- August 14, 2017
- Posted by: Akif CPA
- Category: Business Tax
You have been providing service or an employee of an upcoming company which is still in its growth phase. In order to keep the growth moving and keep you motivated, the Limited Liability Company decides to grant you profit interest. In this blog we will be discussing the basics of profit interest from view of non-employees/independent contractors, management, employees, directors, consultants, or investors who have received or will be receiving profit interest in a Limited Liability Company. So let’s start:
What is Profit Interest?
Profit Interests is a way for a company to grant a person or entity the right to receive LLC profit, loss, deduction, credit, gain, proceed from sale of company and distribution from the date of grant in future appreciation of the company assets, but not have any stake in its current or future equity capital. In other words, only share of future economic value.
Profit interest holders do not have the same rights awarded to capital equity holders, such as voting rights.
Biggest benefit of Profit Interest is that when it is granted and vested, it does not result in a taxable event if properly accounted by the company. Only when sold, that it results in a taxable event (presumably at capital gains rate)
Profit Interest are also called appreciation plan, incentive programs and other creative names.
Profit Interest can be restricted and unrestricted. A restricted profits interest is a profits interest that is non-transferable or is subject to a substantial risk of forfeiture.
Who are profit interests granted or issued to?
Employees from top to bottom such as staff, managers, consultants and advisors within the company to award, retain and attract them with the future growth of the company.
Non-employee (independent contractors) service providers.
Profit Interests can be a great tool for start-ups that are strapped for cash but want to leverage the future growth of their company.
What happens after grant of profit interest?
If an employee is granted a profit interest, he/she is no longer a W-2 employee, but rather a partner in a partnership for tax purposes from the date of grant and will receive form K-1 from the company.
Any payments in lieu of services made by the LLC to profit interest holder after the date of grant will be subjected to self-employment tax. Profit interest holder will be liable to make quarterly estimated payments to IRS which can be a complicated and daunting task.
Profit interest holder must not dispose of the interest within two years from the date of grant in order keep the transaction as a non-taxable event.
In conclusion, grant of profit interest is a great way for LLC to keep the growth on the right path but can also create challenges for employees and service providers in understanding the purpose and tax consequences.
We strongly encourage future or current recipient of profit interest to seek consultation to better understand the complexity of profit interest and IRS regulations. Please contact our office if you are interested in learning more about profit interest and service provide and employee tax consequences.
You must also be interested in reading Dual Status Taxpayer and Taxes if you are a resident alien AND a non-resident alien within the same tax year.