How Are Profits Interests Paid Out From a Company?
Explore the mechanics of how a profits interest award converts to cash. Learn the key factors and company events that determine when and how much you are paid.
A profits interest is a form of equity compensation primarily utilized by entities taxed as partnerships, such as limited liability companies (LLCs). It grants an individual, like an employee or service provider, a stake in the future appreciation and success of the business. Unlike receiving company stock, a profits interest does not require an upfront payment or capital contribution from the recipient. Its value is directly tied to the growth of the company after the grant date, which aligns the interests of the holder with those of the existing owners.
A payout is not a guaranteed event like a regular salary; instead, it is contingent upon specific company performance and strategic decisions that generate distributable cash.
Key Conditions for Payout Eligibility
Before a profits interest holder can receive a cash payout, two fundamental conditions must be met. The first is vesting, the process of earning the right to the equity over a specified period or upon achieving certain goals. Companies use vesting to retain talent, and only the vested portion of the profits interest is eligible for distributions.
Vesting schedules can be time-based, where an employee earns their interest over several years, or performance-based, linking the interest to accomplishing specific business objectives.
The second condition is the distribution threshold, or hurdle rate, which is the company’s value when the profits interest is granted. The holder is only entitled to share in the company’s growth in value above this initial threshold. This protects the equity of prior owners and ensures that if the company were sold at or below this threshold, the profits interest would receive no value.
Receiving Payouts from Operating Distributions
One way a holder can receive a cash payout is through operating distributions. These occur when a profitable company decides to distribute a portion of its earnings to its members. Such distributions are not automatic; the decision to release cash rests with the company’s management, which will assess financial health and investment needs before authorizing a distribution.
When a distribution from operating profits is made, a vested profits interest holder participates based on their ownership percentage. These distributions can be sporadic, happening quarterly, annually, or on an irregular basis depending on the business’s performance.
In some instances, partnerships make “tax distributions.” Because a partnership is a pass-through entity, partners are personally liable for taxes on their share of the company’s income, regardless of whether they receive cash. A tax distribution is made to help members cover this tax liability.
Receiving Payouts from a Capital Event
The most significant payout for a profits interest holder typically occurs during a capital event. A capital event, also referred to as a liquidity event, is a transaction that involves a fundamental change in the company’s ownership structure. Common examples include the sale of the company, a merger, or a significant recapitalization where new investors acquire a large stake.
Upon a capital event, the proceeds from the sale are distributed to stakeholders in a specific, hierarchical order known as a “distribution waterfall.” The first to be paid are the company’s lenders and other debt holders. Once all debts are settled, the remaining funds flow to the equity owners.
Within the equity structure, capital interest holders, who invested their own money into the business, will usually receive their initial investment back first, sometimes with a preferred return. Only after these senior obligations are met do the profits interest holders receive their share. Their payout is calculated based on the growth in value above their specific distribution threshold. The structure of this waterfall is detailed in the company’s operating agreement and is a defining feature of how a profits interest holder gets paid.
How the Payout Amount is Calculated
The calculation of a payout from a profits interest during a capital event follows a distinct sequence to isolate the value created after the interest was granted. The process begins with the total proceeds generated from the transaction, for example, the final sale price of the company.
From this total amount, the company’s value at the time the profits interest was granted is subtracted. This initial value is the distribution threshold established in the grant agreement. The result of this subtraction is the “profit pool,” or the total appreciation in value available for distribution.
In an example where a company is sold for $15 million and the distribution threshold was $10 million, the profit pool would be $5 million. The final step is to multiply this profit pool by the holder’s vested ownership percentage. If the holder has a 5% vested profits interest, their calculation would be 5% of the $5 million profit pool, resulting in a pre-tax payout of $250,000.
Tax Treatment of Payouts
The tax implications of receiving a payout from a profits interest are a significant consideration. The character of the income—whether it is taxed as long-term capital gains or as ordinary income—has a substantial impact on the net amount received. The tax treatment is determined by the holding period of the interest and whether a specific tax election was made at the time of the grant.
The holding period to qualify for more favorable long-term capital gains tax rates is more than one year. However, for certain profits interests, particularly in fields like investment management, a longer holding period of more than three years is necessary. If a payout from a capital event occurs after the required holding period is met, the proceeds are treated as a long-term capital gain, which are taxed at lower rates than ordinary income. If the payout occurs before the holding period is satisfied, the income is taxed at higher rates.
An important action for securing potential long-term capital gains treatment is making a Section 83(b) election with the IRS. This election must be filed within 30 days of receiving the grant. By filing this election, the holder chooses to recognize the value of the interest at the time of the grant—which is typically zero. This starts the holding period clock immediately, increasing the likelihood of meeting the required holding period. All income and distributions related to the profits interest are reported to the holder annually on a Schedule K-1.