By Andreas Pettersson, Founder, Leaders ADAPT
Your general manager has run the place for three years, and she's started asking what she owns. You run an LLC. You want her to share in what she grows, not in the value you spent a decade building. A profits interest closes that gap, and the Skin in the Game test decides whether you should grant one at all.
The short version: A profits interest is a membership interest in an LLC or partnership that entitles the holder only to future profits and future appreciation above the company's value on the grant date, with no claim on the capital that already exists.
In our coaching data on what owner CEOs bring us, 55 percent of 84 owners named hiring and team performance as a live problem. Keeping the one person who carries the operation is the sharpest version of it.
Quick answer: A profits interest gives a service provider a share of an LLC's or partnership's future profits and growth in value, measured from a hurdle set at the company's value on the grant date. Under IRS revenue procedures 93-27 and 2001-43, receiving one is generally not taxable when their conditions are met. Only entities taxed as partnerships can grant one; corporations cannot.
What is a profits interest, in plain words?
Think of your company as two buckets: what it's worth today, and everything it earns and becomes worth from today on.
A capital interest is a share of both buckets. This instrument is a share of the second bucket only.
Rev. Proc. 2001-43 restates the IRS wording: a profits interest is "a partnership interest other than a capital interest," and a capital interest is one that would give the holder a share of the proceeds if the partnership's assets were sold at fair market value and the proceeds distributed in a complete liquidation (IRS Rev. Proc. 2001-43). Sell everything on grant day and the holder gets nothing. That's why receiving it is generally tax free.
The holder becomes a real member. That means an amendment to the operating agreement, a grant agreement and a name on the cap table. Voting rights are yours to design; you can grant economic units with no vote.
What is a hurdle amount?
The hurdle, also called the threshold, is the company value the interest must climb over before it's worth anything. A tax journal describes it as the mechanism that makes the right to liquidation proceeds worthless at grant, and says it must be equal to or greater than the partnership's fair market value on the grant date (The Tax Adviser, January 2025).
A hypothetical makes it concrete. Your LLC is appraised at $4 million, and your general manager gets 5 percent of future growth over a $4 million hurdle. Sell for $10 million and she shares in the $6 million of growth, before debt and taxes.
Sell at $4 million and her slice is zero.
Profits interest vs capital interest: the comparison table
| Feature | Profits interest | Capital interest |
|---|---|---|
| What the holder shares in | Future profits and appreciation above the hurdle | Existing value plus future profits and appreciation |
| Value if the company sold on the grant date | Zero, by design | A share of today's liquidation value |
| Tax to the holder at grant | Generally none under Rev. Proc. 93-27 and 2001-43, if the conditions are met | Ordinary income on the fair market value received |
| 83(b) election | Not required under Rev. Proc. 2001-43; practitioners often file a protective one | Relevant when the interest is unvested; due within 30 days of the transfer |
| Hurdle needed | Yes, at or above fair market value on the grant date | No |
| Effect on existing owners | Dilutes future growth, not existing capital | Transfers part of existing value immediately |
| Typical use | Key hire, operator, advisor, sweat equity | Buy in by a new co-owner, capital contribution, sale of units |
| Who can grant it | LLCs and partnerships only | LLCs and partnerships (corporations issue stock instead) |
Sources: IRS Rev. Proc. 2001-43; The Tax Adviser, January 2025; 26 U.S. Code 83.
The choice is really a question about the past. Do you want to pay this person for what the company already is, or only for what it becomes with them in it? For a key hire, it's almost always the second.
The safe harbor: Rev. Proc. 93-27 and Rev. Proc. 2001-43
The safe harbor is the IRS position, set out in Rev. Proc. 93-27 and extended by Rev. Proc. 2001-43, that receiving a profits interest for services to a partnership is generally not a taxable event for the recipient or the partnership.
Rev. Proc. 93-27, from 1993, carries three exceptions; if any applies, the safe harbor doesn't (The Tax Adviser, January 2025):
- The partnership's income is substantially certain and predictable, such as income from high quality debt securities or a high quality net lease.
- The interest is a limited partnership interest in a publicly traded partnership.
