If the company you run or work for is structured as a limited liability company (“LLC”), you’ve likely heard the term “profits interest” when discussing equity compensation matters. Profits interests are a common, valuable tool for aligning the interests of service providers (employees, managers, consultants, or founders) with the long-term growth of the company. That being said, I’ve found that profits interests are a big source of confusion for those who receive (i.e., service providers) — and grant (i.e., issuer company) — them. Below is a quick summary of what they are and how they work.

Understanding profits interests

A profits interest is a type of equity interest in an LLC, taxed as a partnership, that entitles the holder to a share of the LLC’s future profits and appreciation in value, without granting rights to the LLC’s existing capital at the time the interest is granted. It is important to differentiate a profits interest from a capital interest (most would consider these “ordinary” LLC equity interests), which give the holder a right to existing value in the LLC if it liquidates immediately after the grant.

Important features of profits interests

Perhaps the most important attribute of a profits interest is the fact that, if issued properly, it will have zero current value upon its issuance and thus has attractive tax attributes. A profits interest is generally viewed as an LLC’s equity compensation counterpart to a corporation’s stock option.

Other important features of a profits interest include:

1. tax treatment: generally, upon grant, no taxable income is recognized if the interest is structured properly (since the interest has no current liquidation value);
2. distribution threshold: in order to preserve the intended tax treatment described above, a profits interest must be structured with a “hurdle amount” or “distribution threshold” (typically the value of the company as of grant) to ensure the interest represents only future growth;
3. distributions upon a liquidation event: in typical cases, a holder of a profits interest will only be entitled to distributions upon the occurrence of the liquidation event (such as a sale of the company), at which point the holder would usually be entitled to his or her pro rata share of any liquidating distributions after an amount equal to the distribution hurdle has been distributed to other capital equity holders;
4. vesting: a profits interest is oftentimes subject to time-based or performance-based vesting schedules (meaning the recipient will not enjoy its intended economic benefit unless they stick around or otherwise achieve performance goals);
5. flexibility: the LLC’s operating agreement or profits interest grant documentation/plan can all be customized to meet vesting, allocation, and distribution objectives;
6. alignment with growth: a profits interest is designed to encourage recipients to drive value creation, since the instrument’s value and upside depends on future performance; and
7. not for everyone: upon receipt of a profits interest, if the service provider was previously on payroll with the LLC (i.e., receiving a W-2), the service provider ceases to receive wages and begins to receive compensation as a guaranteed payment reported on a Schedule K-1.

Profits interests are a powerful equity compensation tool for LLCs, offering service providers a stake in future growth without immediate tax burdens. When structured properly, they align incentives and can provide capital gains treatment on eventual upside. However, they require careful legal and tax planning to ensure they are created and issued properly.