Profits interest

What is a profits interest?

A profits interest is a type of equity compensation granted to employees and other service providers, giving the holder the right to receive a share of future profits or company growth. This means the recipient only benefits from the increase in the company's value from the date the interest is granted.

Profits interests are a popular form of equity compensation for partnerships, including limited liability companies (LLCs), limited partnerships (LPs), and limited liability partnerships (LLPs). Their use has grown significantly; while profits interest units (PIUs) were a minority of new equity grants in 2019 for private equity (PE)-backed companies, they represented a majority of grants for both employees and managers by the first half of 2024 for PE-backed companies, according to a 2024 report by Carta. For PE –backed LLCs, 73.9% of newly issued grants to management teams in 2024 were in the form of PIUs.

There are few standard requirements for PIUs. A liquidation threshold is assigned to profits interests on their grant date, meaning that the LLC has to achieve profits at or above a certain amount for the profits interest to participate in exit proceeds. The value of a profits interest is based on the growing value of the LLC, which allows employees (or “partners”) to benefit from the LLC’s appreciation in value.

Think of it as giving someone a stake in the value you'll all create together from this day forward. This structure is a powerful way to align the incentives of your key employees, service providers, and advisors with the company's long-term success. They only profit when the company grows, which makes everyone focused on the same goal of building a more valuable business.

Profits interest vs. capital interest

When you're discussing equity in an LLC, you'll hear about two main types of ownership: profits interests and capital interests. It's helpful to understand the distinction between them, as they represent fundamentally different kinds of ownership.

With a capital interest, the member of the LLC contributes capital to the LLC and has an ownership interest, giving the holder a share of the company's current value, much like owning stock in a corporation. If the company were to be sold the day after a capital interest was granted, the holder would be entitled to a piece of the proceeds.

In contrast, a profits interest—defined by the IRS as a partnership interest other than a “capital interest”—does not represent ownership in the LLC. Instead, they most commonly represent claims to the future appreciation of value for the LLC based on the profits interests liquidation threshold.

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Profits interest vs. stock options

If you're a founder coming from the C corporation world, you're likely familiar with stock options. You might even be wondering what the LLC equivalent is. Profits interests are the answer.

While they are structured differently because of the distinct legal and tax frameworks of C corps and LLCs, they serve the same fundamental purpose. Both grant the holder a right to share in the company's appreciation above a certain value set at the time of the grant.

As an expert from the law firm Weil explains during our Lifecycle of a Private Equity Deal webinar, you can achieve the same economic results with either a stock option or a profits interest. The key difference lies in the taxes on equity and the type of company that can issue them.

→ Learn more: The differences between a C corp and LLC

Understanding the liquidation threshold

Profits interests are assigned a liquidation threshold on their grant date, which is typically equal to the proportional equity value of the underlying LLC. The liquidation threshold is oftentimes referred to as the distribution or hurdle threshold. This threshold is set at a level such that the profits interest would be entitled to $0 of the LLC’s exit proceeds if the LLC were to hypothetically “liquidate” on the profits interest’s grant date. This is unlike a capital interest, which is immediately entitled to exit proceeds on their grant date, subject to other liquidation rights and preferences.

If the recipient of an LLC interest only has a right to share in the appreciation of the LLC’s value growth after their grant date, the interest is a profits interest. If the recipient of the interest has a right to share in the LLC’s value on and after their grant date, the interest is a capital interest. The liquidation threshold serves to avoid the unintended reclassification of a profits interest into a capital interest. The distinctions between a capital interest and a profits interest are important for taxation purposes.

How are profits interests taxed?

A profits interest is not taxable as compensation when granted if structured correctly under the IRS safe harbor rules. This means your employee doesn't have to pay taxes just to receive their equity award, which is a clear advantage over other forms of equity that can trigger immediate tax bills. This special tax treatment requires that the liquidation threshold is equal to the existing company valuation at the time of grant (similar to setting the strike price for options by 409A valuation).

Later, when they receive proceeds from the PIU in an exit event like an acquisition, the proceeds from their profits interests distribution or disposition are typically taxed as a long-term capital gain. The capital gains rate is generally more favorable than the ordinary income tax rate that applies to many other forms of compensation. This tax treatment assumes the holder receives the profits interest in a partnership capacity or in anticipation of becoming a partner.

This tax efficiency makes profits interests a compelling employee benefit for attracting and retaining top talent in a competitive market, especially because of how they're structured to encourage long-term commitment.

