If structured effectively, issuing sweat equity can reward and incentivize employees in a restaurant group. However, when the equity in an LLC (taxed as a partnership) is granted, the value of that equity is generally taxed upon vesting, thus subjecting the employees to tax without receiving any cash. The value of the equity is also not inherently guaranteed. The employee could pay the taxes on the issued equity, and the company’s value could decline due to an unforeseen circumstance, leaving the employee worse off than if they never received equity. A profits interest fixes the problem and is commonly used in restaurants to reward their c-suite, directors, managers, and other employees. A profits interest is a simple and effective way to reward service providers and employees with equity and favorable tax benefits – such as no tax implications upon receipt and capital gain treatment upon sale. In this article, we’ll explain how profits interests work in restaurants and their tax implications so you can decide if it’s the right fit for your restaurant(s).
What is a Profits Interest?
A profits interest is a form of sweat equity that allows the recipient to participate in the company’s future profits and appreciation. This differs from a capital interest in that a capital interest entitles the recipient to all the company’s existing assets plus future profits and appreciation, and is generally taxed to a recipient upon grant. Check out Incentivizing Restaurant Employees with Ownership Equity and Profits to learn more about the differences between profits and capital interests.
How a Profits Interest Works
Assume Jon and Jane contribute $1m each to open Jon’s BBQ Shack, and in five years, they grow to 5 units and are worth $10m as a restaurant group. They want to grant their COO, Brad, a 10% sweat equity plus his salary. With a 10% profits interest, Brad will be entitled to 10% of all the company’s future profits and/or appreciation, and he will only be taxed on the profits he is entitled to when earned. If the company profits $1m in year 1 after Brad joins, Brad is entitled to 10% of those year 1 profits but nothing before his admittance.
Distribution Threshold
Now, assume that after profiting $1m in year 1, Jon’s BBQ Shack issues $1m in distributions. Brad is entitled to his 10% share of the $1m distribution, right? Well, not exactly. Brad is entitled to his share of the $1m in profits, but he might not be entitled to the $1m in distributions because those distributions could be a distribution of profit accumulated before Brad’s admittance. This brings us to the distribution threshold (aka hurdle value). When designing a profits interest agreement, it’s essential to distinguish the pre-admittance value of the company, known as a distribution threshold, to decipher when distributions should be issued to the newly admitted profits interest partners. In the case of Jon’s BBQ shack, the distribution threshold could be set at $10m, the company’s value the day Brad was issued a profits interest. A distribution threshold ensures all the original partners receive 100% of distributions up to the threshold before any profits interest partners receive distributions. This ensures that the original partners and investors are rewarded for their portion of the value that they created. If the distribution threshold is set at $10m, and the original partners received $10m in distributions before Brad joined, then Brad would be entitled to his 10% share of distributions in year 1. However, this is rare because the distribution threshold is typically based on a company’s value, not necessarily its accumulated profit that can be distributed. For example, assume Jon’s BBQ Shack was never profitable because they always reinvested their earnings into additional locations. There would be no profits to distribute. However, before Brad’s admittance, the company’s value could still be $10 million because that’s what they could sell it for. If Jane and Jon were to sell the company for $10m instead of giving Brad a profits interest, they would each receive $5m in distributions. If the company were to sell in 5 years after admitting Brad at a $15m valuation, Jane and Jon would first receive their $10m in distributions, then the remaining $5m in appreciation would get distributed 10% to Brad, 45% to Jane, and 45% to Jon. Brad would receive $500,000 ($5m x 10%), and Jon and Jane would both receive $7.25m ($5m x 45% + $10m x 50%). Here is how it all plays out:
Determining the Threshold Amount
The threshold amount set when issuing a profits interest is typically the business’s fair market value immediately before the profits interest is issued. The fair market value is the hypothetical sales price of the company, which is difficult to determine for a privately held restaurant group. You can typically use the most recent capital call valuation or book value to determine the fair market value and a threshold amount. Regardless, the amount must be reasonable; otherwise, you will not have buy-in from your profits interest partners.
The distribution threshold could be zero or nonexistent if the restaurant has no intangible value. In that case, issuing a profits interest is more straightforward. However, this is rare because most “money partners” or investors will want to prioritize distributions to themselves before issuing distributions to sweat equity partners.
Tax Implications of a Profits Interest
Upon Grant
The receipt of a profits interest is generally not taxable to an employee or service provider because a profits interest in a restaurant is typically speculative and not guaranteed to provide a predictable stream of income or profits to the recipient.
Taxation on Share of Profits and Distributions
Like any other partner, profits interest partners are taxed on their share of profits when earned, not necessarily when the distributions are received. As a result, a profits interest partner may be taxed on income before they receive the income as a distribution. To remedy this, many operating agreements require the partnership to issue quarterly distributions of 30-40% of each partner’s share of taxable profits so they can make quarterly estimated tax payments to cover their share of taxable profits. These are known as tax distributions. We calculate these quarterly for our partnership clients as part of the accounting cycle in accordance with their operating agreement.
The tax profits allocated to a profits interest partner are also determined based on the distribution threshold. If the profits interest partner is not entitled to any profits until the original partners receive their share of earnings up to the distribution threshold, they also shouldn’t be allocated any taxable profits until the original partners are allocated taxable earnings up to the distribution threshold. In fast-growth restaurant groups that rarely experience profitability due to reinvestment of earnings, the distribution threshold is typically not met until a liquidity event (such as a sale to private equity). As a result, profits interest partners don’t receive anything until a liquidity event and, therefore, would not be taxed on any of their sweat equity until an exit. These proceeds from a liquidity event are subject to a favorable capital gains tax rate – which is another benefit of this type of sweat equity structure.
There are other tax implications, such as the need to maintain tax and 704(b) capital accounts so you can track unrecognized 704(c) gain/loss by partner, an 83(b) election, and more, but that’s out of the scope of this article. If you’re considering issuing a profits interest, schedule a call with us to see which specific implications apply to your restaurant.
Schedule K-1 Requirement
Even if a profits interest partner is not entitled to any profits, they are treated like any other partner for tax reporting purposes. They must be paid via guaranteed payments instead of payroll and issued a schedule K-1 instead of a W-2. This complicates the employee or service provider’s personal taxes, and they might not be happy about it. Certain restructurings can be done to avoid this, but generally, this is the case.
Implementing a Sweat Equity Plan
Accurate accounting and bookkeeping are essential for implementing a successful and effective sweat equity program in your restaurant group. An accurate balance sheet reflects your partner’s accumulated contributions and distributions and the company’s book value at a certain point in time. An accurate profit and loss statement measures your restaurant’s performance. You will also gain the trust of your sweat equity partners if you provide them with accurate, timely, and consistent financial data to show the fruits of their labor. Check out our Ultimate Guide to Financial Success in a Restaurant to learn more about building a strong financial foundation for growth in your restaurant, or schedule a chat with a Fork CPAs advisor for more information on profits interests or other sweat equity offerings.
