Lesson #136: Save Taxes With "Profits Interests" vs. "Stock Options"

I recently read an interesting article on how startup employees with material equity stakes can materially save on their long term capital gains taxes, written by Ken Obel, a startup attorney at GoodCounsel here in Chicago.  Ken was gratious enough to let me share it with all of you.

Many startups launch their companies as limited liability companies (LLCs), enjoying the flexibility and tax-efficiency that this type of entity offers (please re-read Lesson #56 for more details here).  A lesser known, but quite significant, advantage of LLC’s is the ability to provide incentive equity in the form of “profits interests”, instead of the more typically seen stock option plans used for incentivizing employees.  A profits interest allows an LLC to give service providers option-like equity without the need for these individuals to put money at risk in order to obtain long-term capital gains tax treatment.

Consider the following example.  In the traditional startup, a company issues options to a new employee priced at the company’s then-fair market value of $1 per share. Issuance of the options has no current tax impact, however, if the employee exercises the options when the company is later acquired at a price of $3 per share, the gain or “spread” of $2 per share will be taxed to the employee at short-term capital gains rates – which can be as high as 35% depending on your income. This is because the holding period for the equity starts upon exercise of the options, not their issuance. Wouldn’t it be better for the employee to exercise the options and hold the underlying equity for a year, in order to receive long-term capital gains treatment at the time of sale -- lowering their tax rate closer to 20%? Of course. But this requires the optionholder to come out of pocket to pay the exercise price (with cash they may not have) and to take the risk that during that year, the equity may lose its value. Few employees will take that risk, and will instead hold the options until a profitable exit is at hand, swallowing the significantly higher tax rate as the price of reducing the risk.

In an LLC, a profits interest is economically equivalent to an option. If a unit of LLC equity has a value of $1, a profits interest issued at that moment comes with a right to participate only in those proceeds of a liquidity event that are in excess of that dollar. (This “hurdle amount" is the economic equivalent of an option's exercise price – both serving to ensure that the optionholder participates only in the economic value he or she participates in creating.) But, unlike an option, which is not "property" (in the view of the IRS), the profits interest is property, and therefore, the capital gains holding period begins to run upon issuance – and the employee never has to come out of pocket with cash. In the previous example, when the company sells for $3 per share, the profits interest holder would receive his or her share of the proceeds beyond the $1 hurdle amount, or $2 per unit, and (assuming at least a year had elapsed between issuance and the sale) these proceeds would be taxed at the lower long-term capital gains rate.

What should you consider before issuing profits interests? First, you have to be an LLC, so you have to be comfortable that this is the right entity for you, your business and your investors (remembering most VC's will most likely require you to be a C-Corp in order for them to invest). Next, consider that profits interests are not the easiest form of incentive equity to explain to your employees. The typical employee understands what an option is; odds are they’ve never heard of a profits interest. But, one view is, if their incentive equity grant is significant, their tax savings from a profits interest stands to be worth a great deal in long term tax savings to them – enough for them to take a few minutes to understand how this works for their benefit.

The most significant negatives arise from the fact that a profits interest holder in an LLC is considered an equity owner, and equity owners are ineligible to be paid as a regular W-2 employee. Instead, the company must report all compensation on a form K-1 (relating to the partner). This has negative ramifications regarding the employee's responsibility for paying their own self-employment taxes and the deductibility of company contributions toward healthcare and other benefits.

These are issues that should be discussed with tax and legal advisors before making a decision about the proper form of incentive equity.  But, in cases where you have a material equity-owning employee, looking to acheive material long term capital gains tax savings, and is willing to deal with the "equity owner vs. employee" tax treatment along the way, this could be a good road to pursue.

Thanks, Ken, for sharing your wisdom here.  If anyone has questions from here, feel free to reach out to Ken directly at 312-380-9406, or e-mail him at the GoodCounsel website.

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