tax payments and could lead to other budgetary concerns. It can add a layer of complexity that some employees may not desire, although hopefully the financial benefit would outweigh those concerns.
Valuations. Additionally, in order to properly execute a profits interest grant, the company will need to be valued by a neutral or reputable third-party or have an adequate idea of its value to ensure that when the grant is made and profits subsequently paid out, the profits interest recipient is not receiving any of the capital of the company and is only receiving gain and profit above the hurdle. Valuations of that nature can, but are not always or even generally, expensive and time-consuming.
Overall, profits interests are a viable alternative to stock options or providing employees and service providers other types of equity in an LLC, provided that the granting and governing documents are drafted intelligently and the LLC has sound advice from their accountant to ensure there are no missteps that would revert the interest into a partial, or full, capital interest in the company. They can be a great way to encourage participation and investment in a business by key employees and others.