199A qualified business income deduction, W-2 wages are preferable to guaranteed payments. Reg. A profits interest can represent a flexible and tax-efficient tool for granting equity compensation to a service provider. There are also no ownership complications if employees come and go. Example: ABC sells to a third-party buyer and recognizes a net cash gain on the transaction of $5 million. “Capital interests” are LLC membership/equity interests which in most cases receive an allocation of LLC profits/losses, share in periodic distributions of LLC profits, and entitle the owner to a percentage of both the current value and future appreciation of the … Copyright © 2020, Jackson Lewis P.C.. All Rights Reserved. The incentive compensation objective sought by both parties was obtained without the complexities of ownership, where traditional ownership was not the primary objective. Sharing real equity or using phantom stock? Business owners and investors alike often use a profits interest grant (an equity-based incentive award) as a means to incentivize employees and protect the owners/investors’ interests in a company. Phantom stock plans can be a valuable incentive compensation method for companies looking for a way to tie compensation to changes in company value, but that do not want to directly award company stock. The primary owners would receive the remaining $4.5 million, for a net cash-in-pocket amount of $3,375,000. Same as profits interest. The award is usually contingent upon the phantom … Assuming an effective combined federal and state tax rate of 25% on the capital gain, this yields those employees a net cash-in-pocket amount of $375,000. By using the site, you consent to the placement of these cookies. Unless otherwise noted, contributors are members of or associated with Baker Tilly Virchow Krause LLP. Capital Interest vs. Profits Interest (Tax Consequences): The tax consequences of a grant of a profits interest in a partnership has evolved over the years. The client wants to know how to accomplish this objective without the complication of giving the five employees profits interests in the LLC, while retaining capital gain treatment. Proc. I. A profits interest holder Consider this common client inquiry: ABC LLC wants to allocate 10% of potential profits from any future exit transaction to a pool of five key employees. For these LLCs, the equivalent of an employee stock ownership plan and incentive stock options are not available. Profits Interest and why we need it Founders who still own and run their businesses may bring on executives to get to the next level and/or to free themselves from being a slave to their success. Businesses that are structured as partnerships or limited liability companies (LLCs) taxed as pass-through entities have a number of options when it comes to compensating and incentivizing their workforce and service providers. Over the coming year, we will be looking back at early issues of the magazine, highlighting interesting tidbits. Subscribe for free. 199A significantly complicates tax filing for affected K-1 recipients. Rather, they issue membership “units” as equity. For example, the phantom equity plan might be structured to require the bonus to be grossed up to yield the same net cash-in-pocket amount of $375,000. The key takeaway here is to think beyond the tax amounts that would affect a recipient and consider the net result for the aggregate group. Phantom equity is when you give your employees (or anyone else, for that matter) a contractual right to the proceeds of the company – profits, distributions, and proceeds from a sale – rather than actually giving them ownership in is a law firm with more than 900 attorneys in major cities nationwide serving clients across a wide range of practices and industries. When assisting a client with decisions of this nature, it is important to consider all aspects of the situation — not only the impact to the recipient of the award, but also the impact to all members of the business group. Changes to charitable giving rules for 2020, QBI deduction: Interaction with various Code provisions, Tax-saving opportunities for the housing and construction industries. For more information, please contact Adam Sweet , Todd Laney , or your local Eide Bailly tax professional. The January 2020 issue marks the 50th anniversary of The Tax Adviser, which was first published in January 1970. 93-27 –Provides guidance on what constitutes a profits interest and tax consequences associated with profits interests –Profits interest defined as an interest Recipient may receive allocations of Schedule K-1 income but no cash It is not literally a profit share, but rather a share of the increase in the value of the LLC over a stated period of time. RSM identifies nine frequently asked questions (FAQs) about phantom stock plans, an incentive compensation tool. Home > Deferred and Executive Compensation > Equity and “Phantom” Equity Based Compensation for LLCs. Profits Interest vs Capital Interest – What's the Difference? Named the "Innovative Law Firm of the Year" by the International Legal Technology Association, the firm’s commitment to client service and depth of expertise draws clients to Jackson Lewis for excellent value-driven legal advice. Furthermore, to maximize the benefit of the Sec. Entire treatises have been written about the tortured history and theoretical Vesting requirements can be attached to this interest. Phantom equity rights, like phantom stock rights, are generally subject to the Section 409A deferred compensation rules. What will be the impact on the primary owners? Phrases such as “restricted stock”, “stock options” and “stock appreciation rights”, all applicable to corporations, are commonly known. From a tax standpoint, an LLC can issue two basic types of membership interests: capital interests and profits interests. Tax Section membership will help you stay up to date and make your practice more efficient. This is particularly true when dealing with LLCs, due to the underlying aggregate theory of taxation at play. For example, it has long been a foregone conclusion for most practitioners when considering employee incentive compensation arrangements that issuing a profit interest to LLC employees, with its potential for capital gain treatment, is preferable to using a phantom equity plan that yields ordinary income upon payout. Equity Compensation Alternatives – Profits Interests (cont.) Capital Interests; 2. Is it a genuine ownership succession plan, or is it a compensatory award intended to aid employee retention and incentives? 93-27 and related authority, will not be eligible to be a W-2 employee from the date of grant. Proc. Under Rev. 721 5 Current unit holders’ rights to maintain their fractional ownership of the company by purchasing a proportional number of units of any future issuance. One such LLC equity incentive is a “profits interest.” This article answers three questions of importance to both the recipient and grantor of a profits interest: (1) what exactly is a “profits interest,” (2) what are the tax consequences ? The one primary caveat with the use of the phantom equity plan is that the primary business owners will need to have sufficient ordinary income in the year the phantom equity bonuses are paid to fully use the benefit of the ordinary tax rate deduction. Nevertheless, the partnership or LLC passthrough remains the most beneficial entity structure for most small and midsize businesses as a consequence of the inherent flexibility of the capital structure, along with the benefit of a single level of tax. 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