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Profit interest is when a person has a right to receive a share of a company’s profit without being obligated to provide capital. Normally, the person with the profit interest provides services for the company, such as investment advice or management services. The profit interest model is a popular incentive model for employees of Limited Liability Companies (LLCs). The employees get a share of the increase in the company’s value. This incentive model has been developed in the style of incentive models from stock corporations.
Many stock corporations give their employees shares to motivate them to do their best. The concept behind that model is simple: When an employee actually profits from the company’s profits, the employee will do his or her best to improve company profits. The profit interest model works much the same way. LLCs do not have shares that they could give to their employees so they give out profit interests instead. The result is the same: The employees get their share in increased company profits.
There are many taxation models for profit interests in the United States. Some of them are favorable for the employees, but others result in additional taxes. The advice of a tax counselor can be necessary to look through all of the different possibilities.
Some senior hedge fund managers in the U.S. use the profit interest model to lower their taxes. They can tax their income from the profit interests at the much lower rate for long-term capital gains instead of at the ordinary income tax rate. This model saves them a huge amount of taxes each year.
Profit interests also are used in the U.S. to transfer wealth and family partnership interests to a younger generation. There are two advantages to doing this. First, the interest is not subject to gift tax, so those in the younger generation receive an income source without any deductions from its original value. Second, those in the older generation can decrease their amount of interests in the family partnership in favor of the younger generation.
Taking all the above mentioned facts into consideration, the profit interest model can be used for various purposes. It can be a viable option for many types of companies and for quite different reasons, such as incentives for employees, saving taxes and redistribution of family wealth from an older generation to a younger generation. To benefit from all of the possible advantages, however, a professional tax counselor and a lawyer should be consulted.
@hamje32 - We have profit sharing where I work. I guess this would be considered a profit interest. I really like this perk. I had $8,000 deposited into my 401k last year; that was the profit sharing bonus.
Like the article says, I did not put any capital to get it. I did, however, put in hours and work hard to help make the business successful. It is a definite incentive to keep me working hard and motivates me to stick around.
Sometimes when I look over the fence to greener pastures (we all do that, I guess) I think about the profit sharing I get, the matching 401k, the health benefits, etc.
Looking at my job as a complete package, it makes sense to stay, so I do. The profit sharing is the biggest consideration in that determination.
@Charred - I like the model too. I don’t think you have to do your work for free, however; at least it doesn’t appear that way from the article.
Also, in all fairness, I don’t think that just any service provider could enter into an agreement with the company to receive the profit interest.
The article mentions people who offer management or investment advice. In other words, you would have to provide significant services to the business, to the point where a profit interest would represent a fair arrangement for them because the services you provided contributed to the company’s bottom line.
I am sure there would be some criteria to determine who is eligible for a profit interest and who is not.
Now this is one idea that I like. I have done database software development for several companies in my community.
Usually I charge a project fee, but as it usually turns out, I make very little on an hourly rate (compared to what I would like to make, that is).
A profit interest model would work very well for me. I’d be willing to do the work, almost for “free” as it were, if I had a share in the company’s profit. This is like residual income, where you keep making money long after the work is done.
The article doesn’t make clear how long the profit interest lasts, but if it is similar to owning shares, then I assume that it lasts as long as you want it to.