A profits interest is a form of LLC equity compensation that entitles the recipient to a share of future profits and appreciation — but not existing value — at the time of grant. Under IRS Revenue Procedures 93-27 and 2001-43, a properly structured profits interest is not taxable at grant.
Profits interests are the LLC equivalent of stock options — they align key employees and partners with future value creation without triggering a taxable event at grant. They are specific to partnerships and LLCs (which are taxed as partnerships); C-corps use RSUs, options, or stock instead. ## IRS Revenue Procedures Rev. Proc. 93-27 establishes that a profits interest is not taxable at grant if: (1) the interest does not relate to a substantially certain and predictable stream of income; (2) the recipient does not dispose of the interest within 2 years of receipt; (3) the interest is not a limited partnership interest in a publicly traded partnership. Rev. Proc. 2001-43 clarifies that a safe harbor exists even if the interest is subject to vesting conditions. ## How It Works A profits interest entitles the holder to a percentage of profits and value created AFTER the grant date. If the LLC is worth $5M today and the employee receives a 10% profits interest, the employee is entitled to 10% of everything above $5M. If the company sells for $9M in 3 years, the employee receives $400K (10% × $4M appreciation). The $400K can qualify as long-term capital gain if the interest is held > 1 year. ## Tax Advantages vs. Phantom Stock Profits interest: not taxable at grant (if structured correctly); future distributions may be capital gain. Phantom stock: ordinary income at payout. For high-value employees, the capital gains treatment of profits interests is materially more valuable — especially in higher ordinary income brackets. ## Complexity Tradeoff Issuing a profits interest makes the employee a partner — they receive a K-1, cannot be paid as a W-2 employee for that same entity (self-employment tax implications), and must be included in the operating agreement. For businesses with simple structures, the administrative burden is real.
A capital interest entitles the holder to a share of existing value — if the LLC liquidated today, the capital interest holder receives a distribution. Receiving a capital interest triggers ordinary income at grant equal to the FMV received. A profits interest entitles the holder only to future profits and appreciation above current value — not existing value — which is why it's not taxable at grant.
Yes, in most cases. The 83(b) election must be filed with the IRS within 30 days of receiving the profits interest, even though no income is recognized at grant. Filing starts the capital gains holding period from grant date. Without an 83(b), if the interest is subject to vesting (a substantial risk of forfeiture), the holding period doesn't start until vesting — delaying LTCG qualification. Work with tax counsel to prepare the election.
No. Profits interests are a partnership/LLC tax concept — they exist under Subchapter K of the IRC. S-corps use stock, RSUs, and stock options. If an S-corp issues a profits interest, it loses its S-corp election (which requires only one class of stock). S-corp equity compensation planning uses different instruments.