- The recipient disposes of the interest within two years of receiving it.
Rev. Proc. 2001-43 covers interests that vest over time. It treats an unvested grant as received on the grant date when three conditions hold (IRS Rev. Proc. 2001-43):
- The partnership and the holder treat the holder as the owner from the grant date.
- Neither the partnership nor any partner deducts any amount for the interest's fair market value, at grant or at vesting.
- All other conditions of Rev. Proc. 93-27 are met.
The owner's translation is short. Set the hurdle properly, treat the person as a member from day one, take no deduction, and don't plan on them selling inside two years.
Do you need an 83(b) election for a profits interest?
Strictly, no. Rev. Proc. 2001-43 says covered taxpayers "need not file an election under section 83(b) of the Code." Many practitioners recommend filing one anyway.
The safe harbor only protects a genuine grant. Set the hurdle too low and part of the grant is a capital interest in disguise, which is taxable. A protective filing fixes the value at grant and starts the statute of limitations.
The deadline: no later than 30 days after the transfer (26 U.S. Code 83). The protective 83(b) election profits interest holders file is one page of paper that can save a long argument.
Profits interest taxation after the grant: K-1s, not W-2s
Owners rarely see this part coming. Your key hire feels it first.
Once someone holds the interest, they're a partner for tax purposes.
Rev. Rul. 69-184 holds that an individual providing services to a partnership cannot be both a partner and an employee of it (RSM US, July 2019). The IRS puts it directly: partners are not employees and shouldn't get a Form W-2; the partnership furnishes a Schedule K-1, and the partner may owe self-employment tax and estimated payments (IRS, Partnerships, reviewed August 2026).
For the general manager in the example, that means:
- Her salary becomes guaranteed payments, reported on the K-1.
- She carries the self-employment tax alone instead of splitting it with an employer (Roedl and Partner, 2017).
- Withholding stops, so she makes estimated payments.
- She's taxed on her share of profits each year whether or not cash is distributed, which is why operating agreements often add tax distributions.
None of this is a reason not to grant. It's a reason to tell her before she signs. A key hire who discovers in April that her paycheck lost its withholding won't feel like an owner.
When should an LLC owner use a profits interest?
Three situations keep coming up. Each one needs the four answers of the Skin in the Game test on the phantom equity hub first.
For a key hire you can't afford to lose
A COO, a general manager, an integrator. A profits interest LLC grant tells that person the next decade of growth is partly theirs, and gives away none of the value already built. Pair it with a real role definition from the guide to hiring a COO.
For an advisor who will help you grow
In fund language this instrument is called carry. The advisor shape I've worked with: carry that matures over 24 months, plus a buyout at then current valuation if no sale happens within about ten years. The second clause matters, because a stake that only pays at a sale is worth little in a company that plans to stay private. The advisor equity page covers agreement terms, vesting and the advisory board option.
When a cash plan is the better tool
Some owners don't want a new member at all. Corporations can't grant this instrument, and The Tax Adviser notes an S corporation can't either. For them, a phantom equity plan that pays cash without issuing ownership does the job with different tax results. If the stake pays off at a sale, read the exit strategy guide for owners first.
What I tell owners before they sign an equity grant
When Canon acquired Arcules, the AI and cloud video company I founded and grew to 150+ employees, I became one of Canon's youngest CEOs, and my own payout ran on an earnout over several years. You learn fast that the tax treatment is the easy part. The paperwork that decides whether it works is the vesting, the leaver terms and the buyout formula.
One co-owner I advised was about to bring a new partner into her company. My advice: tollgates at twelve and twenty four months, so the equity is earned over time instead of granted on day one. That protects you from the person who signs, relaxes and disengages.
And agree a predefined buyout formula now, while everyone still likes each other.
Months later she had the harder conversation, with a partner on the way out. Before anyone sat down, we modeled the redistribution of that partner's equity in a spreadsheet, proportional to the existing cap table. The offer landed as a formula, not a number invented in the room. She had counsel review the cap table first.
