Economic versus Equity Interests
By Jason Watson, CPA
Posted Tuesday, July 6, 2021
You can own different interests in an 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 typically 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.
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. Later, down the road and upon reflection, an economic interest can be piggybacked with or wholly converted to an equity interest.
How does 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 which has two equity member and three additional economic members. All five members would receive K-1s reflecting their portion of the business activities, however, only the two equity members would have capital accounts.
The previous example does not work where the MMLLC is taxed as an S Corp, and without leveraging S corporation elections the members would be pay unnecessary self-employment taxes. One solution is where the economic member owns an entity taxed as an S Corp, and the primary entity pays a fee for service to the S Corp (see previous section for schematics of how this looks visually). Usually contracts memorializing this fee for service arrangement are also created and executed.
So, a couple of lessons here. Economic interests-
- are wonderful tools to provide ownership in a sense,
- allow for baby steps of bringing in a new business partner, and
- can leverage the “mothership” LLC and “baby” S Corp concepts for tax efficiency,
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. We 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.
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