Equity Compensation: Are Profit Interests Right for You?
As a young veterinarian, you may be presented with an opportunity to receive profit interests as a form of equity compensation in a veterinary practice or related business. Confused by what this means and if it’s the right option for you? You’re not alone.
Equity compensation comes with potential benefits and drawbacks, and can be a confusing prospect. It’s vital you really understand what you’re being offered, and the pros and cons involved.
Do you know what profit interests are and how they differ from other forms of equity compensation? Let’s explore this in a little more detail to try and help you gain some clarity on your compensation opportunity.
What Exactly Are Equity Compensation Awards?
Equity compensation is offered to employees in place of cash payment. It may also be used to balance out a below-market salary. Yup, that’s right – non-cash pay. You’ll be agreeing to less money in the bank each month, in exchange for a (hopefully) bigger pay-off in the future.
The main advantage of equity-based compensation is that it ultimately allows employers to offer employees a chance to share in the success of their employer – which is great for you long-term – while not affecting your boss’s bottom line today.
Equity compensation allows you to share in your practice’s profits via appreciation, and may include options, restricted stock, and performance shares; all of these investment vehicles represent ownership in the practice you work for.
Equity compensation does come with some strings attached to it, however. Most require that you stay with your employer for a required period of time before you receive your awards. If you leave before that predetermined time, you may forfeit some or all of your awards. This is why equity compensation awards are also known as “Golden Handcuffs.”
What Are Profit Interests?
Profit interests, also known as carried interests, are a form of equity compensation that is typically granted to key employees and managers of a partnership or limited liability company (LLC).
Profit interests allow key employees and managers to share in the profits of a business without having ownership or control. They can be a valuable tool for aligning the interests of employees with those of the company and its investors. These interests give the recipient the right to share in the profits of the business, but not necessarily in its assets or control.
For example, let’s say a veterinary practice has several partners, one of whom is a veterinarian who plays a significant role in the day-to-day operations and management of the practice. The veterinarian partner may be granted a profit interest, giving them the right to a percentage of the profits generated by the practice. This aligns the veterinarian’s interests with those of the other partners, as they will only make money if the practice is successful.
Another example is a veterinary pharmaceutical company in which a veterinarian is granted a profit interest in a new product. The veterinarian will receive a percentage of the profits generated by the product, but will not have ownership in the company itself. This allows the veterinarian to participate in the upside of the product, while minimizing their downside risk.
Tax Implications of Profit Interests
It’s important to note that profit interests are not the same as traditional equity or stock options. Profit interests do not give the holder ownership or control in the company, and do not have voting rights. Profit interests are also typically not transferable and are subject to certain restrictions.
When a veterinarian is granted a profit interest, they may be required to pay taxes on the fair market value of the interest as if it were ordinary income. However, they may be able to reduce their tax liability by filing an 83(b) election.
This election allows the employee to report the value of the profit interest at the time it is granted, rather than waiting until it is vested or sold. This can be beneficial if the value of the profit interest increases over time, as the employee will pay taxes on the lower initial value.
It’s important to note that your 83(b) election should be filed within 30 days of receiving the profit interest, otherwise the option will not be valid. This election is irrevocable, so it’s important for veterinarians to carefully consider the value of the profit interest and the potential for future appreciation before making the election. Nxt:Gen Financial Planning also recommends speaking to your tax advisor to assess the impact these awards may have on your tax situation going forward.
Are Profit Interests Right for You?
This can be a confusing and complicated decision, and you should carefully consider the terms of the profit interest and the potential for future appreciation, as well as the tax implications.
If you have been offered profit interests I would strongly recommend seeking the guidance of a financial advisor or tax professional to fully understand the implications of the profit interests and make an informed decision.
These types of awards will not only help you feel like you have “skin in the game,” but also have the potential to supercharge your financial future. But remember they do come with one big downside, keeping you wedded to your employer until they pay off.
In order for you to understand if accepting these awards is right for you, it is best to have a clear understanding of your own financial goals. Aligning your money with your long-term life goals can be a difficult process if your plan isn’t clear.
If you’d like to discuss how Nxt:Gen can help you decide if equity compensation in the form of profit interests is the right option for you, I’d love to help. I offer a complimentary intro call, so please do get in touch.