By Ladd Hirsch and Trip Dyer[1]

“There is no such thing as a free lunch.”  It is a common expression with a clear meaning— don’t expect to receive something for nothing.  But there is an important corollary expressed less often: it is possible to receive something that will have value in the future, but without having to pay for it now.  Like seeds waiting to sprout, the concept of a private company profits interest fits this description of an asset with no current worth, but which may become quite valuable over time.  The profits interest therefore has an important role to play in the private company context, but what exactly is a profits interest and how does it work?

Defining a Profits Interest

In brief, a profits interest is a creative way for private company business owners to provide their employees with a significant financial incentive—an ownership stake in the company—but without saddling them with a tax burden when they receive this interest.  A profits interest can serve a purpose that is similar to a stock option by granting an equity interest in the company to the employee, but unlike some stock options, the employee does not recognize income or pay taxes on the grant of a profits interest because the profits interest has no value when it is granted.

The absence of value is because a profits interest is forward-looking; it provides the employee with a share in: (i) the company’s future profits and (ii) the appreciated value of the company.  If the company was liquidated on the day that the profits interest was granted, the employee would receive no proceeds from the liquidation.  The employee receives financial benefits only when the company’s assets are sold for a higher value than the date the profits interest was issued or when the company makes distributions with respect to future profits.  Further, the employee is not required to contribute any capital and is awarded a profits interest based on the services that the employee has provided or will provide to the company.

Pros and Cons of Equity Profits Interests

The pros and cons of equity profits interests are reviewed below.

Equity Profits Interests – The Pros:

  • A key advantage of a profits interest is that it can be issued to employees giving them an equity interest in a valuable company without requiring them to pay tax of any kind.  Unlike stock options, the employee does not have to pay a “strike price” to acquire the profits interest.  The profits interest provides a strong incentive to the employee to increase the value of the business, because the employee will one day share in the amount by which the company’s value increases after the profits interest is granted.  Simply stated, the bigger the pie becomes after the profits interest is granted, the greater the slice the employee will receive when the company is sold.
  • The tax consequences of holding a profits interest follow general principles of partnership taxation, which means that the character of the company’s income that flows to the holder of the profits interest is generally determined at the company level.  Thus, if the company sells assets that it has held for more than one year, the employee holding the profits interest would be taxed at the lower long-term capital gains rate on his or her share of the gain (subject to the new “carried interest” tax legislation), and not at the higher rate that applies to ordinary income.
  • Another important benefit is the avoidance of tax on the profits interest at the time it is issued.   By definition, a profits interest holder receives no proceeds from the liquidation of the company if this liquidation took place immediately after the grant of the profits interest.  As a result, the profits interest has no value on the date it is issued.  All of the value in a profits interest is based on the future – when there are future profits and the future sale of the business for a higher value.  Because the profits interest has no value on the date of issuance, the employee is not subject to any tax upon receiving the profits interest.  The employee will be taxed solely on his/her share of future income and gain of the company.

Equity Profits Interests – The Cons:

  • Profits interests can only be provided to employees by companies treated as partnerships for federal income tax purposes (e.g., limited partnership, general partnership, etc.).  Limited liability companies with more than one member are generally treated as partnerships for federal income tax purposes, unless they make an election to be treated as a corporation.  C corporations and S corporations cannot issue profits interests.
  • Private company business owners may not want to provide this type of equity grant to their employees, because equity ownership typically confers all of the following rights:  (i) the right to assert claims against the company’s officers and managers on a derivative basis based on breaches of fiduciary duties, (ii) the right to demand access to the company’s books and records and (iii) the right to require meetings of equity owners.   Majority owners who want to provide incentives to employees may therefore prefer to provide them with contractual incentives such as stock appreciation rights, bonus compensation or tracking stock rather than a profits interest.
  • Employees who have been working for many years at the company may feel shortchanged by a profits interest, which, at the time of issuance, has no value.  These long-term employees will have to continue waiting for the company to grow in value and become more profitable for them to be able to receive a financial reward for their years of service to the business.

Conclusion

Private company owners who want to incentivize key employees will strive to provide their team members with both value and an incentive to keep growing the business.  Stock options are a typical way to accomplish this result in the corporate context, but the grant of stock options in a valuable company may require employees to pay tax on the issuance or exercise of the option depending on the situation.  A profits interests can therefore effectively thread the needle by providing employees with a company equity interest, but without creating immediate tax liability for them.  For a growing, profitable company, granting a profits interest to key employees may be an excellent way to provide them with seeds that will sprout with value over time.

[1] Trip Dyer is a tax associate with Winstead who contributed significantly to this discussion of the use of profits interests in private companies.