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Private Company Rules for ‘Profit Interest’ Could Get Simpler

Thomson Reuters Tax & Accounting  

Thomson Reuters Tax & Accounting  

By Denise Lugo

Private companies could be getting more clarity about reporting profits interest, a type of equity compensation used by partnerships or Limited Liability Companies (LLCs) to incentivize exceptional performance.

The Private Company Council (PCC) plans to discuss in April how to simplify the rules for profits interest, one of the more common types of compensation cropping up in the private company space, FASB member Susan Cosper said at the February 25, 2020, meeting of the FASB’s trustees. The PCC is the panel that advises the FASB on private company accounting matters. The group is set to meet April 16 – 17.

Under a profits interest plan, participants are granted an equity interest in a company’s future profits, but not any current capital. Its use has spiked among private companies because it does not result in taxable income to the recipient, corporate lawyers told Thomson Reuters on March 3.

“I would say that profits interests are increasing in popularity; although they have some downsides the tax benefits are significant and attractive,” Amalie Tuffin, a partner at Hutchison PLLC, said.

Profits interest are very tax efficient for employees because it can vest without triggering tax and then ideally can be sold at capital gains. But accountants that work with small to mid-sized companies struggle with the topic because the arrangements can be tricky to work with.

“The way a profits interest works is that you’re not entitled to anything on the date of grant, so if the company liquidated at the time of the grant, the profits interest would have no value,” Benjamin Panter, a partner at McDonald Hopkins LLC in Chicago, said. “And so it has a threshold amount, which is similar to the exercise price for a stock option. Companies should understand that as you’re granting interest in the company over time, you have employees that are entitled to varying levels of the company at different times,” he said.

For example: if a company is worth $5 million and an employee joins while it is worth that amount and is granted a profits interest, the employee is only entitled to the appreciation above $5 million. If another employee joins the firm six months later, and the company is worth $5.5 million, that employee (if granted a profits interest) is entitled to appreciation above $5.5 million and so forth.

“And so the accountant needs to track, not only the allocation to all of the partners, but they need to take into account the varying threshold values of each grant,” Panter said. “You get into targeted allocation versus forced allocation,” he said. Targeted allocation generally means to allocate income based upon what the person should get – if the agreement works the way it was intended to work.

Another big issue that impacts the accounting is whether an employee gets a K-1 or W-2 allocation. K-1 is a partnership tax return, and therefore if an employee gets a profits interest in a company, the person gets a K-1 (partnership return). A regular employee without a profits interest would get a W-2. If, however, an employee also has a profits interest in the company the person is ineligible for a W-2. Instead, their salary is a guarantee payment on a K-1.

“So from a tax and accounting perspective, you now have K-1 partners, not W-2 employees – and that’s the issue we are currently dealing with on a regular basis,” Panter said.

Companies have told the FASB, in comment letters, that there is current diversity in practice among companies in accounting for profits interest. Some companies, for example, apply Topic 710, Compensation-General, and others Topic 718, Compensation-Stock Compensation.

Profits interest was also mentioned at a PCC meeting in December during discussions about the “measurement of grant-date fair value of equity-classified share-based awards,” another area of stock compensation rules flagged as costly and complex for private companies. The FASB plans to issue a proposal to address that topic. (See Narrow Private Company Proposal to be Issued Related to Equity-Classified Stock Options in the February 14, 2020, edition of Accounting & Compliance Alert.)

 

This article originally appeared in the March 4, 2020 edition of Accounting & Compliance Alert, available on Checkpoint.

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