Carried Interest vs. Profits Interest: What’s the Difference?
Understand the nuanced relationship between profits interest and its specific subtype, carried interest, focusing on their distinct economic and tax treatments.
In business compensation within partnerships and LLCs, the terms “profits interest” and “carried interest” represent a share in the future success of an enterprise. These interests are distinct forms of compensation tied to business performance, differing from a salary or cash bonus. This article will define profits interest, explain how carried interest functions as a specialized subset, and cover the differences in their tax treatment. Understanding these distinctions is important, as the structure has direct economic and tax consequences.
Defining a Profits Interest
A profits interest is equity compensation that grants the holder a right to a share of future profits and appreciation in a partnership or LLC. The defining characteristic is that at the moment it is granted, it has a liquidation value of zero. If the company were to sell all its assets at their current fair market value and liquidate, the holder of the profits interest would receive nothing.
This structure distinguishes a profits interest from a capital interest, which gives the holder a right to a share of the company’s existing capital. A profits interest holder only begins to share in the value created after their grant date, participating only in the company’s growth. For example, a consulting firm valued at $5 million grants a senior consultant a 5% profits interest. If the firm is later sold for $8 million, her 5% interest applies only to the $3 million of growth, entitling her to $150,000.
This arrangement aligns the interests of the service provider with the existing owners. Because no initial capital investment is required from the recipient, it serves as a tool for operating businesses to attract and retain key talent without diluting the current capital of existing partners.
Understanding Carried Interest
Carried interest, or “carry,” is a specific type of profits interest used in investment funds like private equity and venture capital. It is the primary performance-based compensation for a fund’s general partners (GPs), who manage the investments. The GP’s carried interest is their share of the fund’s profits, commonly 20% of the profits generated for investors.
The mechanics are governed by a “distribution waterfall,” a tiered system for distributing cash between investors (limited partners or LPs) and the GP. The waterfall ensures LPs receive their initial investment back, plus a minimum rate of return, before the GP receives its carried interest. This minimum return is called the “hurdle rate” or preferred return, and is often set around 8% annually.
For example, if LPs invest $100 million, they must first receive their $100 million back plus an 8% annual return. Only after these thresholds are met do profits flow to the GP as carried interest. This structure aligns the interests of the fund managers and the investors, as the GP is incentivized to exceed a specific performance benchmark.
Taxation of Profits and Carried Interests
The tax treatment for these interests differs, with carried interest subject to more stringent rules. For a standard profits interest, the IRS provides a “safe harbor” under Revenue Procedures 93-27 and 2001-43. If the interest is for services rendered and meets other conditions, its receipt is not a taxable event because its value is zero upon grant.
When the partnership later generates income, it “passes through” to partners while retaining its character. If the partnership sells an asset held for more than one year, the resulting long-term capital gain is passed to the profits interest holder and taxed at preferential rates. Income from regular business operations is taxed as ordinary income.
Carried interest faces a stricter standard for long-term capital gains. Internal Revenue Code Section 1061 requires that assets generating the gain be held for more than three years for the carried interest to qualify for the lower tax rate. If an investment is held for three years or less, the GP’s share of the gain is taxed as a short-term capital gain at higher ordinary income rates.
When a profits interest is subject to vesting, a Section 83(b) election is a consideration. Filed within 30 days of grant, this election allows the recipient to recognize the interest’s value as income immediately. Since a safe harbor profits interest has a value of $0 at grant, this results in no immediate tax but starts the capital gains holding period, ensuring future appreciation is taxed as capital gain.
Key Distinctions in Practice
While carried interest is a type of profits interest, their practical applications and structures are different. The primary distinction lies in their usage. Profits interests are broadly used in various operating businesses, like technology companies and consulting firms, to compensate key employees. Carried interest is almost exclusively found in investment funds as the performance fee for general partners.
Their economic structures also diverge. A profits interest is often a straightforward percentage of future profits above a threshold set at the grant date. Carried interest involves a more complex distribution waterfall with hurdle rates that prioritize returns to investors before the fund manager shares in profits. Finally, the tax rules for long-term capital gains differ, as a standard profits interest generally follows a one-year holding period, while carried interest requires a three-year holding period for the same preferential tax treatment.