Employee Incentive Structures: Leveraging Profit Interest Units

Are you looking for ways to motivate employees? How about attracting qualified talent to your startup or growing organization? Is your business set up as a partnership, or alimited liability company taxed as a partnership? If so, offering profit interest units might be beneficial, especially with the flexibility and tax advantages.  

In this article, we'll cover the fundamentals of profit interest units, including the main components, an example, and the tax implications. 

Profit interest units are a form of compensation awarded to employees once certain profit metrics are reached. Partnerships or limited liability companies (LLCs) taxed as a partnership use profit interest units to award employees and service providers once certain metrics are reached, like a valuation threshold. Profit units are worthless until the metric is achieved.  

Profit interest units are not the same thing as equity assigned in an LLC. Equity means the employee or service provider contributed capital to the company, resulting in an ownership interest. Unlike equity interest, profit interest units do not assign ownership but instead give employees the ability to receive a portion of future profits.  

Before you can determine if offering profit interest units is right for your company, you need to understand some of the main components.  

Grant Date 

The first component of a profit interest unit is the grant date. This is the date on which the profit interest units are assigned and the terms of distributions are solidified. Generally, the value of the profit interest units will be zero on the grant date.  

Liquidation Threshold  

The liquidation threshold, also known as the distribution hurdle threshold, is the level at which profit interest units would equal zero on the grant date. Unlike a capital interest that allows a recipient to immediately exit on the grant date, profit interest units are subject to other liquidation rights and preferences. These limitations will be outlined alongside the liquidation threshold.  

Vesting Period  

Even if the profit interest units exceed the liquidation threshold, there are vesting conditions that must also be met to receive a payout. For one, time vesting can prohibit payouts if units are not held for a specified period. In addition, performance vesting restricts when profit interest units are available. For example, a CEO's profit interest units might not start accumulating until the company has doubled in size.  

Limited Participation  

Generally, profit interest units are only offered to "real" company partners or employees who plan on becoming partners. This can limit participation to executives and upper management, especially as the tax advantages of profit interest units are greatest for high-earners.  

83(b) Election  

An 83(b) election with the IRS on the grant date ensures favorable capital gain taxation. This election lets the IRS know that you want to be taxed at the total fair market value on the grant date; however, since profit interest units have no value until the liquidation threshold is exceeded, the tax bill is usually zero. Then, once the profit interest units are sold, the employee will be taxed on the difference in value between the grant date and the date sold at capital gain tax rates.  

Other Components 

Profit interest units have minimal restrictions, giving business owners flexibility in terms. For example, some profit interest units will trigger voting rights while others won't. Similarly, profit interest units don't always have to be paid out in cash. The payout could be shares converted into a new company or deferred under a corporate takeover.  

Let's say that your company is granting senior executives profit interest units to improve motivation and leverage the tax benefits. There are 10 executives in total that are participating. On the grant date, the company has an equity value of $2 million. The company files an 83(b) election on the grant date, locking in a fair market value of $2 million.  

A few years go by, and the company is ready to liquidate. The estimated fair market value is now $7 million. The $2 million valuation on the grant date will be distributed to equity holders, leaving $5 million in profit interest units. Dividing the $5 million by 10 executives results in a $500,000 payout to each profit unit holder.  

Now, let's say that the company faced a few hard years, and the valuation on the liquidation date is $1.5 million. Since this amount is less than the value on the grant date, the 10 executives will not receive a profit interest unit payout. Instead, the $1.5 million will go to equity holders to recover losses.  

One of the main advantages of profit interest units is the long-term capital gain treatment for recipients. However, this does result in non-deductible payouts for the business. Let’s explore these tax implications in more detail.

Recipient

Compensation earned as profit interest units are taxed at long-term capital gain rates, which currently range from 0% to 20% based on the individual’s adjusted gross income. This has the potential to significantly lower an employee’s tax burden, with long-term rates being lower than the top marginal rate of 37%. However, if profit interest units are sold within one year of being received, the gains are taxed at ordinary income rates.

Due to the favorable rates, there are situations where a profit interest unit can lose its tax-preferred treatment. For one, if the profit interest relates to a certain and predictable stream of income, such as a high-quality net lease or debt security income, the payments lose tax-advantaged treatment. In addition, if the profit interest is in a partnership that is traded on an established secondary or securities market, favorable tax treatment may be voided.

Business

One of the main tax implications for businesses offering profit interest units is the deductibility limitations. Businesses are not able to deduct profit interest payments since the payment is not considered employee compensation according to the tax code. Additionally, depending on the structure of the profit interest units, a company may be required to carry the balance on its balance sheet as a liability.

Profit interest units are a great way to motivate employees with additional compensation at favorable tax rates. However, establishing a compliant employee incentive structure requires careful documentation and clear instructions. For more information on creating your profit interest unit plan, contact one of our managed accounting team members today to schedule your free consultation.  

Additional Resources 

• IRS Profit Interest Units Information