What would happen if your key employee left? Could your business continue efficiently? With many limited liability companies (LLC) having only a few owners, reliance upon key employees is increasingly necessary. One way to entice these employees to stay is through a profits interest. This allows the recipient to obtain an interest in the firm’s profitability without having to invest in the company or recognize an immediate tax consequence.
Unlike a traditional membership interest, a profits interest does not entitle the holder to vote or perform member acts. The interest holder can receive his or her share of profits but cannot affect the company’s business or receive anything if it liquidates.
The receipt of a profits interest is a nontaxable event to both the company and the recipient provided you follow the proper IRS rules. In general, to be nontaxable the profits must not: (1) relate to a “substantially certain and predictable stream of income” from the company’s assets; or (2) be disposed of by the recipient within two years of receipt.
The firm’s members must vote to give the interest and then must approve a “profits interest plan” describing the details. The company and recipient must then sign a “Profits Interest Agreement” to address any restrictions on transferability and to acknowledge that the recipient agrees to follow its terms. Because the interest is only in future profits, a valuation of the LLC should be done to provide a baseline for determining future profits.
The Profits Interest Agreement should also address several other issues. Like the owners of the LLC, a profits interest holder may receive “phantom income.” This means the recipient has income attributed but does not actually receive any cash distributions with which to pay the tax liability. A requirement to distribute at least enough money from the company to pay taxes due generally can address this.
Dilution should also be discussed prior to executing any agreement. Profits interests are usually granted in terms of percentages. However, it is important that recipients realize their percentages can be diluted by later grants of profits interests or admittance of new members to the company. The potential for dilution should be expressly stated in the Profits Interest Agreement so there is no shock later when the recipient finds out his or her percentage is not worth the same as in the prior year.
A profits interest can be an effective tool for retaining key employees but any company considering this must look at a variety of factors, including the tax situation of the parties. Any company wishing to issue a profits interest should contact its corporate or tax attorney to discuss the hurdles and pitfalls that can be present when structuring these interests.« Back to news