Incentivizing Employees with Profits Interests

We often are asked by our clients if there is a way to incentivize key employees by granting them equity in the company while also providing those employees with the ability to obtain capital gains treatment upon the sale of the company’s business. Adding another layer of complexity is the desire that the issuance of such equity does not result in a taxable event.

If the client operates through an LLC, then all these items can be accomplished by granting profits interests to those key employees. Without delving into too much detail, a profits interest provides an employee with an ownership interest in the company that shares in the growth of the business commencing on the date of issuance of the profits interest (meaning that the value of the company needs to be established as of the date of such issuance). Further, subject to certain holding period requirements, the employee could receive long term capital gains treatment with respect to such issuance upon the sale of the business. Because the employee only shares in the growth of the business after the date of issuance, the value of the profits interest itself is typically Zero Dollars (assuming that the current valuation of the business is accurate), as the employee would not receive any money if the company were to liquidate on the date of issuance of the profits interest.

The manner in which profits interests should be structured for a particular client, including vesting and forfeiture considerations and whether the key employees should receive the first distributions above the current value of the company or only share in the growth of the business, depend on the client’s goals. Additionally, the key employees may need to file an 83(b) election with the IRS within thirty (30) days of issuance of the profits. Suffice it to say that given the intricacies and complexities of issuing profits interests, it is highly recommended that clients obtain competent legal advice to walk them through this process.