Pass-through entities need competitive tools to attract top talent—but without access to public company equity instruments, compensation planning can be tricky. Traditional capital interests often trigger immediate tax under §83, creating an unwelcome bill for employees and employers alike.
Profits Interests Offer a Solution
Often called “incentive units,” profits interests give recipients a stake in future growth without current tax consequences—provided IRS safe harbor requirements are met. Unlike capital interests, these awards exclude participation in existing equity. Instead, they kick in only once legacy owners recover the company’s fair market value at the time of grant (the “hurdle”).
Key Requirements for Safe Harbor Treatment
- The company must have uncertain, performance-based income (not predictable returns like long-term leases or Treasury notes).
- The award can’t be in a publicly traded partnership.
- The interest must be held for at least two years to retain favorable tax treatment.
The Importance of the Hurdle
The hurdle ensures the incentive unit only participates in post-grant value creation. A defensible valuation at grant is essential, ideally via an independent appraisal. Many recipients file a protective §83(b) election. Though not required, this step starts the statute of limitations should the IRS later question the valuation.
Tax and Accounting Considerations
- At grant: No income, no deduction.
- Going forward: Recipients are treated as partners—not employees. Compensation is reported via Schedule K-1 and subject to self-employment tax.
- On exit: Gains may qualify for long-term capital treatment, but exceptions like §1061 and §751 can apply.
New Accounting Standards to Know
FASB’s ASU 2024-01 may require GAAP expense recognition for many incentive units, even if no tax is due. Entities should model the accounting impact before issuing awards.
Avoid Common Drafting Mistakes
- Explore all incentives – providing an employee with incentive units is a significant reward. There are many other incentive strategies available to reward and retain top talent, so be thoughtful prior to offering units.
- Missteps—like overly aggressive “catch-up” provisions or basing the hurdle on annual profits—can jeopardize tax treatment. So can stale valuations or improperly structured operating agreements.
Aldrich Insights
When structured thoughtfully, incentive units align teams with ownership goals, preserve cash, and reward growth with capital-gain potential. But they aren’t one-size-fits-all. For businesses with little upside or highly predictable cash flow, traditional compensation may still be more effective.
Aldrich can help you structure and implement a compliant plan—from independent valuations to modeling ASC 718 expense. Whether you’re designing your first plan or reviewing an existing one, we’re here to support your equity strategy.
