A profits interest isn’t a new concept. But, it’s becoming increasingly more important for business owners. A profits interest is an interest in an LLC (that’s taxed as a partnership) and provides someone with a share of the company’ s profits going forward. Said another way, it’s an interest in the future profits of the company and not a share of the business’ current assets.
There are three common scenarios when a profits interest can be a good fit for a company:
- Incentivizing a key employee. If you have a key employee or are developing a leadership team with multiple key employees, you could consider granting a profits interest to this person or group. These key employees will then be able to share in the profit of the company going forward and be incentivized to help it grow even more. This is particularly helpful if you have a plan to sell or transition the ownership of your company in 5 or more years when the business has increased in value. Also, a profits interest will typically be structured so that it’s forfeited in any of the key employees leave before a liquidation event so they’re also incentivized to stay with the company through the ownership transition.
- Rewarding a key employee. It’s very common for a company that is growing fast or in the early years of its existence to not have enough cash to pay employees market salaries or give meaningful bonuses. A profits interest can be an important tool to reward key employees who have been with the company during those growth years or since the beginning. If these interests are structured as what’s called a “capital interest” (which also grants a share in the value of the current assets of the company), the key employees would be required to pay tax on the value of the interest they receive. This clearly won’t financially reward them. On the other hand, granting the key employees a profits interest avoids this tax liability and allows them to feel like they’ve financially contributed to the past growth of the company.
- Benefiting the idea partner. If you’re looking to start a company that needs a lot of capital, a profits interest can also be a key planning tool. It’s not unusual for a startup business in a situation like this to have a person who has come up with the idea and another person or group who has the money to fund it. A profits interest can be a way of granting the idea partner an ownership interest in the startup LLC without triggering tax liability.