Peter Elias is a tax partner at Orrick Herrington & Sutcliffe LLP
Any opinions, analyses, and conclusions or recommendations expressed in this article are those of the author alone and do not reflect the views of their employer or eShares, Inc. DBA Carta, Inc.
LLCs often wish to make non-taxable equity grants to service providers (i.e. as profits interests). However, in certain situations, the LLC also desires to provide the grantee with economic rights to current capital value of the LLC as of the date of the grant (which is typically not permitted without losing the tax-favored status of the grant as a profits interest).
In such cases, rather than making a typical profits interest grant, an LLC might consider structuring the grant as what is known as a “catch-up” profits interest.
How it works
A typical profits interest grant would normally provide that the grantee only participates in her pro rata share of proceeds from the sale of LLC which exceed the fair market value (FMV) of the LLC as of the time of the grant (such grant-date FMV often being referred to as the “threshold amount”).
Here are two examples to explain how it works—first, a profits interest grant with no catch-up provision, and then a grant with a catch-up provision
Example #1 (no catch-up):
A hypothetical LLC has a current FMV of, say, $10 million, and makes a 5% profits interest grant to an executive, with no “catch-up” concept. The terms of the grant would provide that if the LLC is subsequently sold for $10 million or less, the executive would receive nothing. However, if the LLC is sold for anything more than the $10 million threshold amount, the executive would receive 5% of the proceeds above $10 million.
As can be seen, a typical profits interest grant is not as valuable as a regular capital interest in the LLC because the profits interest grant only shares in proceeds above the threshold amount, but receives nothing attributable to the threshold amount itself.
Under a “catch-up” profits interest, the grantee would still receive zero if the LLC were subsequently sold for total proceeds equal to or less than the threshold amount. But the catch-up concept would provide the grantee with an enhanced share of exit proceeds above the threshold amount until the grantee is “caught up” to her pro rata share, with any additional proceeds thereafter then being shared pro rata.
Example #2 (catch-up):
Same as above except that the profits interest grant has a “catch-up” concept. Thus, if the LLC subsequently sold for, say, $10 million or less, the executive still receives zero. But, in this case, if the LLC is subsequently sold for anything greater than $10 million, the executive receives 100% (not 5%) of the excess proceeds until the executive has received 5% of total proceeds (i.e. roughly $526,000 to the executive), and 5% thereafter.
Thus, if the LLC were sold for, say, $15,000,000, the executive would receive $750,000, which is the same amount the executive would have received (i.e. 5% of the total) had she held a regular capital interest in the LLC, rather than a profits interest.
Additional considerations
The catch-up profits interest concept can be a useful mechanism to minimize the economic differences between a profits interest grant, on the one hand, and a capital interest, on the other, while still preserving the tax-favored status of the profits interest.
However, as can be seen by the examples above, the catch-up profits interest is not a perfect solution because the LLC still must appreciate in value subsequent to the grant in order for the executive to be “caught-up.” Thus, if the LLC is ultimately sold for an exit price equal to or less than the threshold amount, the executive is still at risk of not receiving the same sale proceeds that a capital interest holder would have been entitled to receive.
Even still, the catch-up profits interest can significantly minimize the executive’s economic risks in this regard, while still preserving the beneficial tax treatment of the profits interest grant. This is because in many cases, the LLC will only need to appreciate in value by relatively small amounts for the grantee to be caught up in full (i.e., in the examples above, the LLC only had to appreciate in value from $10 million to $10.526 million in order to fully catch up a 5% profits interest holder).
Tax treatment for equity holders
So long as the terms of the grant provide that if the LLC is subsequently sold for an amount equal to or less than the threshold amount, the grantee receives zero, the catch-up profits interest grant should still qualify as a “profits interest” for tax purposes. Thus, in most cases, a catch-up grant can be documented and structured in a manner which is non-taxable to the grantee at the time of grant.
It should be noted that over the past few years the IRS has issued proposed rules and other pronouncements that seek to address more aggressive uses of this type of “catch-up” (or similar concept). However, most types of catch-up grants that are not abusive or aggressive should still receive the beneficial tax status afforded to profits interests generally. But professional advice should be obtained in establishing these types of arrangements.
Tax treatment for companies
Because a profits interest grant is non-taxable to the grantee, the issuing LLC does not receive a tax deduction attributable to the grant (unlike the case in a corporation, where a compensatory grant of stock is taxable to the grantee as compensation based on grant-date FMV, and the issuing corporation receives an equivalent tax deduction).
What valuations are needed for this equity type
For any grants of profits interests (whether including the catch-up concept or not), it is important for the LLC to establish a defensible valuation of the company as of the date of grant. Third-party appraisals (similar to those obtained under IRC Section 409A in connection with corporate stock option grants) are sometimes advisable to support the underlying valuation.
How employees can understand the value of this equity
Profits interest grants (in comparison to, for example, corporate stock options, etc.) can sometimes be very complex for grantees to understand, and catch-up concepts even moreso. In addition, a holder of a profits interest is generally required to be treated by the LLC as a “partner” in the partnership. This requires profits interests holders to receive K-1s each year, which can impact their individual tax filings. IRS has also taken the position that a direct member of an LLC operating company must report to the IRS as a self-employed person, rather than as an “employee” of the LLC. This can further complicate tax filings for individuals who are not familiar with such matters.