Profits interest

Profits interest

Author: Kristoffer Warren, CAIA
|
Read time:  4 minutes
Published date:  August 30, 2022
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Updated date:  April 15, 2024
A profits interest is a form of equity-like compensation available to LLCs. Learn about profits interest units, their tax treatment, and valuations.

What is a profits interest?

A profits interest is an equity-like form of compensation that limited liability companies (LLC) can offer to employees and other service providers. There are very limited requirements for profits interest units, though a liquidation threshold is often assigned to profits interests on their grant date, meaning that the LLC has to achieve profits at or above a certain amount for the profits interest to participate in exit proceeds. The value of a profits interest is based on the growing value of the LLC, which allows employees (or “partners”) to benefit from the LLC’s appreciation in value.

Below we’ll break down the benefits, key requirements, and definitions that you need to know for profits interest units.

Profits interest vs. capital interest

A capital interest is a type of equity commonly issued by LLCs, under which the member of the LLC contributes capital to the LLC and has an ownership interest.

Unlike a capital interest, profits interests do not represent ownership in the LLC. Instead, they most commonly represent claims to the future appreciation of value for the LLC based on the profits interests “liquidation threshold”.

Learn more about equity incentive plans for LLCs

What is the liquidation threshold?

Profits interests are often assigned a liquidation threshold on their grant date, which is typically equal to the proportional equity value of the underlying LLC. The liquidation threshold is oftentimes referred to as the distribution or hurdle threshold. This threshold is set at a level such that the profits interest would be entitled to $0 of the LLC’s exit proceeds if the LLC were to hypothetically “liquidate” on the profits interest’s grant date. This is unlike a capital interest, which is immediately entitled to exit proceeds on their grant date, subject to other liquidation rights and preferences.

If the recipient of an LLC interest only has a right to share in the appreciation of the LLC’s value growth after their grant date, the interest is a profits interest. If the recipient of the interest has a right to share in the LLC’s value on and after their grant date, the interest is a capital interest. The liquidation threshold serves to avoid the unintended reclassification of a profits interest into a capital interest. The distinctions between a capital interest and a profits interest are important for taxation purposes.

Example exit scenario

For example, assume the LLC’s equity value is $10 million on the profits interests grant date, and therefore the liquidation threshold of those profits interests would be $10 million. If the LLC hypothetically liquidates on that grant date, based on the liquidation threshold, it is required that $10 million first be paid to prior outstanding equity holders, leaving $0 of exit proceeds for the newly granted profits interests. However, if the LLC were to exit on a future date for $12 million, those profits interests would be entitled to participate pro rata with the capital interests in $2 million of the exit proceeds.

Security type

Ownership percentage

Liquidation threshold on grant date

Hypothetical exit proceeds on grant date

Exit proceeds on future date*

Profit interest

50%

$10M

$0

$1M

Capital interests (e.g. common units)

50%

N/A

$10M

$11M

*Assumes an exit value of $12M

This example does not consider vesting, and assumes the liquidation threshold is established based on the equity value of the LLC as opposed to the equity value on a per unit basis, which would be similar to the strike price of an option.

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It’s important to note that the profits interest units received by an employee do not have any value when granted. Instead, the LLC’s value has to increase for the employee to receive any future payout. Then if the LLC were to liquidate after several months or years, the employee would be entitled to a payout according to the percentage of their holdings and vesting requirements.

Profits interest tax treatment

A capital interest received for services may be taxable as compensation. There can be additional tax obligations as the interest vests, unless the holder files a timely 83(b) election. The capital interest is also subject to capital gains tax if sold at a later date.

A profits interest is not taxable as compensation when granted. This special tax treatment requires that the liquidation threshold is equal to the existing company valuation at the time of grant (similar to setting the strike price for options by 409A valuation). Accordingly, assuming the profits interest holder files a timely 83(b) election, their proceeds from their profits interests distribution or disposition will only be subject to capital gains tax, thereby potentially receiving more favorable tax treatment than capital interests. This tax treatment assumes the holder receives the profits interest in a partnership capacity or in anticipation of becoming a partner.

As a caution, even when following the rules above, a profits interest will lose its favorable tax treatment under the following circumstances:

  1. If the profits interest relates to a substantially certain and predictable stream of income, such as income from high-quality debt securities or a high-quality net lease.

  2. If the profits interest holder sells the profits interest within two years of receipt.

  3. If the profits interest is an interest in a partnership that is traded on an established securities market or any secondary market.

Carta provides liquidation threshold and profits interest valuations

An LLC issuing profits interest units must determine the LLC’s value to establish a liquidation threshold for the profits interests on their grant date, and the LLC must keep an accounting of that value for the benefit of existing profits interest holders. Carta keeps a record of thresholds using our cap table tool and valuation ledger so that LLCs know the threshold that has been granted to all outstanding profits interests.

Carta valuations offer liquidation threshold and profits interest valuations for LLCs alongside our 409A service. With the support of Carta’s cap table management platform and in-house LLC valuation analysts, we help LLCs offer equity and profits interests to their employees.

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