Frequently asked questions about profits interests

An equity-based compensation device that could help incentivize key employees

Apr 02, 2024
Business tax Employee benefits Compensation & benefits

Executive summary: Frequently asked questions about profits interests

Partnerships can issue profits interests as a way to attract and motivate employees or contractors by giving them a stake in the future profits of the company. However, to avoid unintended tax consequences, when structuring a profits interest, there are specific requirements to keep in mind. If properly structured, a profits interest can be issued with a no tax impact upon the date of grant and allow the recipient to be taxed at capital gain rates upon a future sale.

Before deciding what type of executive compensation device is right for your company, here are some answers to frequently asked questions about profits interests.

Equity compensation can reward employees, increase engagement, and enhance overall company performance and morale. In partnerships, employers use profits interests as a way to attract and motivate employees or contractors (service providers) by giving them a stake in the future profits of a partnership or an entity taxed as a partnership for US tax purposes, such as a limited liability company (LLC) or limited partnerships (referred to herein as “partnerships”). The following are answers to some frequently asked questions regarding profits interests issued to service providers.

Q. What is a profits interest?

A. A profits interest is an actual ownership interest in the partnership, issued in exchange for services provided to the company, which has no right to cash if the company were to liquidate on the date the interest (or interests) is issued. Thus, a profits interest is specifically designed to provide the owner with a right to share in the future profits and appreciation of the company. This is generally accomplished by applying a ‘threshold’ or hurdle based on the market value of the company on the date of issuance. For example:

ABC, LLC wants to issue a profits interest to Dave equal to 5% of future profits. A determination is made that if the company were to sell all of its assets and liquidate on the date the company is planning to issue the profits interest to Dave, the existing owners of ABC, LLC would receive $100. Therefore, the hurdle value used for Dave’s profits interest would be $100.

Later, if the company is sold for $300, Dave would receive an allocation of $10 as result of his ownership of the profits interest (5% of the $200 in appreciation).

Q. How are profits interests treated for federal income tax purposes?

A. Generally, when property (such as a capital interest in a partnership or shares in a corporation) is transferred to a service provider, section 83 governs the transfer and the service provider recognizes taxable compensation equal to the fair market value (FMV) of the property on the date of grant (or vesting, depending on the facts), less any amount the service provider paid for the property. However, profits interests are subject to specific requirements defined in Rev. Proc. 93-27, and further clarified in Rev. Proc. 2001-43, which when satisfied result in favorable tax treatment for service providers.

A profits interest $0 liquidation value on the date of grant allows for a deemed $0 value overall for compensation tax purposes, which is the defining characteristic of a profits interest. However, a company must satisfy the requirements below to ensure issuances qualify as a safe harbor profits interest:

  • The recipient receives the interest in exchange for services provided to or for the benefit of a partnership, in a partner capacity or in anticipation of being a partner,
  • The interest does not relate to a substantially certain and predictable stream of income from partnership assets,
  • The partner cannot dispose of the interest within two years of receipt,
  • The interest cannot be as a limited partner in a publicly traded partnership,
  • The partnership and the service provider treat the service provider as the owner of the partnership interest from the date of issuance and the service provider takes into account the distributive share of partnership income, gain, loss, deduction, and credit associated with that interest in computing their income tax liability for the entire period during which the service provider has the interest, and
  • Upon the grant of the interest or at the time that the interest becomes substantially vested, neither the partnership nor any of the partners deducts any amount (as wages, compensation, or otherwise) for the fair market value of the interest.

Q. What is the benefit of a profits interest?

A. Profits interests can be granted with no immediate tax impact to the recipient and are generally taxed at capital gains rates upon a later sale.

The ability to rely on the holder’s $0 liquidation value on the date of issuance allows for a tax-free grant to a service provider in many cases. That is, the issuance of a safe harbor profits interest is not considered a taxable event for the service provider or the partnership. Comparatively, if the company were to issue a capital interest, or even the option to purchase an interest, the recipient would be taxed on the value of such instruments on the date of grant, vesting or exercise.

Unlike other equity-based compensation structures (such as phantom equity or equity-based bonuses) profits interests are treated as equity for income tax purposes. The primary benefit of this treatment is the ability to utilize capital gains tax rates when the units are sold or redeemed, or if the company were to sell its assets.

Q. Must the partnership or LLC agreement specifically provide for profits interests?

A. Generally, yes. Profits interest holders are, and thus should be treated as, equity holders in the company. The partnership or LLC agreement should not only include provisions that ensure the desired tax treatment but also make clear how income and loss is allocated, how distributions are paid, and what steps should be taken in the event of a forfeiture of the issued profits interests (if subject to restrictions upon issuance).

Q. Can profits interests be subject to restrictions or vesting requirements?

A. Yes, many profits interests are issued subject to restrictions, such as vesting or forced repurchase upon the occurrence of certain events, such as termination of the service relationship. However, vesting is often ignored, and the recipient is instead considered a partner for federal income tax purposes as of the date of grant.

