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.