Emerging Views®

Why Profits Interest May Be More Attractive than Incentive Stock Options (ISO's)

Many businesses grant equity interests to key employees or other service providers in an effort to incentivize them to help grow the business. Businesses organized as corporations often turn to the grant of stock options in order to accomplish this goal. However,  limited liability companies (“LLCs”) have the advantage of being able to issue a “profits interest” in the LLC. As described below, a profits interest may be structured to be similar to a stock option but may be more attractive to service providers, as it can provide that all appreciation in value may be taxed as long-term capital gains rather than ordinary income. Furthermore, unlike a stock option, the service provider does not have to pay an option exercise price to receive this favorable treatment. As a result, profits interests can be structured to have the benefits of stock options, but also be more favorable to key service providers.

OVERVIEW OF PROFITS INTERESTS.

Under federal tax law, businesses that are organized as LLCs or partnerships may create a separate class of equity (or membership) interests known as a “profits interest” that can be granted to service providers. By receiving a profits interest grant, the recipient will be entitled to (i) receive distributions of future profits of the LLC and (ii) participate in the increase in the enterprise value of the business which occurs following the date of grant. However, recipients do not share in any value created before the grant date. For example, assume that YourCo, LLC issues a 3% profits interest to Employee on January 1, 2010 at a time when the fair market value of YourCo is $1,000,000. If the value of YourCo has increased to $5,000,000 at the time YourCo is sold, then Employee would be entitled to an amount equal to 3% x ($5,000,000 – $1,000,000), or $120,000.

Profits interests, like stock options, can be granted subject to vesting provisions. Businesses often structure a stock option or profits interest grant to vest over a three-year period, or longer, in order to induce the recipient to maintain his or her employment until, at a minimum, such time as the stock options or profits interest has become fully vested. As with stock options, a profits interest vesting schedule can, and typically does, accelerate upon a liquidity event such as a sale of the company. Vesting generally ceases upon termination of employment, except that the interest should be 100% forfeited upon a termination for cause. A business can (but is not required to) structure all profits interests as non-voting membership interests, thus enabling the primary owners to maintain full voting control.

ADVANTAGES OF PROFITS INTERESTS OVER STOCK OPTIONS.

Profits interests have several distinct advantages as compared to stock options, particularly when viewed from the perspective of the service provider, including:

  1. Payment Upon Exercise. Service providers receiving a profits interest do not have to pay for their right to receive profits of Company and increase in enterprise value, although the LLC has the flexibility of requiring such a payment if it would prefer the recipient to have some “skin in the game.” With stock options, however, there is no such flexibility: service providers receiving stock options must pay to exercise those options. If the issuing company is privately held, then the service provider will not likely be able to sell the shares upon exercise, and thus will not have funds to purchase the shares or will have to use after-tax earnings. A related obligation with stock options is that after the service provider exercises the options, he or she must hold the shares for 1 year to receive capital gains treatment, and the stock can decline in value thus causing a loss.
  2. Capital Gains vs. Ordinary Income. As a result of the IRS’s publication of Rev. Proc. 93-27 (as clarified by Rev. Proc. 2001-43), the receipt of a profits interest is not a taxable event, and any resulting distributions received by the service provider upon a sale of the company will be taxed at long-term capital gains rates if held for more than 1 year. Stock options, on the other hand, will only be taxed at capital gains rates if the grant adheres to the rigid rules required for treatment as “incentive stock options,” or “ISOs,” including the requirement that the recipient hold the option for at least 1 year prior to exercise and then, following exercise, hold the issued shares for an additional 1 year. Failure to adhere to such holding periods will cause the options to be characterized as “non-qualified options” or “non-statutory options,” which will subject the recipient to taxation on the difference between the fair market value of the shares and the option exercise price for such shares. This amount is considered ordinary income to the recipient, and is taxed at ordinary income rates. Employers may take a deduction for this amount, which is one aspect of non-qualified options, or “NQOs,” that is favored by employers. It should be noted that regardless of whether a business is issuing stock options or profits interests, the recipient will not receive favorable tax treatment unless the option or profits interest is issued at fair market value, measured as of the date of grant. Any issuances below fair value will subject the recipient to additional taxation and penalties under §409A of the Internal Revenue Code.
  3. Flexibility. As noted above, a stock option will only be characterized as an ISO if the grant adheres to a lengthy series of rigid rules, including strict holding periods and the requirement that the issuing company be a corporation. Although LLCs are unable to structure their grants as ISOs, they have the flexibility to structure the grants of profits interests to be like ISOs, if desired. LLCs should turn to the grants of profits interests, which do not subject the LLC or the service provider to the myriad rules related to stock option grants and unfavorable tax treatment.

 


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