Tax firms explain the safe harbor well. What they rarely see is the owner in year three who granted everything on day one, has no buyout formula and now negotiates with a disengaged member holding a permanent slice of the upside.
Reasons aren't results. Write the formula while it's cheap.
Five mistakes owners make with profits interests
- Setting the hurdle without a real valuation. A hurdle below fair market value turns part of the grant into a taxable capital interest.
- Granting a capital interest by accident. Wording that lets the holder share in a liquidation of today's value defeats the purpose.
- Ignoring the W-2 to K-1 switch. Plan payroll, withholding, benefits and tax distributions before the grant, not after.
- Skipping vesting and leaver terms. No tollgates, no forfeiture for cause, no call right on departure, and you've handed a permanent stake to someone who might leave next year.
- Missing the 83(b) window or selling inside two years. Thirty days for the protective election. Two years before a disposition, or the third exception bites.
The plain rule on paperwork: your attorney drafts the operating agreement amendment and the grant agreement, and your CPA signs off on the valuation, the hurdle and the tax reporting before anyone signs anything. This page explains the mechanics. They own the documents.
Profits interest FAQ
What is a profits interest?
A profits interest is an interest in an LLC or partnership, granted for services, that entitles the holder only to a share of future profits and future appreciation above the company's value on the grant date. A liquidation on the grant date would pay the holder nothing. The IRS defines it in Rev. Proc. 93-27 as a partnership interest other than a capital interest.
What is the difference between a profits interest and a capital interest?
A capital interest gives the holder a share of the company's existing value plus future profits. A profits interest shares only in growth and profits above a hurdle set at the grant date value. A capital interest received for services is generally taxable as ordinary income on receipt; the growth only interest generally is not, under the IRS safe harbor.
Is a profits interest taxable when granted?
Generally no. Under Rev. Proc. 93-27, receiving a profits interest for services is not taxable unless an exception applies: predictable income such as high quality debt or a net lease, a publicly traded partnership interest, or a disposition within two years. Rev. Proc. 2001-43 extends the same treatment to unvested interests if its conditions are met.
Do I need an 83(b) election for a profits interest?
Rev. Proc. 2001-43 states that taxpayers covered by it need not file a Section 83(b) election. Many tax practitioners still recommend a protective election, filed within 30 days of the grant, in case the hurdle was set below fair market value and part of the interest is treated as a taxable capital interest.
Can a corporation grant a profits interest?
No. A profits interest exists only in an entity taxed as a partnership, such as a multi member LLC or a limited partnership. C corporations and S corporations issue stock, so they use stock options, restricted stock, stock appreciation rights or phantom stock instead. An LLC that elected corporate tax treatment cannot grant one either.
What is a hurdle amount?
A hurdle amount, also called a threshold, is the company value the interest must exceed before the holder shares in any proceeds. It is set at or above the fair market value of the LLC or partnership on the grant date, which makes the holder's liquidation value zero at grant. A hurdle set too low can turn part of the grant into a taxable capital interest.
Give a stake in what they build, not in what you already built
That's the whole logic. A profits interest is the cleanest way an LLC owner can say "the next chapter is partly yours" without giving away the last one.
The tax side is settled. The leadership side isn't: who gets it, for which result, over which tollgates, bought back on what formula. Those answers come from you.
Turn the grant into a plan: how 1:1 CEO advisory structures it
My 1:1 CEO advisory takes an owner from "I should give her something" to a one page term sheet her attorney and CPA can finalize. The first conversation is a call where we name the person, the result, and whether this instrument, phantom units or plain cash fits. The first 90 days run as assessments, a deep dive on your numbers and people, and a six month plan capped at three priorities, one of them the grant itself, tollgates and buyout formula written out.
For the right company, I take part of my own advisory pay the same way: an instrument that converts only if the results we agreed on arrive after a set period, and expires if they don't. There's one more piece I add before any grant is drafted, a page most owners have never written, and I'll show you on the call.
Tomorrow morning, write two lines: the name of the person you'd least like to lose, and today's company value you'd set as their hurdle. Bring both lines to a 1:1 CEO advisory conversation and we'll build the profits interest around them.
