News & Publications - Archived
by James N. Phillips
Businesses often offer equity compensation as part of the incentive package for key employees. In the case of a corporation, the equity may consist of vested stock, restricted stock, options, or a combination of stock and options. In general, there are two components to equity, the "base value" and the "future appreciation." The base value is the current value of the equity. For example, if a corporation is worth $1 million and there are 100 shares outstanding the base value attributable to one share is $10,000. Each share also represents the right to participate in one percent of the future appreciation of the corporation.
If the corporation wants to provide the employee with only future appreciation the corporation may choose to award stock options, or may choose to sell stock to the employee at today's value. The sale of stock at today's value may be more beneficial for the employee in that the employee will usually receive long-term capital gain treatment for gain upon the sale of the stock, but less beneficial for the employee in that the employee assumes the risk that the stock will decline in value. In the case of an option, the employee does not assume any risk that the stock will decline in value, but as a trade-off must report as compensation income at the time of the exercise of the option the excess of the value of the stock received upon the exercise of the option over the option exercise price. The corporation is entitled to an equal compensation deduction.
Partnerships have been able to provide equity-based compensation to key employees with the economics of a stock option but with the favorable long-term capital gain treatment of stock. This equity interest, which only shares in "future appreciation," is called a "profits interest." Until recently, the use of profits interests was not common in operating businesses, as most operating business were structured as C-corporations or S-corporations. However, with the development of limited liability companies (LLCs), which generally are treated as partnerships for income tax purposes, the number of operating businesses being taxed as partnerships has increased significantly.
A profits interest is typically structured as follows. If the profits interest is being created upon the organization of the LLC, those members who contribute cash or operating assets receive a credit in their capital accounts for the fair market value of their contribution. The key employees who receive profits interests would make no contribution to the LLC, or a substantially smaller contribution to the LLC. Future profits and losses would be allocated among the members in a manner that provided for a substantially higher allocation of profits to the key employee than what the key employee would otherwise receive if profits were allocated on the basis of the amount of their contributions. The operating agreement for the LLC would provide that upon liquidation of the LLC each member is entitled to receive an amount equal to the positive balance in the member's capital account. The member's capital account would initially be equal to the value of the member's contribution, and thereafter would be increased by the member's allocable share of profits, and decreased by the member's allocable share of losses and distributions. Overall, the key employee who receives a profits interest is sharing in future appreciation without having to make a significant economic outlay.
One of the advantages for the key employee is that the gain ultimately realized attributable to the disposition of the profits interest will often be long-term capital gain. Either the profits interest will be sold, with in most cases primarily capital gain treatment for the gain, or the business will be sold, with in most cases a substantial portion of the gain allocable to the key employee constituting capital gain. Significantly, the key employee's basis in the profits interest will increase annually as the LLC allocates income to the employee, with a corresponding reduction in the capital gain due to the increased basis at the time of sale.
At one time the tax consequences of the receipt of a profits interest was unclear, and the IRS took the position that the receipt of the interest was taxable to the recipient. Ultimately the IRS issued a revenue procedure in 1993 that sets forth the IRS' position that a receipt of a profits interest is a non-taxable event to the recipient party, provided that certain requirements are satisfied. With the growth of LLCs, you can expect to see and hear more about profits interests in the future.