Economic versus Equity Interests (Profits Interest)

Can you give someone a share of the profits without giving up a piece of the business? Yes. You can own different interests in an entity, and the most common are economic and equity. Generally, as an equity owner you own a share of the business’s equity, which includes its assets (tangible, and intangible such as goodwill) minus its liabilities and debts. This also typically means that your equity interest entitles you to a share of the proceeds upon sale (unless contracts and agreements state otherwise). The tax law calls this a capital interest.

An economic interest is generally a share of the profits, but it does not necessarily entitle you to the equity or value of the entity itself. The tax law calls this a profits interest. Many businesses have a profit-sharing plan, which is similar to an economic interest, but those are usually reserved for certain employees or groups of employees and are not memorialized in a business’s Operating Agreement.

Here is the side-by-side-

Two Examples

You work for Google, and they have a profit-sharing plan where you receive a prorated amount of the allocated profit sharing based on a formula (such as salary and years of service). This is generally not viewed as owning an economic interest in Google, although Google probably has at least a contractual obligation to you.

You work for an accounting firm. You are paid 30% of the gross revenues less direct labor attributed to your efforts. This payment is made directly to you and bypasses payroll (in other words, it is not reported on your W-2). The Operating Agreement of the accounting firm reflects all this, and you are named a non-voting member. This is commonly regarded as an economic interest, and as such you are technically a partner in the accounting firm and will receive annual K-1s reflecting your earnings.

Subtle difference, with real consequences. As a partner-

• You cannot also be a W-2 employee of the same partnership (Rev. Rul. 69-184). This extends to a disregarded LLC owned by the partnership, so you cannot sidestep it by putting payroll in a subsidiary (Treas. Reg. 301.7701-2(c)(2)(iv)(C)).
• Your 30% revenue-based compensation might be treated as a guaranteed payment under IRC Section 707(c), reported on your K-1 and generally subject to self-employment tax. A true share of partnership profits is a different animal, even though it also appears on your K-1.
• You lose the W-2 employee treatment of certain fringe benefits. Health insurance, for example, generally moves into the guaranteed payment and self-employed health insurance deduction world. Same insurance, different tax gymnastics.

Welcome to partnership, where compensation, payroll and benefits just got more interesting.

The short version is that in a corporation like Google, a “profits interest” is usually just a contract, so you stay an employee and the money shows up as a bonus on your W-2. In a partnership, a real economic interest makes you a partner, which moves you off the W-2 and onto a K-1, along with everything in the list above.

What’s the big deal? At times you might not want to immediately give away or sell the net worth of a business to a partner. Rather, you want to split the difference. You want them to feel like an owner, think like an owner and get compensated like an owner, without actually owning the sticks and bricks. In your mind you say, “You get a piece of tomorrow without getting a piece of everything I built yesterday.” Seems fair, right? Later, down the road and upon reflection, an economic interest can be piggybacked with or wholly converted to an equity interest.

The Tax Reason It Works

Here is the tax reason this works so well. When you grant a capital interest to someone for services, they generally recognize taxable compensation based on its fair market value, since you just handed them a slice of the existing business. But a properly structured profits interest generally isn’t taxable when received under Rev. Proc. 93-27. There are exceptions, including disposing of the interest within two years, so don’t get too clever. The new partner generally starts with a capital account of zero and shares in future profits and appreciation rather than the value that existed before joining. No check to the IRS just for showing up.

Sidebar: Fair market value is an interesting concept here. Minority interests carry sizeable discounts for lack of control (DLOC) and lack of marketability (DLOM). As such, a 10% interest in a company valued at $2 million is worth considerably less than $200,000. That is good news if you are granting a capital interest for services, since the taxable amount shrinks with the discounts.

How do the entity structures work with an economic interest? It is not much different than the arrangements discussed in this chapter. You could very easily have a multi-member LLC with two equity members and three additional economic members. All five members receive K-1s, and all five have capital accounts. The profits interest members generally start at zero and participate in future profits and appreciation, while the Operating Agreement protects the existing owners’ value when the new members join.

Economic Interests and the S Corp Problem

The previous example does not work where the MMLLC is taxed as an S Corp, since an S Corp can have only one class of stock and cannot carve out a profits-only owner. And without leveraging S corporation elections, the members would pay unnecessary self-employment taxes. One solution is for the economic member to own an entity taxed as an S Corp, and the primary entity pays a fee for service to that S Corp (see the mothership baby S Corp schematics in another section).

This is not technically a profits interest, since the baby S Corp earns service fees rather than owning part of the underlying business, but the economic arrangement can produce a similar outcome. In fact, you can bake a “profits interest” right into the services agreement. The performance fee bonus we described in another section can be a percentage of the mothership’s profits, and the contract can even promise a slice of the proceeds if the business is sold. The difference is that it’s a contract right rather than ownership, so there is no vote, no capital account, and a sale bonus is taxed as ordinary income rather than capital gain. The fees still need to reflect real services and commercially supportable terms. Contracts memorializing this fee for service arrangement are created and executed, as always.

So, a couple of lessons here. Economic interests-

• Are wonderful tools to provide ownership in a sense.
• Allow for baby steps in bringing on a new business partner (stress test your relationship).
• Can be granted without a tax bill when structured as a true profits interest.
• Can leverage the mothership LLC and baby S Corp concepts for tax efficiency.

Expanding ownership is tricky, and it requires legal documents to be done safely, but it is also unlimited in terms of buy-in arrangements, splits, vesting schedules, exit strategies and so on. WCG CPAs & Advisors can help with the imagination! You’ll freak out, because casting future unknowns in stone can keep you awake at night. We can also help make things malleable without being locked into a once-was-good-but-now-is-bad deal.