The IRS safe harbor

The Internal Revenue Service (IRS) provides a "safe harbor," a set of rules that, if followed, allow for this tax-free grant. Adhering to these rules gives you and your employees confidence that the grant will receive its intended tax treatment, removing uncertainty, and potential tax complications down the road. The main safe harbor conditions, found in IRS Revenue Procedures 93-27 and 2001-43, are straightforward.

• Granted for services: The profits interest must be granted in exchange for services provided to the partnership.

• Two-year holding period: The recipient generally should not sell or dispose of the interest within two years of receiving it. This rule helps ensure the interest is held for a meaningful period.

• Not a predictable income stream: The partnership's income should not come from a "substantially certain and predictable" source, like high-quality debt securities. This condition applies to most operating startups, which inherently have uncertain future income.

The Section 83(b) election

When you grant a profits interest subject to vesting, the recipient should consider making an 83(b) election. This is a simple but very time-sensitive filing, where the recipient sends a letter to the IRS within 30 days of being granted the unvested equity.

The purpose of this election is to tell the IRS that the recipient chooses to be taxed on the value of their equity on the grant date. Since a properly structured profits interest has a value of zero on the day it's granted, this election effectively locks in that zero-dollar value for tax purposes. This protects the holder from potentially paying taxes on the appreciation of their interest as it vests over time, which could otherwise be a significant tax burden.

How to grant profits interests

Proper equity management is a practical process that, when done correctly, prevents major headaches during fundraising or an exit. The first step for many founders is moving away from messy spreadsheets and adopting a dedicated platform for equity management. Carta's equity management software for LLCs provides a centralized and automated platform to give you a single, accurate record of ownership from day one.

For growing LLCs, managing complex equity structures is a common challenge. This complexity becomes tangible when you consider that nearly 40% of managers hold two or more different interest types, often a mix of PIUs and capital interest units.

For legal technology company Relativity, partnering with Carta was key to managing its global employee equity program. As Timothy Cha, Relativity’s senior manager for compensation solutions, explains, "We have three entities we use to offer three different interest types...Carta LLC has given us the ability to easily create, manage, and represent all our different entities and interest types."

Setting the hurdle with a valuation

The profits interest hurdle, also known as a participation threshold, is the fair market value (FMV) of the company at the time of the grant. This hurdle is the mechanism that separates the company's current value from its future growth, which allows profits interest holders to share only in the appreciation they help create.

This isn't a number you can just guess. You need accurate, defensible company valuations to establish the hurdle and secure the favorable tax benefits of profits interests. Carta provides audit-ready profits interest valuations, giving you the confidence to issue these awards correctly.

Structuring vesting schedules

A common approach is a time-based vesting schedule. At private equity–backed LLCs, where profits interests are a common form of equity, grants are often designed to keep employees invested for the long haul. For instance, data shows that about 72% of initial executive grants at these LLCs have annual vesting schedules, a structure that encourages talent to stay year-over-year. Vesting can also be tied to specific performance goals, linking the equity award directly to the achievement of company milestones, or individual targets.

Updating your operating agreement

You can't just start handing out profits interests on a whim. Your LLC's operating agreement, the core rulebook for your company, must be formally amended to authorize a new class of equity for these grants.

This is a formal legal process that you should undertake with your law firm. They will help you draft the necessary language to create the PIUs and define their rights and what happens upon termination. Carta is trusted by leading law firms because our platform makes managing these complex equity structures simple and professional, keeping everyone on the same page.

For entities structured as LPs or LLPs, this governing document is instead referred to as the partnership agreement or, occasionally, the limited partnership agreement (LPA). Regardless of the entity type, the foundational rules for issuing PIUs must be formally amended in the company's core governing document.

What granting profits interests means for your team

As a founder, it's not enough to just grant equity; you need to be able to explain what it means for your team members. This is especially true with profits interests, as receiving them changes an employee's tax status.

Providing clarity and transparency is key to helping your team understand their compensation, especially the value of their private company equity. The Carta interest holder portal helps with this by giving employees a real-time view of their ownership. They can see their vesting progress, and access all the important documents related to their grant in one place.

From W-2 employee to K-1 partner

When a team member accepts a profits interest, they legally become a partner in the business, which is the governing term for members in an LLC, LP, or LLP for tax purposes. This transition often leads to many tax questions for employees, as for tax purposes, an individual cannot be both an employee and a partner in the same partnership. You should communicate this transition clearly and empathetically, as it has significant implications for how they are paid and how they handle their taxes.

