Equity Compensation and Profits Interest Incentive Structures in Companies

With the end of the fiscal year approaching, we continue to see an uptick in the number of clients seeking counsel on structuring equity incentive plans. As our clients take a look back at the prior year’s performance and a look forward to tax planning and financial strategy for the upcoming fiscal year, often now is a time when clients will consider implementing an equity-based incentive structure. The use of equity-based incentives remains a central strategy for our clients seeking to attract, retain, motivate, and compensate employees and independent contractors. As the formation of partnerships — including limited liability companies (LLCs) classified as partnerships for income tax purposes — has proliferated, so too has the issuance of profits interests as a primary form of equity compensation in these entities.

This article outlines the key considerations in structuring equity grants and profits interests, with a focus on their tax treatment, compliance requirements, and common pitfalls.

Equity Compensation Structures

In corporations, equity compensation plans typically include restricted stock and stock option grants. These awards are designed to align the interests of recipients with those of the company, providing value that increases as the company grows. Vesting schedules may be based on time or performance milestones, and, importantly, such grants are generally structured to avoid immediate tax liability for the recipient at the time of grant.

For partnerships, including LLCs classified as partnerships for income tax purposes, profits interests serve as the primary equity incentive plan structure for our clients’ employees and independent contractors. The flexibility inherent in partnership structures allows profits interests to be tailored in numerous ways, including entitlements to current operating cash flow, capital event proceeds from liquidity events, and/or returns tied to specific subsidiaries, business lines, or assets. Profits interests also offer important tax benefits, including, not being immediately taxable at issuance and allowing the recipient’s proceeds to potentially be taxable at lower rates applicable to long-term capital gain (as opposed to ordinary compensation income).

The primary constraints on profits interest-based equity incentive structures are the complexity of the underlying documentation, the accompanying drafting, and the ongoing administration of the plans, as well as tax considerations.

Sponsor and Investor Structures

A common sponsor structure involves sharing promote interests (or carried interests) in a parent entity that receives promote distributions from underlying business entities. This approach can facilitate alignment among sponsors and investors while providing flexibility in the allocation of profits interests to employees and independent contractors.

Tax Requirements and Considerations

A critical tax requirement for profits interest grants is that, at the time of issuance, the profits interest must not entitle the recipient to any share of the existing value in the entity (i.e., have zero value at grant). In other words, if the entity’s assets were sold at fair market value, all liabilities were satisfied, and the remaining proceeds distributed in liquidation, the profits interest holder should not be entitled to any of the net proceeds. Where the entity has existing value at the time of issuance, care must be given to ensure the profits interests may only participate in future appreciation above that existing value threshold, commonly referred to as a “hurdle.” Additional tax considerations include compliance with certain safe harbor requirements, proper allocation of profits and losses, availability of tax distributions, and the potential for recipients to make “protective” Section 83(b) elections. In some cases, catch-up allocations may be used to eliminate the hurdle and align interests more closely with other equity holders, provided they are structured properly to not potentially jeopardize the tax treatment of profits interests.

A recipient of a profits interest will also become a “partner” in the issuing entity and subject to applicable partnership tax reporting and compliance obligations. These requirements can be complex, including estimated tax payments and tax return filing obligations in multiple state jurisdictions. Employees and independent contractors used to receiving only compensation income (e.g., on W-2s or 1099s) should be made aware of these ongoing obligations to avoid potential surprises.

Securities Law Compliance

The issuance of profits interests typically constitutes a securities transaction, requiring compliance with federal and state securities laws. On a one-off basis, issuances may rely on exemptions such as Regulation D for accredited investors. For plan-based issuances, Rule 701 under federal law and corresponding state exemptions applicable to stock option plans are commonly utilized. Both federal and state law exemptions impose specific requirements for plan-based issuances, which should be carefully adhered to so as to avoid running afoul of federal and state securities laws.

Common Pitfalls

Frequent mistakes in the implementation of profits interest and equity compensation plans include failure to properly structure the interests to meet tax requirements, inadequate documentation, and noncompliance with securities laws. Careful attention to drafting, administration, and regulatory compliance is essential to avoid adverse tax consequences and potential liability.

While equity compensation plans and profits interests grants are powerful tools for incentivizing key personnel in both corporate and partnership structures, their successful implementation requires careful consideration of tax, securities, and administrative requirements. Accordingly, sponsors and investors should work closely with legal and tax advisors to ensure that equity awards are properly structured and compliant with applicable laws. Please do not hesitate to contact us with any questions you may have regarding this process.