Granting a Profits Interest as an Incentive to a Key Employee

Granting a Profits Interest as an Incentive to a Key Employee

What options are available for rewarding a key employee whose work has been crucial to the success of that company? This question comes up often for growing businesses with talented and enthusiastic employees that want to make sure those employees stay where they are.

Growing companies can be cash-poor, so ownership or ownership-like forms of compensation, rather than additional cash compensation, can be appealing. However, this requires careful thought on the part of the business owner and the employee. Business considerations include the following four factors:

Does this employee possess a unique skill that’s vital to the success of the business? What are the long-term plans for this business? Will it be eventually sold to the employee or an outside investor? Will this employee make a good future business partner? Are the current owners comfortable with giving up some portion of control of the business?

However, many of the available options require the employee to pony up cash, which may not be feasible or desirable. Purchasing shares of a company can be a substantial investment, and granting an ownership interest in the company triggers taxable compensation income to the employee when that interest vests.

How We Solved That Issue With a Client at my Dormer Firm

Smith Company, LLC, was a single-member limited liability corporation that had been taxed as an S corporation since 2002. Brian Smith, the sole shareholder, wanted to reward and keep his second in command, Lisa Jones, on board.

All of the options that would have kept the S corporation status intact would have required either a substantial financial investment from Jones or a big tax bill for her, but these options were not acceptable to her. Jones wanted a true ownership interest, so a phantom stock plan or stock appreciation rights were also off the table. At an impasse, Smith and Jones began exploring the option of liquidating the S corporation and reforming as a partnership. This is where they found a solution.

Partnership law includes a provision for granting a “profits only” interest. As long as the IRS safe harbor provisions are followed, granting a profits interest to a key employee is a tax-free event. The holder of a profits interest benefits from the future growth of the company, but the value of their interest does not include the company’s current value.

Details of the safe harbor provisions can be found in revenue procedures 93-27 and 2001-43. Chief among these provisions is that the profits interest holder must now include his or her allocated share of partnership income in taxable income, which will be reported on Schedule K-1; the holder also cannot dispose of this interest for two years.

As a partner, the holder no longer receives W-2 wages, but instead receives guaranteed payments. He or she now also pays self-employment tax on guaranteed payments and on the share of self-employment income from the partnership.

Switching to a partnership had tax consequences for Smith and Jones. For Jones, this meant that tax filing would now be more complex than simply handing her accountant a W-2. She now had to make estimated tax payments from her cash distributions from Smith Company, but with help from our firm, this was pretty simple for her.

Smith bore a much larger burden. Besides losing the tax-saving advantages of an S corporation, he also picked up a taxable gain on the liquidation of the S corporation. But, Jones was too valuable to the business to risk losing, and Smith was willing to pay the price to keep her. 

Under the check-the-box regulations, Smith Company made an election on Form 8832, Entity Classification Election, to change its classification to that of a partnership. Using this approach, the corporation was treated as if it had sold its assets net of liabilities to Smith at fair market value. Then, Smith contributed the assets – now with a stepped-up basis – to the new partnership in exchange for an interest in the partnership.

Three years have since passed, and this arrangement has been a success. Invigorated by her 30 percent profits interest, Jones’ commitment to the company has strengthened and the company’s revenues continue on an upward trajectory. For Smith, the increase in revenues and profits, plus the assurance of Jones’ continued engagement, has more than made up for his higher tax bill.