In summary, if the change in employment status and added tax reporting burden are not deal-killers, the receipt of a profits interest has the distinct advantages over other types of equity incentives of both no current taxation and a potential for capital gains treatment.Nonetheless, a grantee must be comfortable that the terms of the profits interest represent a meaningful incentive.Existing value is attributed to the current LLC equity holders.
Because the grantee is now a partner, she should not be treated as an employee for tax purposes.
Thus, the grantee will receive Forms K-1, reporting her share of the LLC’s fiscal year profit and loss (if any) in accordance with the LLC’s Operating Agreement and payments for services (i.e., formerly “salary”).
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Until the options are exercised for stock, appreciation rights and options do not represent equity, and any value that is attributable to these forms of equity incentives is treated as ordinary income, taxed at higher ordinary income tax rates, and may also be subject to Social Security and Medicare taxes.
A third important difference is that upon receipt of a profits interest, the grantee becomes a partner for tax purposes.The grantee will be solely responsible for paying periodically estimated taxes and self-employment taxes.The LLC should no longer report payments for services on a Form W-2 or withhold income and Social Security and Medicare taxes or pay the employer’s share of such taxes.Thus, there is no tax liability to the recipient associated with the grant of a profits interest.This treatment is different from the grant of restricted stock/restricted capital interest where, upon the grant of restricted stock/restricted capital interest, the recipient is subject to tax, at ordinary income rates, upon the difference between the price she paid for the equity and the value of the equity.I just received documentation indicating I have a “profits interest.” I was expecting restricted stock, stock options or, perhaps, stock appreciation rights. ” A: There are two types of equity in an LLC taxed as a partnership – “capital interests” and “profits interests.” A , like a share of stock in an entity taxed as a corporation, represents a slice of existing company value; this means that if the LLC were to liquidate right after grant, the recipient of a capital interest would receive a share of the liquidation proceeds or capital.