What is a “Profits Interest”?

Equity compensation is a non-cash pay that is offered to employees and represents ownership in the company.  This can come in many forms, such as restricted stock and performance shares and is a benefit offered by many public companies, as well as some private companies.  One of the forms of equity compensation that is offered to employees is called profits interest.

Profits interest is given to an individual for their service to the partnership and is based on the future value of the partnership.  This award consists of receiving a percentage of profits from a partnership without having to contribute capital.  Oftentimes, this is used to motivate employees when there is limited funds for monetary compensation, which is common among startups.

Aside from being a great incentive for employees, profits interest offers the following benefits:

  • Flexibility – Profit interests are made up of two parts, which are an annual profit allocation and liquidation value upon certain events.  Based on this design, companies can use different combinations in order to keep everyone happy.
  • They’re Accretive – The value of the profits interest depends on the success of the business in the future, which means it has no value at grant.  This means that business owners can feel comfortable giving this to employees since they know they’re only giving away a portion of the growth of their company.
  • It’s Taxed as a Capital Gain – The employee that receives the profits interest won’t have to pay any taxes at grant or at vesting.  They will pay taxes on capital gains upon liquidation, making it a great long-term incentive.

Profit interest is a great resource for both employees and employers.  That being said, the plan needs to be designed in order for both parties to receive the best outcome.  If you’re interested in learning more about profit interests or starting the process for your company, get help from an opportunity zones attorney.

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