Profits interest awards are a flexible type of equity compensation used by limited liability companies (LLCs) and partnerships to incentivize exceptional performance. The Private Company Council (PCC) plans to meet in the coming months to discuss ways to simplify the accounting rules that apply to these awards and how to reduce diversity in practice. The PCC is the panel that advises the Financial Accounting Standards Board (FASB) on private company accounting matters.
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 it doesn’t result in taxable income to the recipient.
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).
There are also valuation issues to consider. On the date 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. So, valuing these awards is similar to determining the exercise price for a stock option.
However, you always need to understand the agreement under which the profits interest awards are granted, because the facts can be very different for each award. The term “income” is explicitly defined by the company’s operating agreement, an employment contract or another agreement between the owners. Income often refers to future appreciation in value or residual value, such as 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.
Profits interest units may be further restricted by various terms and conditions, such as:
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 and the determination of what GAAP standards the awards fall under for accounting purposes.
Suppose, for example, that ABC Company was worth $5 million as of December 31, 2018. John (an employee) joined the company on December 31, 2018, and was granted a profits interest in the company’s future appreciation. So, he would be entitled to the pro rata appreciation above $5 million. On June 30, 2019, the value of ABC Company had grown to $5.5 million. Jane (another employee) joined the company on June 30, 2019, and was also granted a profits interest in the company’s future appreciation. But she would be entitled only to the pro rata appreciation above $5.5 million.
Reporting a profits interest award can get complicated because it requires a current business valuation. Plus, your accountant must track the number of profits interests awarded and the threshold values of each grant on the grant date.
Another issue that could impact the accounting is whether an employee gets a W-2 or K-1 allocation. A regular employee without a profits interest would receive Form W-2, but an employee who gets a profits interest in a company receives a K-1 (partner’s share of profits form) 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.
At a future meeting, the PCC will discuss the current diversity in practice among companies in accounting for profits interest. This topic 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. Expect to hear more on this issue in the coming months — including proposed guidance from the FASB to help clarify matters.
Contact Beth Reho at breho@cohencpa.com or a member of your service team to discuss this topic further.
Cohen & Company is not rendering legal, accounting or other professional advice. Information contained in this post is considered accurate as of the date of publishing. Any action taken based on information in this blog should be taken only after a detailed review of the specific facts, circumstances and current law.