Q: Can my S corporation issue profits interests to employees?
A: Companies taxed as partnerships for U.S. federal income tax purposes may use a grant of “profits interests” in order to incentivize key employees with an equity stake in the company in a tax-advantaged manner. As discussed below, while it is not possible to issue profits interests directly from an S corporation, there are several alternative structures for S corporations to consider.
Profits interests entitle the recipient to a share of the partnership’s future profits and appreciation (but no share of the company’s current value). The recipient of a properly-structured profits interest is not taxed upon either grant or vesting. The reason for this attractive tax treatment rests on the fact that if the company liquidates immediately after the grant of a profits interest, the profits interest holder is not entitled to any portion of the company’s liquidation value.
- As an example, an LLC taxed as a partnership grants a 1% profits interest to an employee when the fair market value of the company is $10,000,000. If the company were to immediately liquidate, the employee would be entitled to nothing. However, in five years, if the company is sold for $15,000,000, the employee would be entitled to 1% of the $5,000,000 of post-grant appreciation.
By contrast, because of the “one class of stock” rule in IRC Section 1361(b)(1)(C) which requires that all outstanding shares of stock of the company confer identical rights to the company’s distribution and liquidation proceeds, an S corporation cannot directly issue profits interests. The unhappy result of issuing profits interests in an S corporation would be the termination of the company’s S election and resulting C corporation status.
S corporations wishing to implement a profit interests equity incentive plan are not completely out of luck, however. It may be possible for an S corporation to transfer its operations to a disregarded entity subsidiary and to issue profits interests in the subsidiary entity, which would be taxed as a partnership after the issuance of the profits interests. Alternatively, owners of S corporations should consider alternatives such as having employees purchase stock from the company in exchange for a promissory note, granting employees restricted stock units, or implementing a stock option plan or synthetic equity plan (e.g., stock appreciation rights or phantom stock). The tax consequences of each of these structures should be discussed with your tax advisor.
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