Economic versus Equity Interests

By Jason Watson, CPA
Posted Saturday, August 3, 2024

You can own different interests in an LLC entity, and the most common are economic and equity. Generally, as an equity owner you are an owner of the business’s equity which includes its assets (tangible, and intangible such as goodwill) minus the liabilities and debts. This also typically means that your equity interest entitles you to a share of the proceeds upon sale (unless contracts and agreement state otherwise).

An economic interest is generally a share of the profits but does not necessarily entitle you to the equity or value of the entity itself. Many businesses will have a profit-sharing plan which is similar to an economic interest, however these are usually reserved for certain employees or groups of employees, and not necessarily memorialized in a business’s Operating Agreement. Here are some 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, however 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 (i.e., 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.

What’s the big deal? In a true business environment, 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. Later, down the road and upon reflection, an economic interest can be piggybacked with or wholly converted to an equity interest.

In a real estate investment environment, it is common to not view the operation like a business, but it truly is. Aside from maximizing rent and minimizing expenses like any business, you might also have a maintenance person or a listing agent who is very much valuable to the overall success. As such, you might envision them becoming owners in some capacity.

In a pure rental property environment, you might want to report your activities on a partnership tax return (Form 1065) as mentioned previously on page xx. To do so, you could add another member to your LLC in an economic interest capacity only. They would receive a K-1 with their portion of the rental income or loss, but they would not own equity in the LLC or the rental real estate directly. You could make their economic portion super tiny as well, such as 0.1% (you would be allocated 99.9% of the net rental real estate income or loss accordingly).

Expanding ownership is tricky and it requires legal documents to be safe; but it is also unlimited in terms of buy-in arrangements, splits, vesting schedules, exit strategies, etc. 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.