Profits interests, a relatively new form of equity compensation specific to limited liability companies, provide a share of future “profit” in the company and are used as an incentive to attract, retain, and reward employees.

Their use has increased with the growth in and benefits of limited liability companies as an alternative to traditional C or S corporations.

Under U.S. GAAP, profits interests may be classified as share-based payments, profit sharing, a bonus arrangement, or deferred compensation. 

In nearly all circumstances, the fair value basis of the award must be recorded as an income statement expense. Profits interests can also result in the recognition of a liability on the balance sheet and require footnote disclosures.

This article provides a discussion of profits interests and summarizes general guidelines on their accounting requirements.

A limited liability company can issue two primary classes of equity-related securities: capital interests, generally provided in exchange for an investment or capital contribution; and profits interests, typically provided in exchange for services.

Profits interests can be issued to management, employees, directors, consultants, or investors. A profits interest, which can have broad flexibility and be designed with a wide range of features, can have different names, such as an incentive program, appreciation plan, management units, or other terms.

In order to comply with U.S. GAAP, most profits interests are accounted for as share-based payment awards. Specific provisions relating to share-based payments in private companies are provided under ASC 718 (the successor to FAS 123R) for profits interests granted to employees and directors. ASC 505-50 provides accounting guidance for profits interests granted to other service providers.

Regardless, profits interest must be classified as subject to either equity or liability treatment, whereby the classification of the award as equity or liability determines its accounting requirements.

The value for profits interests used in financial reporting is based on fair value, as defined under ASC 718.  This definition of “fair value” applies specifically to equity compensation, and is different from the “fair market value” standard pertaining to most tax matters, which treatment and interpretation the paper further discusses.

In summary, the financial statement reporting requirements for profits interests presented in this discussion are consistent with the accounting treatment for other types of share-based payments in private companies.  As with any form of compensation, the value of profits interests in a company’s financial statements must comply with U.S. GAAP.

By, David Howell, MBA, ASA, Principal at Plante Moran in Chicago and David Grubb, CPA, Partner at Plante Moran with 25 years of specialized experience in public accounting. 

Content originally from Transaction Advisors