Profits interests are a special form of equity compensation issued by limited liability companies. They provide a share of future “profit” in the company and are used as an incentive to attract, retain, and reward employees.
Profits interests are a relatively new form of equity compensation that are specific to limited liability companies. Their use has increased with the growth in and benefits of limited liability companies as an alternative to traditional C or S corporations.
Under U.S. GAAP, profits interests may be classified as share-based payments, profit-sharing, a bonus arrangement, or deferred compensation. The classification is determined by the specific terms and features of the profits interest. In nearly all circumstances, the fair value basis of the award must be recorded as an income statement expense. Profits interests can also result in the recognition of a liability on the balance sheet and require footnote disclosures.
This article provides a discussion of profits interests and summarizes general guidelines on accounting requirements for this type of equity compensation.
What Are Profits Interests?
A limited liability company can issue two primary classes of equity related securities: capital interests and profits interests. Capital interests are generally provided in exchange for an investment or capital contribution.
Profits interests are distinct from capital interests, and are typically provided in exchange for services. They can be issued to management, employees, directors, consultants, or investors. A profits interest can also have different names, such as an incentive program, appreciation plan, management units, or other terms.
Profits interests provide the recipient with a defined share of future “profit” in the company. The future profit component can include a variety of items such as a share of income, distributions, or proceeds from a sale of the company. Profits interests can have vesting requirements for service, performance or market conditions. They may also have other contingencies, such as a required return for investors, achieving a specific company value, or a completing a transaction.
As a form of compensation, profits interests have broad flexibility and can be designed with a wide range of features. There are no standard requirements for the terms of a profits interest, and it could conceptually incorporate anything the parties agree to. Profits interests are often simply identified as anything that is not a capital interest.
Profits interests can potentially be designed to receive favorable tax treatment when they comply with certain provisions of IRS Revenue Procedures 93-27, 2001-43 and proposed in 2005-43. Generally, those require the profits interest cannot participate in the current equity value of the company, restricting it to a share of defined future profits. Profits interests may also be structured to meet certain safe harbor provisions and be considered exempt from IRC Section 409A requirements relating to deferred compensation.
Accounting Requirements
As a form of compensation, profits interests are subject to various financial reporting requirements in order to comply with US GAAP. Most profits interests are accounted for as share-based payment awards. Specific provisions relating to share based payments in private companies are provided under ASC 718 (the successor to FAS 123R) for profits interests granted to employees and directors. ASC 505-50 provides accounting guidance for profits interests granted to other service providers.
The profits interest must be classified as subject to either equity or liability treatment. The classification of the award as equity or liability determines its accounting requirements. Generally, equity awards are settled (paid) in equity interests and liability awards are paid (settled) in cash.
For equity awards, the fair value of the profits interests will be established as of the grant date, and recognized as an expense over the corresponding service period. The service period frequently is the vesting period. The fair value of an equity award is not adjusted for changes in fair value over the expense period. The expense may be adjusted for forfeitures or certain modifications. The offsetting entry for the compensation expense is recognized as an increase in members’ equity.
For liability awards, private companies can make an accounting policy election to measure the value of the award at either fair value or intrinsic value. The corresponding value of the profits interest is initially determined as of the grant date and an estimated expense is established for the service period. In addition, a liability for the associated total value of the award is recorded on the balance sheet. Thereafter and until the obligation is settled or retired, the liability and expense are adjusted (“marked to market”) at each future reporting date reflecting any changes in value, forfeitures, or certain modifications.
In addition to the income statement and balance sheet treatment described above, both equity and liability profits interests generally require footnote disclosures. In certain situations they can also result in the recognition of deferred tax assets, reflecting differences in tax versus US GAAP treatment.
Value for Financial Reporting
The value for profits interests used in financial reporting is based on fair value, which under ASC 718 is defined as:
“the amount at which an asset (or liability) could be bought (or incurred) or sold (or settled) in a current transaction between willing parties, that is, other than in a forced or liquidation sale.”
This definition of “fair value” applies specifically to equity compensation, and is different from the “fair market value” standard pertaining to most tax matters. It is also different from the definition of fair value that applies to other areas of financial statement reporting provided under ASC 820. Another important distinction is the objective in financial reporting to establish the fair value of a single equity compensation unit, as opposed to total equity or an overall value of the business. This can result in discounts or other adjustments to fair value reflecting control or marketability factors.
As previously described, the financial statement recognition for some liability awards may be based on intrinsic value. To determine a unit’s intrinsic value, the fair value is first determined. The intrinsic value is the positive difference between that fair value and any financial consideration or threshold amount required for the profits interest. This is essentially the net value that would result if the unit were redeemed as of the measurement date.
Profits interests may have different values for financial reporting or tax purposes. For example, a profits interest designed to comply with the IRS Revenue Procedures may not be taxable at grant, however for financial reporting purposes it can have a positive value based on its share of potential future profits. Or in another case, a liability award that had little or no value at grant could grow over time to represent a material amount on the balance sheet.
The fair value of profits interests is determined using standard professionally recognized valuation approaches such as income, market, and option methods. However, these methods may require adjustment for use with profits interests, and certain methods should not be used. Guidelines on valuation for profits interests are provided in the 2013 AICPA Accounting and Valuation Guide Valuation of Privately – Held – Company Equity Securities Issued as Compensation. Additional discussion relating to the valuation of profits interests is provided in The Value of Profits Interests.
The fair value used for financial reporting on profits interests as equity compensation must be current. AICPA guidelines recommend a contemporaneous valuation for the grant or other measurement date. Additionally, these guidelines generally indicate a fair value can be used when it is not more than one year since the last full valuation, and there has been no change that would have a material effect on fair value. Additional discussion on this subject is provided in Is Your Valuation Current?
In instances where profits interests are intended to comply with IRS Revenue Procedures and receive favorable tax treatment as described above, it is important to establish the threshold equity amount associated with the profits interest. The basis for this purpose is specific to and described in the IRS Revenue Procedures. It is effectively the equity value, in total and/or per unit, where the intrinsic value at the date of grant is zero. This threshold should be calculated as of the grant date to document that amount for the specific units awarded. The threshold amount may also be a required component for valuation methods used to determine the fair value of the profits interests.
Summary
Profits interests are a special type of compensation used by limited liability companies to attract, retain, incent, and reward employees based on their potential future economic gains. The financial statement reporting requirements for profits interests presented in this discussion are consistent with the accounting treatment for other types of share based payments in private companies.
Profits interests impact both the income statement and balance sheet of a limited liability company. Their value is expensed over the corresponding service period, and can result in changes to equity or balance sheet liabilities.
As with any form of compensation, it is important to appropriately record the value of profits interests in the company’s financial statements to comply with U.S. GAAP.
