However, while the change in employment status and the additional tax burden are not hitmen, maintaining an interest rate on profits has clear advantages over other types of equity incentives that have no current taxation and capital gains treatment potential. Nevertheless, a stock exchange should feel comfortable that earnings interest rate conditions are a useful incentive. A careful review of the profit interest terms, which are typically set out in a grant agreement and in LLC`s operating agreement, is required. Since the granting of an interest rate is only a right to a share of the future value of the LLC and does not lead the beneficiary to report the taxable income related to obtaining an interest rate, LLC would not be entitled to a deduction for the transfer of interest from profits to the beneficiary. A second reason for issuing an interest rate on earnings is that, since interest on profits represents LLC`s equity, the subsequent sale or redemption of the stake generally generates taxable income at more advantageous capital rates. Some partnership tax rules, which also apply to equity participations, may reorganize part of the capital income as ordinary income. As noted above, a partnership taxed LLC may also issue options for the purchase of partnership shares. However, these options would likely be treated in the same way as uns qualified stock options in a corporate environment, which means that, although there is generally no tax impact on the beneficiary or LLC when granting the LLC option, the beneficiary, when exercising the option, records ordinary income and taxes on the spread between the fair value of the acquired interest and that of the beneficiaries. The value attributable to these forms of equity incentive would not only be considered ordinary income taxed at higher normal income tax rates, but may also be subject to Social Security and Medicare taxes.
Any future appreciation would benefit from the treatment of capital gains; However, given the differences in tax impact, interest rates on profits could improve long-term tax outcomes for the beneficiary. From a tax perspective, since the recipient of a profit sharing becomes a partner for tax purposes, LLC provides the new partner with a Form K-1 reporting its share of LLC`s profits and losses and should no longer report payments for services on a Form W-2, or withhold income, Social Security and Medicare taxes or pay the employer`s share of those taxes. Like stock options, the granting of profit shares should not lead to a taxable event for the beneficiary at the time of grant. . . .