Here's what this change means for them:

• No more W-2: Their salary is now considered a guaranteed payment from the partnership and they will no longer receive a W-2 form at the end of the year.

• Hello, Schedule K-1: Instead, they will receive a Schedule K-1 tax form. This form reports their share of the LLC's income, deductions, and credits for the year, which they must then report on their personal tax return.

• Quarterly estimated taxes: They are now responsible for paying their own quarterly estimated income and self-employment taxes, and should also be aware of other potential tax implications.

How profits interest holders get paid

While holders of profits interests may receive LLC distributions from operating profits during the life of the company, the most significant value is typically realized in a liquidity event, such as an acquisition. The distribution waterfall, governed by the liquidation preferences in the operating agreement, defines the rules for the allocation of proceeds.

The waterfall is the set of rules in your operating agreement that dictates the order and amount of payouts in an exit. You can think of it like boarding an airplane: First-class passengers board first and get their orange juice before anyone else. Similarly, certain classes of equity get paid back their investment (the basis for calculating metrics like multiple on invested capital (MOIC)) plus any preferred return, before other equity holders receive their share.

Modeling this in a spreadsheet is notoriously difficult, and the risks are very real. The complexity of equity management means that costly mistakes are common. Carta's waterfall modeling and distributions products automate these complex calculations directly from your cap table. This provides accuracy and saves you from the chaos and risk of manual spreadsheets.

Example exit scenario

For example, assume the LLC’s equity value is $10 million on the profits interests grant date, and therefore the liquidation threshold of those profits interests would be $10 million. If the LLC hypothetically liquidates on that grant date, based on the liquidation threshold, it is required that $10 million first be paid to prior outstanding equity holders, leaving $0 of exit proceeds for the newly granted profits interests. However, if the LLC were to exit on a future date for $12 million, those profits interests would be entitled to participate pro rata with the capital interests in $2 million of the exit proceeds.

*Assumes an exit value of $12M

This example does not consider vesting, and assumes the liquidation threshold is established based on the equity value of the LLC as opposed to the equity value on a per unit basis, which would be similar to the strike price of an option.

It’s important to note that the PIUs received by an employee do not have any value when granted. Instead, the LLC’s value has to increase for the employee to receive any future payout. Then if the LLC were to liquidate after several months or years, the employee would be entitled to a payout according to the percentage of their holdings and vesting requirements.

Managing your LLC equity with Carta

An LLC issuing PIUs must determine the LLC’s value to establish a liquidation threshold for the profits interests on their grant date, and the LLC must keep an accounting of that value for the benefit of existing profits interest holders.

While profits interests can be the right tool for LLCs to grant equity, they create administrative and compliance work that spreadsheets simply can't handle. From tracking hurdles to modeling complex waterfalls, managing LLC equity, especially in companies backed by private equity, requires a specialized approach.

Carta is the comprehensive platform designed for this complexity. We provide a single source of truth that connects your LLC cap table, valuations, waterfall modeling, and distributions. This integration eliminates manual work, reduces the risk of costly errors, and keeps you prepared for any questions from investors or auditors.

Carta valuations offer liquidation threshold and profits interest valuations for LLCs alongside our 409A service. With the support of Carta’s cap table management platform and in-house LLC valuation analysts, we help LLCs offer equity and profits interests to their employees.

With Carta, you can turn equity into a strategic advantage for hiring and growth, rather than letting it become an administrative burden. Request a demo to see how.

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Frequently asked questions about profits interests

What is an example of a profits interest payout?

Imagine a company is sold. To determine the payout for a profits interest holder, you first subtract the grant's hurdle amount (the company’s value at the time of the grant) from the total sale price. This determines the total profit generated. The profits interest holder then receives their ownership percentage of that profit.

Keep in mind, this is a simplified model. In reality, proceeds are paid out in a waterfall sequence. The profit pool is often shared among all profits interest holders and other equity awards, which means the final payout for any single individual could be diluted by additional participating units.

Can a profits interest be forfeited?

Yes, similar to other awards like incentive stock options (ISO), employees’ unvested profits interests are subject to forfeiture if they leave the company. The operating agreement also specifies what happens to vested interests, which are often subject to repurchase by the company.

Do profits interests have voting rights?

The company's operating agreement determines this. You can structure profits interests as non-voting to keep your company’s governance simple. Instead of granting voting rights, they give employees a share of the company’s future profits. This structure separates them from capital interest units, which represent true equity ownership and are more commonly issued to investors.

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