Related to my last blog (issues with continuing to treat an employee just granted an ownership interest in a limited liability company as an employee for tax purposes) is this month’s subject on the importance of determining what type of ownership interest is being granted to that employee—a capital interest or a profits interest. Which type chosen can have a significant tax consequence to both parties—sometimes quite unintended.
What is the difference between a capital interest and a profits interest (there are a variety of profits interests available)? The recipient of a capital interest shares in profits and, upon sale or liquidation, a pro rata share of the net liquidation proceeds. The recipient of a profits interest shares in the profits going forward, but only in the appreciation arising from the date of the grant going forward, not in the value created from the point of inception of the company to the date of the grant.
Let’s take an example. You have a very good employee and you decide to grant that person a 10% ownership interest in your company as an incentive to remain and grow with the company. However, you failed to specify what type of ownership interest it is that you granted. Your employee probably thinks that a 10% interest in the total value of the company since inception has been granted and not just an interest in future profits and a cut of the appreciation in value from that point forward.
After the end of the year when starting to prepare the company tax return, your accountant asks if your key employee knows that income taxes on that 10% grant to him or her will need to be paid. And you can only think to ask the accountant, “Taxes, what taxes? How did that happen?” Since the interest granted was not distinguished as to whether it was a capital interest or a profits interest, what you have here is a potential mess. The employee is likely going to be quite unhappy to learn the granted interest is not what was expected if you try to reclassify it as a profits interest. And you or the employee will be unhappy if there is a big income tax to be paid on compensation income if it is treated as a capital interest.
What’s the lesson here? When an employer is contemplating granting a key employee an ownership interest in a limited liability company, the employer would be well off to check with the company lawyer and CPA to determine which type of ownership interest is being granted and what the tax consequences will be. This insures that everyone will be on the same page.
Disclaimer: This blog is for information purposes only. Legal advice is provided only through a formal, written attorney/client agreement.