Carried Interest (or Profit Interest) for LLCs: Incentivizing Key Employees
This post discusses general legal issues, but it does not constitute legal advice in any respect. This post is not a substitute for legal advice and is intended to generate discussion of various issues. No reader should act or refrain from acting on the basis of any information presented herein without seeking the advice of counsel. Cara Stone, LLP and the author expressly disclaims all liability in respect of any actions taken or not taken based on any contents of this post. The views expressed herein are personal opinion.
As a company grows, many business owners want to reward their key employees with equity in the business or rewards tied to the business’s performance. We’ve discussed several equity incentive plans for LLCs in prior posts, and today, we’re focusing on carried interest in LLCs.
Profits interests is the right to receive profits from the company. Profit interest plans can be set up to distribute profits from ongoing operations of a company, exit proceeds of a company, or sometimes both. Profits interests are common in LLCs and can be beneficial for companies across industries.
“Carried Interest” or “carry” are common terms in the Venture Capital Fund or Private Equity Fund context. Carried interest is a similar concept to a profits interest.
The main difference between profits interest and carried interest is when the person receiving the grant, the grantee, is receiving the value of the interest. One of the primary benefits of a profit interest plan is the grantee is not entitled to anything on the day of the grant. This means, that there is no tax consequence for someone receiving a profits interest grant. Carried interest on the other hand, gives the grantee a piece of the company and that piece of the company can be taxed as income. Another benefit of profits interests are that a profits interest can be subject to vesting. Vesting enables the company to buy back the interests if the grantee were to leave the company or discontinue services. Carried interests have no vesting provisions so the company has less control over reclaiming that ownership.
One factor LLCs will want to consider relating to profits interests is that once a profit interest is given, the grantee will no longer be considered a W2 employee of the company (if the company is taxed as a partnership). Instead, the grantee will be considered a K1 partner. This means instead of being issued a W2, employees would be issued a K-1 at the end of the year. This can complicate matters for employees use to a W2. For instance, it means that employees will need to plan to pay taxes at the end of the year when they receive their K-1, rather than taxes being taken as part of their normal payroll procedure. Most employees will not be able to apply for a tax refund. Additionally, because K1’s often take longer to distribute than W2’s, employees may need to plan to file an extension on their tax returns.
On the company side, K1 partners may have certain rights to get information about the company including financial information. Companies may not be comfortable sharing company information widely among employees or contractors with a profits interest in the company. Additionally, K-1 partners may have voting rights in the company that enable them to influence management. Voting and informational rights depend on where the state is incorporated. There are also legal strategies that can be put in place to limit informational or voting rights. However company’s should be aware that these rights are out there and can be complicated to structure. For this reason, profits interests are most common among high-level members of the management team.
If you’re thinking about issuing profits interests for your teams, Cara Stone is happy to help. Check out our videos and blog posts on equity incentives for LLCs to learn more and reach out to us with any questions or to start your plan.
This post discusses general legal issues, but it does not constitute legal advice in any respect. This post is not a substitute for legal advice and is intended to generate discussion of various issues. No reader should act or refrain from acting on the basis of any information presented herein without seeking the advice of counsel. Cara Stone, LLP and the author expressly disclaims all liability in respect of any actions taken or not taken based on any contents of this post. The views expressed herein are personal opinion.
As a company grows, many business owners want to reward their key employees with equity in the business or rewards tied to the business’s performance. We’ve discussed several equity incentive plans for LLCs in prior posts, and today, we’re focusing on carried interest in LLCs.
Profits interests is the right to receive profits from the company. Profit interest plans can be set up to distribute profits from ongoing operations of a company, exit proceeds of a company, or sometimes both. Profits interests are common in LLCs and can be beneficial for companies across industries.
“Carried Interest” or “carry” are common terms in the Venture Capital Fund or Private Equity Fund context. Carried interest is a similar concept to a profits interest.
The main difference between profits interest and carried interest is when the person receiving the grant, the grantee, is receiving the value of the interest. One of the primary benefits of a profit interest plan is the grantee is not entitled to anything on the day of the grant. This means, that there is no tax consequence for someone receiving a profits interest grant. Carried interest on the other hand, gives the grantee a piece of the company and that piece of the company can be taxed as income. Another benefit of profits interests are that a profits interest can be subject to vesting. Vesting enables the company to buy back the interests if the grantee were to leave the company or discontinue services. Carried interests have no vesting provisions so the company has less control over reclaiming that ownership.
One factor LLCs will want to consider relating to profits interests is that once a profit interest is given, the grantee will no longer be considered a W2 employee of the company (if the company is taxed as a partnership). Instead, the grantee will be considered a K1 partner. This means instead of being issued a W2, employees would be issued a K-1 at the end of the year. This can complicate matters for employees use to a W2. For instance, it means that employees will need to plan to pay taxes at the end of the year when they receive their K-1, rather than taxes being taken as part of their normal payroll procedure. Most employees will not be able to apply for a tax refund. Additionally, because K1’s often take longer to distribute than W2’s, employees may need to plan to file an extension on their tax returns.
On the company side, K1 partners may have certain rights to get information about the company including financial information. Companies may not be comfortable sharing company information widely among employees or contractors with a profits interest in the company. Additionally, K-1 partners may have voting rights in the company that enable them to influence management. Voting and informational rights depend on where the state is incorporated. There are also legal strategies that can be put in place to limit informational or voting rights. However company’s should be aware that these rights are out there and can be complicated to structure. For this reason, profits interests are most common among high-level members of the management team.
If you’re thinking about issuing profits interests for your teams, Cara Stone is happy to help. Check out our videos and blog posts on equity incentives for LLCs to learn more and reach out to us with any questions or to start your plan.
