Special equity compensation known as profits interests (PI) are only issued by Limited Liability Companies (LLCs). They provide for a share of profit in the company after a specific point in time. These relatively new forms of equity have paralleled the growth in LLCs, as an alternative to C or S corporations. The PI is analogous to a SAR, stock appreciation right, in the C or S.
These rights are distinct from traditional common stock options, since the profits interest is a current, actual ownership in the LLC. However, so long as stock options are not granted in the money (equal to or less than fair value of the share), the grants are not taxed. Profits interests, structured in compliance with IRS “safe harbors,” are tax free to the recipient. The PIs do not represent an interest in the current firm value, but an ownership of the future growth. PIs are subject to vesting provisions, similar to stock options. And, they are granted solely for services rendered to the firm. The vesting may be time-based over a period of years. The alternative is to grant the interest as a result of the recipient and/or the company attaining predetermined goals. For tax purposes, once a profits interest is issued, the receiver is treated as a partner (versus a W-2 employee). PIs can also be granted to non-employee service providers, such as advisors, board members, and consultants.
To comply with the IRS “safe harbor” profits interests should be held at least two years. Also, they cannot be pegged to a certain stream of income, such as a profit sharing plan. Generally, they are not transferrable. If held for a year beyond the vesting, the redemption of the PI is treated as long term capital gain.
Unit Plan
Unit plans within an LLC are very much like phantom stock or SARs. Sometimes they are referred to as unit appreciation rights plans.
As part of the Unit Plan, the employer grants a hypothetical number of membership interests which vest over time. When the employee tax benefits is not a critical consideration, these plans allow for employee taxation (W-2 income). Thus, estimated tax returns and K-1 statements are eliminated.
Valuation
While an independent valuation is not imposed by statute, most advisors suggest that a professional valuation be conducted at the time of the grant. This establishes a defensible basis for the taxation of future benefits. The independent valuation also supports that the grant value is not less than fair value. Distributions of earnings to PI holders need not be in proportion to the equity interest. In some plans, funds distributions are based upon vested or allocated units. Often, partner capital interest returns must be met prior to any PI distributions.
The valuation must incorporate the economics of the equity capital. The LLC Agreement, as amended, will provide for a capitalization (cap) table similar to a C or S corporation. The document should distinguish contributed capital and preferred returns, as well as distribution rights for each class of units (not called shares). Since the PIs are based on future performance or benchmarks, an option framework is required. In other words, the payout of PIs is parallel to a call option. Some type of simulation of future occurrences is required, either by way of an option-pricing model or Monte Carlo analysis. Key considerations are the timing of distributions and the volatility of the enterprise’s capital equity. Other provisions of the LLC Agreement that add complexity to the valuation are:
- Dividends prior to a liquidity event
- Provisions for claw backs and “catch-ups”
- Varying preferred returns for invested capital