Profits interests: How to prepare for your year-end audit

Profits interests are a unique type of equity-based compensation issued by limited liability companies (LLCs). This incentive is favored by many private equity firms to help recruit, retain, reward, and align employees with long-term value creation strategies.

Although the tax basis of profits interests at the grant date is often $0, the financial reporting requirement differs because it accounts for the potential of future increases in value.

Although the tax basis of profits interests at the grant date is often $0, the financial reporting requirement differs.

This leads to a specific set of financial reporting requirements in order to comply with GAAP. The following items are needed for your year-end financial statement audit:

• Cap table: Prepare an up-to-date capitalization schedule for all equity interests covering each grant date and at fiscal year-end. It should track additions, vesting, modifications, redemptions, and forfeitures over the year. Make sure you properly identify and document the IRS safe-harbor threshold for each grant.
• Agreements & records: Put together copies of all agreements for awards made during the year.  Assemble the latest copy of the LLC operating or partnership agreement, profits interests plan documentation, amendments, modifications, and board approvals since the last audit.
• Valuation information: Determine the fair value at grant date for profits interests issued during the period and at year-end for units with liability treatment. You’ll need supporting valuation analysis on the fair value for these dates or to estimate materiality. Remember that, for accounting, the grant date fair value is not zero.
• Expense schedules & footnotes: Put together the rollforward of expense schedules, journal entries, and EBITDA calculations for the year. Prepare draft footnote disclosure narrative and tables.

Underwater conditions

In addition to the above items, you should also consider the potential impact of economic conditions in 2020 on your profits interests plan. If the equity value of the business declined during the past year — a situation experienced by many companies in 2020 — it may have fallen below the IRS safe-harbor threshold previously set for some profits interests — a condition referred to as being “underwater.” Depending on how the underwater condition is addressed, the effect on incentive-based employee compensation packages can have a significant impact to your financial reporting, audit, and tax situation. Accounting for underwater profits interests is complex and should be discussed with your auditors to identify what’s needed for reporting purposes.

This advance preparation should help the audit process on your profits interests go smoothly. For additional information on audit preparations or to discuss your specific circumstances for this year’s audit, please contact us.