Economic versus Equity Interests
By Jason Watson, CPA
Posted February 22, 2020
You can own different interests in an entity, and the most common are economic and equity. Generally speaking, 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 debs. 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 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.
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.
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? Typically 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.
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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