What are profits interests?
Limited Liability Companies (“LLCs”) can issue capital interest units and profits interest units.
Capital interests are commonly issued by C-Corporations, such as the issuance of common stock and preferred stock, options and warrants. Alternatively, profits interests are best defined as anything that is not a capital interest and are commonly issued by LLCs.
There are very limited requirements for profits interest units. Accordingly, this article summarizes the baseline mechanics and benefits of profits interest units, along with key requirements and definitions.
What distinguishes a capital interest from a profits interest?
Profits interests are often assigned a liquidation threshold on their grant date, which is typically equal to the equity value of the underlying LLC. The liquidation threshold is oftentimes referred to as the distribution or hurdle threshold. Either way, this threshold ensures the profits interest would be entitled to $0 of the LLC’s exit proceeds were the LLC 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.
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 liquidated 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 in $2 million of the exit proceeds. This example does not consider vesting, and assumes the liquidation threshold is established based on the equity value of the Company as opposed to the equity value on a per unit basis, which would be similar to the strike price of an option.
In summary, if the recipient of an LLC interest only has a right to share in the appreciation of the LLC’s value subsequent to 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 subsequent to their grant date, the interest is a capital interest. The liquidation threshold discussed above is simply a mechanism 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, which we summarize next.
How are profits interests taxed?
A capital interest may be taxable as compensation upon vesting, or as of the grant date if the interest is not subject to vesting or if the holder files a timely 83(b) election. The capital interest is also subject to long-term capital gains tax if sold at a later date.
A profits interest is not taxable as compensation upon granting because the liquidation threshold renders it effectively worthless on its grant date. Accordingly, if the profits interest holder files a timely 83(b) election, their profits interests will only be subject to long-term capital gains tax, thereby receiving favorable tax treatment over 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 over capital interests under three 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 within two years of receipt, the profits interest holder disposes of the profits interest; or
(3) if the profits interest is an interest in a partnership whose interests are traded on an established securities market or any secondary market.
Carta provides liquidation threshold and profits interest valuations
Valuation complexities associated with issuing profits interests are a potential drawback. 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 Valuations offers liquidation threshold and profits interest valuations for LLCs alongside its experienced 409A service. With the support of Carta’s cap table management platform and in-house LLC valuation analysts, Carta can help LLCs avoid the unintended reclassification of profits interests into capital interests by setting valid liquidation thresholds at an annual cadence or per material event, and by maintaining an accounting of all outstanding profits interests.
As of today, Carta provides valuations and cap table management software to hundreds of LLCs and the vast majority have profits interests.
To talk to an expert and learn more about how Carta helps LLCs with valuations and cap table management, request a demo.
DISCLOSURE: This publication contains general information only and Carta Valuations, LLC (“Carta”), an affiliate of eShares, Inc. dba Carta, Inc., is not, by means of this publication, rendering accounting, business, financial, investment, legal, tax, or other professional advice or services. This publication is not a substitute for such professional advice or services nor should it be used as a basis for any decision or action that may affect your business or interests. Before making any decision or taking any action that may affect your business or interests, you should consult a qualified professional advisor. This communication is not intended as a recommendation, offer or solicitation for the purchase or sale of any security. Carta does not assume any liability for reliance on the information provided herein.
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