Creating a Profits Interest in an S Corporation

Assume Glenn and Art are equal shareholders in Allen, Inc., an S corporation.  Bob is employed by Allen and manages one aspect of its business, but not all business is conducted by Allen.  All of the parties would agree to give Bob a profits interest as incentive for performance and would like to do so without immediate tax consequences to Bob.  Assume that the value of the business interest involved is $1 million.  Further, we will assume that if the business were immediately sold, this $1 million would go entirely to Glenn and Art because it is their intention for Bob to receive an interest in future profits only.

Bob cannot be issued stock in Allen, Inc. in a manner that will accomplish this.  In the first place, the stock in Allen, Inc. will bring with it all rights relating to that percentage of all of Allen, Inc.’s businesses and assets and the existing value represented by that stock.  Because of the single class of stock requirement that is necessary to enable the corporation to maintain its S corporation status, it is not possible to issue shares of stock in Allen, Inc. that would carry with it only a profits interest.

One disadvantage of the S corporation compared to the LLC is that S corporations lack flexibility of creating different classes of economic interests for its owners.  In fact, S corporations have virtually no flexibility in this regard because of the single class of stock requirement and because the determination of the existence of different classes of stock is based on whether there are differences in the economic rights associated with the stock, whether that be with current distributions or liquidating distributions.  Essentially, distributions on stock, in order to avoid the second class of stock issue, must be pro rata as must allocations of income gain and loss.

As a result, it is not possible to create a zero value equity interest that could be transferred to Bob directly from the S corporation.  A grant of 10% of the stock of the corporation would result in Bob being taxed on the value of that stock.  Since the stock carried with it the right to 10% of any liquidating distributions as well as 10% of any current distributions, there would be an immediate income tax consequence.  Also, if it is Glenn and Art’s desire to limit Bob’s involvement just to future profits and not to have an interest in any existing value, or in just one aspect of Allen’s business, this cannot be achieved through the S corporation.

An option might be for Glenn and Art, through Allen, Inc., and Bob to create a limited liability company, Euclid, LLC.  Allen, Inc. would contribute to Euclid, LLC the particular business asset that Bob is to manage and participate in.  Assuming the value of these assets is $1 million, Allen’s initial capital account would be $1 million and it would have a 90% interest in future profits.  Bob would receive a 10% profits interest and initially a zero capital account balance.  The LLC will operate the business formerly operated through Allen, Inc.  The operating agreement of the LLC will comply with the allocation and distribution rules of Section 704(b) including making liquidating distributions on the basis of capital account balances such that immediately after the formation, Allen, Inc. would be entitled to all of the distributions if Euclid, LLC’s assets were sold for fair market value and the net proceeds of the sale distributed in liquidation.

Thereafter, allocations could be made in much the same fashion as described in the above examples.  That is, Bob could receive 10% of future profits including 10% of any build-up in the value of capital.  The operating agreement of Euclid, LLC could include catch-up allocations and there might even be opportunities to accelerate the catch-up allocations with subsequent book-up events.  A transaction similar to this was approved in a private letter ruling (PLR 200123035) in which an S corporation operating several automobile dealerships wanted to give a manager a direct ownership interest in one of them, but not all of them.  In that particular ruling, certain dealerships were contributed to the LLC and the manager contributed cash.  The ruling held that the manager received no income because the value of his interest did not exceed his actual cash contribution.

Can acorporation do this with all of its assets?  Assume, for example, that Allen, Inc. transferred substantially all of its business assets into Euclid, LLC in exchange for a capital account equal to the value of the assets contributed and a 90% profits interest.  Bob again would receive a 10% profits interest with a zero capital account value and presumably no income on the formation.  However, the concern here would be that the Service would argue that what Allen, Inc. has done through the LLC is effectively create a second class of stock.

Multiple Divisions

Expanding on the above example, assume that Allen, Inc. is in the business of selling office supplies, furniture and services.  Allen, Inc. has three stores in various locations, the main store in Woodbury, and stores in Belford and Iselin.  The store in Woodbury is operated principally by Glenn and Art but they have hired managers to operate the other stores.  Doug would manage the Belford store and Dina would manage the Iselin store.  Glenn and Art would be willing to give Doug and Dina each a 10% ownership interest in their particular store.  Also, the parties would like to do this without income tax consequences to Doug and Dina and would like them each to profit from their individual efforts on behalf of the store that they manage.

Because Allen, Inc. is an S corporation, it is impossible to create a class or classes of stock that would accomplish these objectives.  Any stock in Allen, Inc. would carry with it liquidation rights to the existing value in all of Allen’s assets and therefore transfer existing value from Glenn and Art to Doug and Dina.  Also, it would not separate performance of each store.

Tto accomplish their goals, Art and Glenn could have Allen, Inc. create two new limited liability companies, Allen-Belford, LLC and Allen-Iselin, LLC.  Allen, Inc. would transfer the assets of the Belford store, with a fair market value of $1 million into Allen-Belford, LLC in exchange for a 90% interest and a capital account balance of $1 million.  Doug would receive a 10% interest in Allen-Belford, LLC with an initial zero capital account balance.  As in all prior examples where it is the intention to create zero profits interest for the service provider, the operating agreement for the LLC will comply with the substantial economic effect test under the regulations under Code §704(b).  Similarly, Allen, Inc. will contribute the assets of the Iselin store to Allen-Iselin, LLC with similar interests going to Allen, Inc. and Dina and in this case with Allen, Inc. receiving a capital account balance of $1.5 million.

With the above structure, both Doug and Dina will have received profits-only interests in the LLC that owns and operates the store that he or she manages.  Art and Glenn have structured the new arrangement so that each of Doug and Dina will profit from the performance of his or her own store.  They could also, if they want, include forfeiture provisions requiring Doug and Dena to work for a certain number of years to maintain their LLC interests.  Finally, Art and Glenn will have retained the full value of the stores as of the date of the creation of this structure.

If Art and Glenn wish, either or both of the new LLC’s can employ catch-up allocations and they may attempt to accelerate catch-up allocations, depending on how they intend to compensate Doug and Dina.  There may be different reasons for providing or not providing catch-up allocations for one or the other and that can certainly be done.  On the other hand, neither could be done through the S corporation. While corporations can divide different business enterprises, a split up under Code §355, the rules are complicated and do not work for S corporations where the desire is to issue a zero profits interest to the manager.

Note that proposed regulations issued in 2005, but never finalized, would change the manner in which the transfer of a profits interest is made without immediate income tax consequences to the transfers.  While in most cases, it would be possible under the proposed regulations to obtain the same result, we will have to see what the final regulations will provide.