Use of “Profits Interests” for LLC Equity Compensation

With limited liability companies (LLCs) having become a widely-used form of business entity for new private companies, I am often asked by LLC clients about compensating employees and other service providers in company equity.

The basic tax planning goal in setting up these equity grants is to avoid triggering an immediate tax to the recipient prior to any distribution of cash to pay this tax.  This is not a practical issue with true startup companies that have no or very limited value, since there is not a significant tax.  However, if the company does have value, and it makes a simple grant of equity to a recipient, there is taxable income to the recipient equal to the fair market value of the equity.

This issue can be mitigated by instead granting what the IRS has termed “profits interests” in an LLC.  Essentially, the recipient is receiving the right to receive a share of only the increase in the value of the company (if any) from the date of grant forward.  The interest therefore has no initial value and doesn’t trigger a tax.  The details of IRS rules on profits interests are highly technical and beyond the scope of this summary, but suffice it to say that you should not attempt to implement these grants without the guidance of a qualified tax advisor.

A super-basic illustration of profits interests in action:

  • January 1, 2013 – A and B each own 45 units of capital interests (i.e., regular, not profits interests) of the Company.  They are the sole owners.  The Company has a value of $1 million.
  • January 2, 2013 – The Company grants 10 units of profits interests to C.
  • January 1, 2016 – The Company is sold for $10 million.  The first $1 million is shared equally by just A and B, since that represents the value on the date of grant.  Then, the remaining $9 million is split 45% each for A and B, and 10% for C.

Note that in the above example, if C instead was granted 10 units of capital interests, there would be taxable income of $100,000 to C (10% of the value of the company), payable before any Company distribution to C to cover the tax.