Profits interests issued to service providers are generally designed to be subject to a substantial risk of forfeiture (i.e., a vesting schedule). The vesting can be either time-based (where an individual must continue to provide services for a period of time) or performance-based (where the company or individual must achieve certain performance criteria, e.g., earnings before interest, taxes, depreciation and amortization (EBITDA) threshold or personal performance goal). It is common to have some units subject to time-based vesting and some subject to performance-based vesting.

Q. How does the individual receive value from the profits interest?

A. Profits interest holders often have rights to distributions of profits, although the most common way in which holders see value is as the result of liquidity events in which they are entitled participate, such as participating in the proceeds from a sale of the company, or through the sale of their units when retiring or otherwise exiting the company.

Q. Is a section 83(b) election available for profits interests?

A. Yes, and most advisors recommend making a protective section 83(b) election with respect to a safe harbor profits interest, especially if the interest has some sort of vesting provision. A section 83(b) election allows a service provider to elect to recognize the value of the profits interest during the year of grant ($0 in the case of a safe harbor profits interest) despite the fact that the rights to such profits interest may not yet be vested. This election must be made within 30 days after the grant date. Given that the safe harbor deems the value of the interest to be $0 at the time of grant, this election can help protect the service provider from possibly being taxed on the FMV of the profits interest on the vesting date (when the profits interest may no longer have a $0 value). Also, by making a section 83(b) election, the taxpayer is treated as an owner of the profits interest from the date of grant. The regulations provide that the capital gain holding period on ownership interests subject to an election starts on the date of grant, even though the ownership interests are still subject to a substantial risk of forfeiture under the grant agreement (and thus the individual is more likely to have long term capital gain treatment on a later sale of the vested ownership interest).

IRS guidance suggests that if a safe harbor profits interest is held for more than two years, it is treated as having made a deemed section 83(b) election. However, in the event a profits interest is disposed of before satisfying the two year holding period, no such protection is available unless an actual section 83(b) election was timely made. The 83(b) election does not guarantee that the profits interest meets the safe harbor but may limit the amount of compensation on which the individual could be taxed because of the early disposal of the interest.

Q. Are there any reporting issues on the grant of a profits interest?

A. If the employee works for the entity that is issuing the profits interest (or a disregarded entity of the partnership issuing the units), there may be employee characterization issues. Specifically, an individual cannot generally be treated as both an “employee” and a “partner” of the same entity (and, furthermore, cannot be a partner of one entity and an employee of a disregarded entity owned by the partnership). Thus, if a partnership transfers a profits interest to a service provider, the individual becomes a partner on the date of grant and should start to receive a Schedule K-1, even if the individual holds an unvested profits interest. For employees, status as an employee ends as of that date because the individual becomes a partner. The individual’s salary should generally be treated as a “guaranteed payment” reported on Schedule K-1, and the individual may not be treated as an employee for some of the company’s employee benefit programs (or may be allowed to participate in some of the employee benefit plans but under the less beneficial partner treatment).

Some employees find the lack of Form W-2 treatment, federal income tax withholding (replaced by a need to do their own estimated taxes), and the need to pay taxes in states where the partnership does business to be burdensome. Accordingly, some company’s may consider alternatives by restructuring or using a different compensation mechanism. However, to avoid unintended tax consequences, any restructuring must be done with care.

Q. Will a service provider receive a Schedule K-1?

A. As discussed above, a service provider who receives a profits interest under the safe harbor rules will generally be treated as a partner, beginning on the date of grant of such profits interest (irrespective of whether the interest has vested), which triggers the issuance of a Schedule K-1 to the service provider. Additionally, depending upon the specifics of the interest granted, the service provider may also be allocated a share of the operating income from the partnership, even in instances in which the interest has yet to vest, which would be reflected on the Schedule K-1 received from the partnership. As a note, allocations of operating income prior to the vesting of an interest may create additional complexity in the event the service provider later forfeits the interest.

Q. What should a company consider when designing a profits interest plan?

A. Because issuing profits interests results in service providers being treated as owners in the business, partnerships should consider the following when formulating aspects of their written plan:

  • Does the partnership agreement allow for such grants?
  • What percentage of future earnings are existing partners willing to share with key individuals?
  • The IRS maintains that employees cannot be partners, and as such, would the lack of employee characterization be too burdensome for the individuals receiving the grant of profits interests?
  • What type of vesting terms will most likely incentivize but also retain service providers?
  • Will special vesting rules apply in the case of death, disability, or other events?
  • What types of forfeiture provisions should apply if the individual voluntarily leaves the organization while holding unvested units?

The attributes of profits interest plans should be thoughtfully considered and reviewed with a trusted tax advisor to determine whether it is the right type of equity to meet a company’s needs.

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