Limited liability companies (LLCs) taxed as partnerships have become the preferred legal entity for business. The owners of these entities enjoy the flow-through tax treatment of a partnership as well as the liability insulation of a corporation.

Nationally, LLCs represent the largest entity type for partnerships, according to the latest statistics released by the Internal Revenue Service. For 2005, the number of LLCs increased 15.4 percent to 1,465,223, surpassing all other entity types for the fourth consecutive year.

Often, the owners of an LLC want to provide an equity interest to motivate and retain key employees. The most commonly used approach is to provide "profits interests," essentially the right to a share of the future income and/or appreciation in value of the LLC.

For example, a profits interest could be designed to provide a share of the LLC's future earnings or losses to key management employees (e.g. the holder is entitled to receive 5 percent of the LLC's income or loss) or could be designed to provide a share of the proceeds realized upon sale of the LLC or its assets.

A profits interest generally can be designed to have pre-tax economic consequences that are the same as, or come very close to, those of stock options. Typically, profits interests awarded to the key management employees are subject to forfeiture under certain circumstances (e.g. the employee quits or is terminated for cause).

Historically, many tax practitioners took the position that the profits interest always had no fair market value upon receipt, although proposed guidance indicates that the government does not agree with that position.

Unless distributions of future income of the LLC are made to the holders of the profits interests, then no further taxes are paid until the profits interests are sold or otherwise disposed. At the time of granting the award, if there is no value, there is no tax obligation. Profits interest taxes would then be paid according to capital gains tax rates when the interest is sold.

Proposed (not finalized) guidance from the Treasury Department provided a "safe harbor" for valuing profits interest by stating that, if certain requirements are met, the profits interests may be valued at their liquidation value at the time of transfer (generally, this is zero).

In order to be eligible for the safe-harbor election, several requirements must be satisfied including: 1) the partners must consent to the election; 2) the election must be filed with the IRS; 3) no partner may report income or fail to file information reports in a manner inconsistent with the election; and 4) the services for which the partnership interest is issued must be rendered to the partnership. Additional requirements also apply.

Profits interests can be tax-free at grant only if provided to employees or other service providers. If profits interests are held for at least one year after the interests vest, the amount received is treated as a long-term capital gain; otherwise, it is a short-term gain.

In addition, if a profits interest holder makes an 83(b) election or when the profits interest is no longer subject to forfeiture, it must be handled as though the holder actually has an equity stake. The holder can expect a K-1 statement that attributes a share, if any, of profits or losses and would have to pay the respective taxes. The LLC can make distributions here. Should the employee give up the profits interest for any number of reasons, such as not vesting, the employer must make a specific allocation to counter gains or losses related to a specific employee.