Equity incentives can be a valuable form of compensation for limited liability companies (LLCs). Corporations are more familiar with equity incentives; possibly in the form of restricted stock, stock options, or stock appreciation rights (SARs). However, “profit interest awards” are fairly new and gaining in popularity. The coronavirus pandemic has further spiked their appeal due to tight cash flow for many organizations.
What is a “profit interest?”
An LLC with more than a single member is classified as a partnership for US federal tax purposes unless it elects to be classified as a corporation. There are two types of equity in an LLC taxed as a partnership – “capital interests” and “profits interests.”
- A capital interest is a financial interest in a company (i.e. a share of stock). It represents a piece of existing company value and only has value upon the occurrence of a triggering capital event (typically a sale or liquidation).
- A profits interest represents only a right to share in the future growth of the entity; that is, income and/or appreciation that is generated after the date of grant.
Types of awards and how to account for them
U.S. Generally Accepted Accounting Principles (GAAP) includes four primary profits interest awards. They, along with their summarized accounting guidance, are listed below:
- Share-based payments
- Bonus arrangements
- Deferred compensation.
Accounting for each type is dependent on the features of the profit interest award and will fall under either Accounting Standards Codification (ASC) 710, Compensation – General or ASC 718, Compensation-Stock Compensation. ASC 710 includes guidance for profit-sharing, performance bonuses, and deferred compensation plans. However, share-based payments are excluded and specifically addressed under ASC 718.
The key differences between the two accounting models include:
- Recognition – Under ASC 710, the awards are recognized when payment is both probably and reasonably estimable. Under ASC 718, the awards are generally recognized as employee services are rendered.
- Measurement – Under ASC 710, the awards are measured at present value and then remeasured at each reporting date. In contrast, ASC 718 calls for awards to be measured at fair value based on either the grant or settlement date.
- Classification – Both sections provide guidance on classifying the awards as a liability. However, share-based payments should be evaluated to determine if they are truly an equity transaction.
- Presentation – ASC 710 calls distributions to holders compensation cost. ASC 718 are typically treated as capital transactions (i.e. dividends)
U.S. GAAP does not provide explicit guidance on how to account for profit interests. Business entities must evaluate all terms, conditions, and characteristics of such awards to determine the best treatment. This often involves “looking through” the legal form of the instruments to determine the true intent. Based on this, there is often diversity in how entities account for-profit interests. The Financial Accounting Standards Board (FASB) has acknowledged the awards as a potential area where clarification and simplification may be needed.
Regardless of the intricacy in the accounting for the awards, they may prove to be a valuable tool for organizations looking for a way to reward employees during these periods of low-level cash flow.