Profits Interests 101: Part I – A Crash Course in Profits Interests

As executive compensation attorneys, we hear this question from our clients frequently. In Part I of this two-part series, we will provide a conceptual introduction to profits interests, which come with special tax advantages – but also pitfalls. In Part II, we will introduce a framework for assessing an offer of profits interests.

1. WHAT IS A PROFITS INTEREST?

A profits interest, also known as “carried interest” or “promote,” is an equity interest in the future appreciation of a partnership (or an LLC that is taxed as a partnership). Profits interests are sometimes described as options, but there are some key differences between the two types of incentives. For one thing, with a profits interest, you become a partner for tax purposes from the date you receive your award; you don’t need to exercise your profits interests or pay a strike price. In addition, if properly structured, a profits interest will not trigger W-2 compensation income to you, and may offer an immediate capital gains opportunity depending on the nature of the distributions you receive.** And finally, in comparison to the “plain vanilla” economics that we typically see with options on common stock, the economic rights of a profits interest can be highly bespoke and negotiable, particularly for a company’s most senior executives.

** Because they can turn compensation into capital gains, profits interests have frequently faced legislative scrutiny -- most recently as part of the initially proposed version of the Inflation Reduction Act of 2022. Under that early version of the bill, carried interests held by covered investment services professionals would have faced additional hurdles to eligibility for long-term capital gains treatment. (Bottom line: Many investment managers would have faced higher taxes on their awards.) While the law as ultimately enacted did not close the so-called “carried interest loophole,” don’t be surprised if Congress considers enacting a similar reform again down the road.

2. HOW DO YOU VALUE A PROFITS INTEREST?

As a baseline, in order for your profits interests to qualify for the intended preferential tax treatment (never treated as compensation, and immediate capital gains opportunity), they need to have a “day 1” value of $0, meaning that if the company liquidated on the date you received your award, you wouldn’t receive even a penny in distributions. Rather, you would only share in the value of the company to the extent it appreciates following your grant date. As a result, one critical item to consider is whether and how distributions are limited for tax purposes (including how the company determines its “day 1” value – akin to the determination of fair market value in the case of an option strike price). If distributions aren’t sufficiently limited, a profits interest holder could face negative tax consequences as soon as the award vests. And conversely, if distributions are limited excessively, a holder could miss out on amounts that would be permitted under tax rules.

As an aside: It is generally prudent to make a so-called “83(b) election” in connection with your receipt of profits interests. In other contexts, an 83(b) election could require you to pay real taxes up front on a right that you may forfeit in future. But for profits interests, with their “day 1” value of $0, the 83(b) election is “protective.” That means the election will reinforce the intended tax qualification in future while not actually triggering taxes today. An 83(b) election must normally be filed with the IRS within 30 days after acquiring the profits interests. To avoid missing the deadline, you should be sure to get professional tax advice promptly at issuance.

3. OKAY, BUT I STILL NEED TO EVALUATE MY PROFITS INTEREST ECONOMICS. HOW DO I DO THAT?

Setting aside the tax-required “day 1” limitations, the ultimate value of a profits interest award will depend on a number of factors. The award size is certainly one factor to consider, including in relation to the larger management pool and other individual management awards. However, additional business terms will impact the bottom line. While these terms may well be non-negotiable and outside of management’s control, you should know what economic deal you’re getting before agreeing to your award. Among the items to consider are:

• Current capitalization: There may be other classes of interests outstanding, including preferred classes. And some interests may have priority distribution rights that will eat into the company’s future appreciation.

• Future dilution: If new investors or additional profits interest grants are anticipated, they may have a dilutive effect on the value of your profits interests. Conversely, you may receive a windfall if other profits interest holders leave before a major distribution event.

• Participation rights: Partnership “waterfalls” (the rules of participation by owners in distributions) can get complicated. Often, there is a single path that a distribution takes, but sometimes that single path splits into two (or more) parallel paths. In addition, profits interests may participate in distributions immediately upon vesting, or only upon a change in control or other triggering event. Profits interests sometimes receive, and sometimes miss out on, distributions that were made before they vested. And profits interests sometimes participate in distributions to the maximum extent permitted for tax purposes, or may have a performance threshold on top of the tax carveout (for example, participation only after the sponsor has taken back a specified multiple on its investment or achieved a specified internal rate of return).

• Expected company appreciation: The owner, sponsor or investor may expect to lock in a specific amount of growth before it puts itself up for sale (if a sale is the ultimate business goal). This might also take time. How long does the sponsor plan to wait until an exit?

4. WHAT DOES IT MEAN TO BECOME AN EMPLOYEE-PARTNER?

You cannot be both a W-2 employee and a partner of a single entity (or of separate entities that file a consolidated tax return). This has all sorts of impacts on both you and the company, mainly in the areas of (i) tax reporting and withholding and (ii) employee benefit plan participation. You’ll be a partner of the issuer of the profits interests, and the income attributable to your interests will be reported on Schedule K-1. This might complicate your tax returns if you have never been a partner before. Some employers solve for this by getting into compliance with the tax rules; others solve for this by keeping the profits interest entity separate from the employer entity for tax purposes; and still others simply fail to comply, which can have negative tax and benefits consequences for everyone – the company, you and even your non-partner colleagues. We recommend speaking with an executive compensation attorney or tax professional to make sure you aren’t sacrificing legal and tax compliance by accepting a profits interest award.

Bottom line: Profits interests offer a tax-efficient way to participate in company growth, but their economics can get very complex. And if they are poorly designed, you may face adverse tax consequences as well as a disappointing return.

Zahava Blumenthal, Esq. is an executive compensation attorney who advises regularly on the topic of equity-based incentives, including profits interests, stock options and restricted stock units. She can be reached at zahava@cohenbuckmann.com.

Would you like to consult a lawyer for advice about profits interests? Submit the form below and we’ll contact you directly to see how we can help. While legal fees will vary depending on the specifics of your matter, $2,000 to $4,000 is a typical range for review of the legal, tax and business terms of a profits interest grant, including the related partnership or operating agreement.

Want to learn more on your own? Please share your contact information below to access Part II: Seven Key Questions Executives Should Ask About Their Profits Interests.