Profits interest units

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Profits interest units

Profits interest units (PIUs) are the most common form of LLC incentive equity. Upon a sale of the company, PIU holders—who are considered members or partners—receive a percentage share of the proceeds, based on the increase in the company’s value that occurred during the time they held the PIU.

Typically issued to: Mid-to-upper-level management

Plan highlights

Free for recipients

Free for recipients

Employees can benefit from your company’s growth without having to pay for this equity

Share of future profits

Share of future profits

Company’s threshold value is set at time of grant, and profits above that are shared with recipient

Payout protection

Payout protection

Existing owners retain their share; all payouts to new shareholders come from future growth

Tax Icon

Tax-advantaged

Taxed at long-term capital gains rates and only when cashed out, if handled correctly

Potential cash distributions

Potential cash distributions

Can be structured to share annual profits with employee-partners

Common variations

PIUs with catch-up provision

Profits interest units with a catch-up provision have greater economic value compared to regular PIUs and may help attract key hires.

 

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PIUs with separate holding co.

This version of regular PIUs can be useful if you want employees to continue receiving W-2s and avoid self-employment taxes.

 

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PIUs are the most common type of equity grant made by LLCs, and for good reason—unlike traditional stock options, employees don’t have to purchase them, and they don’t have to pay Uncle Sam when they’re granted. It’s a win-win for the company and for employees.

Haley Ayure and John McGrady
Buchanan Ingersoll & Rooney

What are profits interest?

A profits interest is an equity stake in an LLC’s future economic growth. For example, if a company is sold for a higher value than it had when the equity was granted, the holder receives a percentage of that difference.

The idea is that recipients of this type of equity will be incentivized to help the company grow in value, since they may personally profit from that growth.

Unless specifically structured to do so, a profits interest does not entitle the holder to an ownership stake in the company’s existing value or capital assets at the time of the PIU grant—only the growth in value that happens after they were granted the PIUs.

(For information on a different equity type that includes a stake in the existing value of the company payable from future profits, see the section ”Profit interest units with a catch-up provision.”)

How it works

The recipient of a profits interest unit participates in a percentage share of any proceeds from the sale of the LLC that exceeds the company’s Fair Market Value when the profit interest was granted.

This baseline value calculation at the time of the grant is known as the “threshold value” (or “hurdle value”).

Another way to think of this: The Day One value of any profits interest granted is $0, increasing as the company’s value increases over time.

To grant a profits interest, a company typically will rely on a third-party valuation analysis to establish the threshold value. This snapshot of the company’s valuation ensures that the current value of the business is locked in for existing owners, and makes clear what level of value must be exceeded in a sale for newer PIU holders to begin participating in profits.

An example

  1. XYZ LLC offered a profits interest plan to its employees on July 1, 2023. As of that day, its fair market value is $1M. That means recipients will only be paid out on money collected in the sale of the company over and above $1M.
  2. Eve Employee is granted 1% of XYZ LLC as a profits interest, which will vest over 4 years.
  3. The company was sold on July 1, 2028, for $5M.
  4. Eve Employee will be paid 1% of $4M or $40,000 since she does not participate in the first $1M of the sale as that was the threshold value associated with her profits interest.*

A profits interest plan is governed by its plan document (which can be incorporated into the LLC operating agreement), the LLC operating agreement, and the individual grant agreement.

Founders and executives of an LLC can structure the profits interest plan to allow participants a variety of rights, including transferability, vesting, annual participation in distributions (if any), or forfeiture on departure from the company.

*simplified scenario; does not include potential dilution by other shareholders

Advantages

Employees don’t have to pay

There’s no payment needed by recipients to acquire the profits interest—it is granted by the LLC and entitles the recipient to benefit from the future growth of the company.

Contrast this with more traditional corporate equity awards, which can sometimes require a sizable cash payment by the employee. For example, employees who have stock options, a common form of corporate equity, must buy shares at a predetermined “strike price” to be able to profit from the company’s future growth. Even if the strike price is a small amount, the employee may have to pay hundreds or thousands of dollars to exercise their options, depending on the specifics of the stock option grant.

Preferential tax treatment for holder

Profits interests are considered a tax-advantaged form of equity because holders may be taxed based on the value of the asset at the time of the grant, which for tax purposes is considered to be zero, rather than when it vests, when there might be an increase in valuation and a taxable event. Filing an 83(b) election within 30 days of the grant is typically done as a protective measure; other requirements for the tax safe harbor for profits interests also need to be satisfied. (See more on how 83b elections can save equity holders money on their taxes.)

When sold, PIUs may be taxed at long-term capital gains rates, assuming applicable holding periods are met, rather than ordinary income tax rates, which in most cases are significantly higher.

Payout protection for existing owners

PIUs safeguard potential payouts on current LLC value for existing owners, because PIUs are pegged to the company’s Fair Market Value or “threshold” at the time of any new grant. In the event of a payout, as in a sale or change of control of the company, members do not get a share of the value that was created by previous recipients.

This protection can be particularly attractive to existing owners because they get to keep the value that they built thus far, and only share in the future increased value with their employees.

