Profits interest awards are a flexible type of equity compensation used by partnerships and limited liability companies (LLCs) to incentivize exceptional performance. The Private Company Council (PCC) recently recommended the Financial Accounting Standards Board (FASB) add a project to its technical agenda to clarify the rules for reporting profits interest awards.
Rewarding top performers
Under a profits interest plan, participants are usually granted an equity interest in a company’s future profits, but not any current capital. The use of these plans has spiked among private companies, in part, because they don’t result in taxable income to the recipients.
Profits interest awards are tax efficient for employees because they can vest without triggering tax and then ideally can be sold at a capital gain. But accountants who work with small to midsized companies struggle with the topic because the arrangements can be tricky to report under the tax rules and U.S. Generally Accepted Accounting Principles (GAAP).
Valuing awards
Unlike capital interest units, which convey the full rights of ownership, awards of profits interest units give the recipient rights to a specific type of future income. What the term “income” refers to is explicitly defined by the company’s operating agreement, an employment contract or another agreement between the owners.
It often refers to future appreciation in value or residual value, say, after the business is sold or liquidated. But it can also refer to a stream of income, such as earnings before tax, operating cash flow, cost savings or revenue from a division of the business.
On the date that a profits interest is granted, the recipient isn’t entitled to anything. In other words, if the company liquidated on the grant date, a profits interest award generally has no value. It grows in value as the company’s value increases. Valuing these awards is similar to determining the exercise price for a stock option.
These awards may be restricted by various terms and conditions, such as:
- Vesting requirements,
- Time limitations,
- Specific performance thresholds, and
- Forfeiture provisions.
There’s no standard definition of a profits interest; it can refer to whatever is agreed to by the company and the recipient of the profits interest. This allows the company to customize awards for various purposes. The varieties of terms and conditions that can be incorporated into a profits interest require the use of customized valuation techniques.
Reporting issues
Accounting for these awards can get complicated. It requires a current business valuation. Plus, the accountant must track the number of profits interests awarded and the threshold values of each grant on the grant date.
Another big issue that impacts accounting is whether an employee gets a W-2 or K-1 allocation. A regular employee without a profits interest would receive a Form W-2. But an employee who gets a profits interest in a company receives a K-1 (Form 1065) “Partner’s Share of Income, Deductions, Credits, Etc.” and is ineligible for a W-2. Instead, his or her salary is a guaranteed payment on the K-1.
Under GAAP, there are multiple rules that apply to these awards. Some companies apply Accounting Standards Codification (ASC) Topic 710, Compensation — General. Others apply ASC Topic 718, Compensation — Stock Compensation. This has created confusion and led to diversity in practice among companies.
Clarifying the rules
In April, the PCC, an advisory panel for the interests of privately held businesses, recommended that the FASB add this issue to its technical agenda. Specifically, PCC Chair Candace Wright called on the FASB to provide illustrative examples to help companies understand the factors to consider and improve consistency in the application of the guidance.
However, the PCC determined that the FASB project should not include a private company practical expedient. Members felt that an alternate path to the same outcome might create more issues, particularly for private companies that subsequently decide to go public.
Wait and see
The FASB will vote in an upcoming meeting on whether to add a project on profits interests to its agenda. In the meantime, FASB Technical Director Hillary Salo suggested that the PCC develop materials to help the FASB expand its codification.
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