Private companies: How to account for “profits interest” in LLCs
Published July 26, 2019
The use of profits interest, a relatively new form of equity compensation issued by limited liability companies (LLCs), has spiked. Now, private companies and their advisors are asking the Financial Accounting Standards Board (FASB) to simplify the complex rules that have evolved to account for these transactions.
As the name suggests, “profits interest” arrangements provide recipients with a share of the company’s future profits. Under existing U.S. Generally Accepted Accounting Principles (GAAP), these transactions may be classified as:
- Share-based payments,
- Bonus arrangements, or
- Deferred compensation.
The classification is determined by the specific terms and features of the profits interest. In most cases, the fair value basis of the award must be recorded as an income statement expense. Profits interest can also result in the recognition of a liability on the balance sheet and require footnote disclosures. The disclosure requirements have been flagged by private companies as one area in need of simplification.
Need for improvement
The use of profits interest awards as a tool to attract and retain skilled workers has increased, as more companies are being structured as LLCs, rather than as C corporations or S corporations. Profits interests are used exclusively by LLCs. Corporations tend to award traditional share options instead.
“Profits interest continues to come up as an area private companies are struggling with,” said Candace Wright, Chair of the Private Company Council (PCC) during a June meeting with the FASB. She called profits interest “a topic we all need to have on our radar as to whether or not there are some simplifications that we can do in that space.”
The topic surfaced as PCC members were discussing plans to provide a “practical expedient to measure grant-date fair value of equity-classified share-based awards.” The PCC’s current work is aimed at allowing private companies to use the exercise price of their equity-classified share options as the current price for purposes of determining the grant-date fair value of an award in certain circumstances.
The panel has been trying to understand the process a private company uses to establish an award’s strike price and the audit procedures associated with that process. The work is still ongoing.
For more information
Many companies could incentivize exceptional performance by awarding profits interest and other types of equity-based compensation. But accounting complexity has caused some private companies to shy away from these arrangements.
Simplification of the financial reporting guidance would be welcome news for many employers and employees. Contact your MCM professional for help reporting these transactions under existing U.S. GAAP or for an update on the latest developments from the FASB.