Profits interests represent a transfer of true equity and, accordingly, profits-interest partners are true partners. Thus, the set-up and maintenance costs of profits interests can be relatively high compared with off-the-shelf, synthetic-equity incentive plans. Profits Interests are property and, as such, the operating agreement specifies the “buy-sell” terms, meaning what specifically happens in any triggering payout event such change in control, separation of service, retirement, termination for cause, and death/disability. The holder of a majority interest in the partnership generally owes a fiduciary duty to the all owners/partners, including profits interest partners. A profits interest requires a determination of a threshold value of the company, which typically means a third-party valuation. Because there are few prototype profits interest plans, drafting a profits interest often requires customized legal documentation. Because the recipient of a profits interest must be treated as a true partner, the recipient should, among other things, pay estimated taxes on guaranteed payments and self-employment taxes, pay for certain corporate benefits, receive a K-1, and file taxes in each state that the partnership operates— costs typically borne by the partnership. Further, consistent with all true equity plans, the redemption of profits interests is not tax deductible by the company (a reason why synthetic equity is a very viable strategic-incentive alternative for LLCs). Some of these implementation costs can be mitigated by using an experienced team of value architecture professionals. Still, we expect the smallest middle-market companies may not wish to shoulder the cost of implementing profits interests.
Potential tax qualifications
Some private equity and hedge funds have been scrutinized for using a certain type of profits interest called carried interest to reposition a portion of their periodic fee compensation as long-term capital gains. Congress and the IRS have publicly considered taking exception to this use—claiming that, among other things, some private equity or hedge funds have exchanged predictable fee income for profits interests that are ineligible under the safe harbor rules. We anticipate that profits interests that fail to meet the safe harbor rules (see profits interest qualifications sidebar earlier in this paper) will be treated as compensation, not as property. Congress and the IRS could also eliminate the profits interest safe harbor altogether, but that does not appears to be very likely.
Is the profits interest the right solution for your organization?
The profits interest is a truly unique strategic incentive for middle-market companies. From a tax and incentive perspective, few structures can match its versatility and benefits. Still, given the implementation considerations, profits interests are certainly not for everyone. Owners and their advisors need to understand when and how to put this powerful tool to work in concert with other candidate executive incentive strategies.
We expect profits interests to become increasingly popular as many more middle market companies choose to be structured as an LLC taxed as a partnership. Designed properly, profits interests offer many advantages. They can bolster business performance—by rewarding achievements and fostering a founder’s mentality in key executives. They can facilitate business continuity and control—by promoting leadership succession, enabling the amassing and transfer of capital, and expanding owner optionality. They can enhance human capital—by attracting new talent and retaining key employees. They can strengthen high-performance cultures—by nurturing meritocracies and promoting equity and fairness.
Indeed, the profits interest is a powerful and dynamic tool for incentive planning in middle-market partnerships.
1 Richard Ruben, “Knotted-Up Tax Systems Make an Overhaul So Tricky” The Wall Street Journal, Feb. 8, 2016.
2 In some cases, a part of the capital gain is re-characterized as ordinary income if the partner is selling a share of so-called hot assets such as unrealized receivables, inventory or fixed assets where there is depreciation recapture.
3 Please see our blog
4 Clayton Christensen Institute for Disruptive Innovation, Jobs to be Done
5 Paul Nunes and Tim Breene, Jumping the S-Curve: How to beat the growth cycle, get on top, and stay there Accenture, 2010.
6 Chris Zook and James Allen, The 3 Things That Keep Companies Growing Harvard Business Review, June 8, 2016
7 For more information, see Mark C. Bronfman, Synthetic Equity, Sagemark Consulting, 2013
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* Licensed, not practicing.