Business owners who wish to offer employees a percentage of future profits may be considering a profits interest method for doing so. This can be a beneficial opportunity for all involved.
Before you offer profits interest, it’s important to make sure it’s the right option for your business. Once you’ve done that, you need to be sure to implement it properly to achieve the goals you have. Here’s what you need to know about profits interest to put you on the right path forward.
What Is Profits Interest and Why Does It Matter?
Profits interest is a share in the company’s future growth. It is a type of equity right based on the future value of a partnership that is awarded to a person for their service to the company. This award is in the form of a percentage of the company’s profits – even though the individual did not contribute capital to the company.
Profits interest makes the individual you name a partner in the business. It is only available for companies that are taxed as partnerships. If that is the case, your organization may wish to pursue this opportunity as an incentive in the form of compensation.
As a type of equity compensation, it may be used to help give workers an incentive to remain with the company and to work towards company goals. Sometimes it is used when monetary compensation is difficult due to funding limits, especially in startups.
Things to Note About Profits Interest
Profits interest is often structured like a stock option. That is, there are often vesting terms as a component of the package. That means a person may need to serve the company for a specific amount of time before they gain access to profits interest. Other times, vesting may require meeting a specific performance goal before they can claim profits interest. It’s possible to structure this in several ways to meet the goals of the company and, therefore, to make the process worthwhile.
Another important factor is to consider what happens once it is claimed. At that point, the employee is not considered a partner with the company. That means the person is now technically self-employed and no longer an employee of the company. It’s necessary to update their status when filing taxes at this point.
Implementing Profits Interest in Your Business
Once you learn how well profit interest fits your business needs and goals, it’s time to implement profit interest into the company. This is not as simple as just creating a single document. Rather, there are numerous steps to consider to ensure the process goes well and the best interests of your business are maintained throughout. Here are a few steps involved in that process.
Step 1: Review Your Partnership or Operating Agreement
It is somewhat common for organizations to need to make adjustments to their existing partnership or operating agreement to allow for profits interest. This needs to be done specifically to limit the rights of partners and to understand the provisions within these agreements for adding partners. A second option is to add a new class of equity for profits interest that will limit the rights of employee-equity holders.
Step 2: Create Terms for the Grant
Write out specific and clear terms and conditions of the profits interest. This should provide all details of the offer to current employees and future partners, so they know what they are receiving, what limitations are in place, and what their rights are throughout the process.
This agreement outlines the value above which the employee will be able to participate. It should outline the agreed-upon value of the company on the specific date of issuing the grant to eliminate any risk of dispute as to the value of the company with the employee’s share of appreciation.
This statement should outline all factors involved include the vesting schedule, contractual rights the company maintains, and restrictive covenants to protect your business.
Step 3: Consult with Your Accountant
Incorporating profits interest into your business may prove beneficial, but it can also be complicated. That is why it is so important to have a team of professionals available to provide guidance throughout the process.
Profits interest must be recorded properly. If not done so, you and your employees may face expensive tax problems down the road. Accountants can help to ensure there is oversight in place to minimize these risks.
At Pasquesi Partners, we are experts on tax topics such as profits interest. We’ll provide you with insight and support as you work through this consideration and in determining the advantages it may bring to your business. We will also ensure everything is prepared and implemented correctly should you decide to go forward with it to minimize any risk down the road.Contact us today to learn more about the work we do and how our team of dedicated professionals can help you!