Incentives aligned among employees, company

Because profits interests only provide the holder a slice of equity that they directly helped create, recipients are incentivized to do their best work, stick around longer, and contribute more, since they’re going to want to create as much value as possible to increase the value of the company and, as a result, their equity. This makes it easier for company leaders to communicate and foster a team-oriented “ownership culture” within the organization.

Potential cash distributions

PIU holders could also benefit even without an “exit” event like a sale of the company, if the PIU is structured to provide annual distribution of profits.

Considerations

Impact on employee status and benefits

Employees who receive PIUs become a member or partner of the LLC. Although such persons may be considered to be “employees” for labor law purposes, the IRS has long taken the position that an LLC member cannot be treated as an employee for tax purposes. In addition, members or partners will receive a Schedule K-1 tax form rather than a W-2 from the LLC, and they will have to file and pay taxes as self-employed. Depending on your company plan’s policies, some employee benefits, such as 401(k) plans, may not be available to non-employees.

Some companies try to avoid this conversion of employee status by structuring the profits interest program to have the awards issued by a separate entity that holds equity interests of the operating company. (For more on this variation of PIUs, see the section ”PIUs from a separate holding company”.)

Profits limited to future value growth

For some employees, especially key hires, the PIU structure could be a disincentive because it does not enable the holder to participate in the value already established for the company. As a way around that, LLCs can grant PIUs with a “catch-up” provision to enhance the potential profits for the recipient. (For more on this variation of PIUs, see the section ”PIUs with a catch-up provision”.)

Ongoing administrative burden

A profit interest plan requires more administrative work than other LLC equity types, such as phantom equity or options to acquire units. For some companies, especially those with robust internal finance, tax, and human-resources teams, that additional work may be outweighed by the benefits to the company and the holders.

Here are some of the administrative requirements for PIUs:

Multiple PIUs to track: As you grant equity in your company over time, you will have multiple equity holders, who may have different Fair Market Value or “threshold” amounts tied to their equity grants. All of this must be accurately tracked, so that cash distributions and liquidity events are handled correctly and everyone is rewarded properly according to their equity. (Carta offers a full platform to handle LLC equity management.)

Company governance requirements: New partners or members must be admitted to the LLC in accordance with the LLC’s governing documents. This requires legal paperwork and accurate record-keeping.

Regular valuations required: Your company will need to establish valuations regularly. You don’t need to conduct one every time a new grant is issued, but they should be conducted fairly regularly, typically annually or following any material events that may impact company value.

Reporting requirements: Your company must make annual reports and provide disclosures to stakeholders, depending on the information-sharing rights provided.

Preparation of tax documents: Your company must prepare Schedule K-1 forms for each partner—a tax document that breaks down each LLC partner’s share of the partnership’s income, losses, deductions, and credits for a given tax year. As a pass-through entity, the LLC is not taxed directly—taxes are passed through to partners.

Tax treatment

For the company:

There are no particular tax benefits for a company issuing PIUs—there is no tax deduction, either at the time of the grant or in the event of liquidity. However, at the time of exit or other distribution on the PIUs, the PIU holder’s share of proceeds are directly taxable to that holder, thus providing an “effective” tax deduction to the other members.

For employees:

Capital gains tax: In a liquidity event, such as the sale of the company that results in a cash payout to the PIU holder, that payout is generally taxed at a capital-gains tax rate instead of higher ordinary income tax rates, if qualifications are met.

Self-employment tax: As LLC partners, PIU holders are no longer considered W-2 employees for tax purposes, as the IRS takes the view that they cannot be both employees and partners of the same entity. This means wages will be paid in the form of a “guaranteed payment” on a K-1. The company no longer withholds taxes, and the partner must file self-employment taxes and withhold/pay their own quarterly taxes. There is a workaround that allows a holder to maintain being an employee of the company by utilizing a separate holding company structure to hold the PIUs. Then the employee would get both a K-1 in the holding entity and a W-2 for the main company—see below for information on the equity type “PIUs with separate holding company structure”.

Pass-through company taxes: As a pass-through entity, the LLC is not taxed directly—taxes are passed through to partners or members. If the company is running profitably, this could pose a significant tax burden on those who hold PIUs. Many LLCs choose to include a provision in their operating agreement providing for mandatory distributions to cover the tax payments required to be made by their partners or members. This kind of mandatory tax distribution provision, however, is not always included, so it is important to understand and determine whether your LLC will make mandatory tax distributions. Even when an operating agreement provides for mandatory tax distributions, there are almost always exceptions, such as when the company does not have sufficient funds or needs its cash to fund debt obligations or other priorities.

83(b) elections: Profits interests are considered to have zero value when granted (not because the company does not have value, but because all existing value of the company is “locked in” for existing members at the time of each PIU grant). With most types of company equity grants (such as stock grants by corporations), which are subject to vesting, the employee will typically be required to file an 83(b) election within 30 days of the grant in order to avoid adverse tax consequences which would otherwise arise upon vesting. With a PIU, 83(b) elections are typically filed by the grantee on a protective basis.

It is important to understand that the 83(b) election (whether protective or not) must be filed with the IRS within 30 days after the grant date—no exceptions.

Cash distributions: Periodic distributions from operating profits would be taxable for PIU holders. In this case, the cash distributions would be taxed as ordinary income.

DISCLAIMER: This publication contains general information only and Carta 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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