Misconception vs. reality: The truth about profits interests

Understanding the fundamental tax considerations of issuing and receiving profits interests

January 29, 2025
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Private equity Compensation & benefits
Personal tax planning Business tax Private client services Employee benefits

Executive summary

Profits interests for services are often touted as one of the most valuable management incentive tools available to partnerships (and limited liability companies taxed as partnerships). If certain requirements are met, profits interests receive capital treatment (versus ordinary) and tax is generally deferred until disposition. However, there is often confusion around the tax attributes of profits interests and the requirements necessary to achieve the desired tax treatment. This article seeks to demystify some of the fundamentals of taxing profits interests by addressing common misconceptions. For additional information on the taxation of profits interests, check out our previously published RSM US profits interests FAQs.


The top 10

Misconception #1: Profits interests are not equity

Reality: Profits interests are a partnership interest and, as such, an equity interest. They are distinguished from capital interests because they give the holder no right to proceeds if the company were to liquidate on the date of grant. A recipient of a profits interest should generally be treated as a partner in the partnership from the date of grant, which is typically evidenced by cessation of treatment of income as wages, changing information reporting (i.e., issuance of a Schedule K-1) and modifying participation in company sponsored benefits accordingly.

Misconception #2: Profits interests holders are not partners

Reality: Profits interests are an equity interest in the partnership. The holder is generally treated as a partner from the date of grant. They will typically sign a joinder (or are deemed to have signed and be bound by) the partnership agreement. Failure to treat a profits interest holder as an owner from the date of grant could jeopardize satisfaction of the safe harbor requirements and therefore the interests being respected as good profits interests. See also Misconception #8.

Misconception #3: Profits interests recipients do not receive Schedules K-1

Reality: All equity holders should receive a Schedule K-1. It’s possible that the Schedule K-1 may be blank, but it should still be filed and furnished each year. Also, this is one of the ways that partner classification is evidenced in satisfaction of the IRS safe harbor requirements for profits interests.

Misconception #4: Profits interests only pay out on a sale or liquidation

Reality: This is very much dependent upon the specific economic terms of the partnership/LLC operating agreement and/or the terms of the individual award agreements. While this result can be achieved with proper structuring and drafting, it’s important to keep in mind that the IRS wants to ensure that you are truly a ‘partner’ in the partnership, rather than an employee receiving a disguised form of compensation. Many agreements, if not structured and drafted to achieve this result, will entitle the profits interests to share in distributions (both current and tax distributions) should the company have sufficient profitability and/or appreciation prior to sale or liquidation.

Misconception #5: Profits interests are never entitled to allocations of income or loss prior to a sale/liquidation event

Reality: The allocation of partnership income/loss is based upon the agreement of the partners, which is typically memorialized in what’s referred to as a partnership or LLC operating agreement; these agreements have specific sections that govern the allocation of profits and losses, and it is those sections that ultimately determine whether a profits interest is entitled to an allocation of income or loss. It is also important to note that the allocations may differ on a year-by-year basis, so if a profits interest shares in the allocations of income in one year, it isn’t certain that they’ll share in the next year; this is all dependent upon the facts and circumstances of the business and its operating agreement.

Misconception #6: Profits interests holders receive a Schedule K-1 for their profits interests and a Form W-2 for their wages for the same period

Reality: Sometimes. A partner cannot be an employee of the same entity in which they hold their partnership interest. However, if an employee of a lower-tier entity receives a profits interests from an upper-tier entity for services provided to the lower-tier entity that is separately respected for federal income tax purposes, then they would receive a Form W-2 and a Schedule K-1. While other alternative structures exist, this is most commonly achieved through a tiered partnership structure where management holds their profits interests in an upper-tier entity (like a management holding partnership) and also receives wages as employees of a lower-tier operating partnership. It’s important to note that a wholly-owned, single member LLC (SMLLC) owned by the partnership issuing the profits interest is not sufficient separation because SMLLCs are disregarded entities for federal income tax purposes. If a single partnership or partnership that owns a disregarded entity issues profits interests to employees of the partnership or disregarded entity, the recipients should be transitioned from employees to partners. This means, among other things, that they will no longer receive Forms W-2 reporting wages but rather Schedules K-1 reporting guaranteed payments. Additionally, partner compensation is self-employment income and is not subject to federal income tax withholding. Different rules will apply for the benefits in which they participate. Note that in the year of issuance, a profits interests recipient will receive both a Form W-2 and a Schedule K-1 covering the periods that they are an employee and a partner, respectively. See also Misconception #7.

Misconception #7: Profits interests recipients can continue to participate in the company’s health and benefit plans like they did as employees.

Reality: It depends. Different rules apply for partners and employees when it comes to fringe benefits. Some plan participation is prohibited for partners altogether, such as in flexible spending accounts (FSAs), whereas others have different tax impacts. Unlike the typical tax-favored treatment of group health coverage payments for employees, health insurance payments made by the partner and any contributions by the company are treated as guaranteed payments to the partner (offsetting individual deductions may apply but that is beyond the scope of this article). Similarly, how compensation is calculated for purposes of certain retirement plan contributions is different for partners and employees. For partners, compensation is based on the partner’s net earnings from self-employment and for employees it is based generally on wages. Ineligible participation or incorrectly calculating benefits in a plan would likely require some corrections on part of the company that carry an administrative burden; and in a worst-case scenario, it could disqualify the plan.

Misconception #8: Misclassification of partners as employees does not result in exposure for the company

Reality: Untrue. Incorrect information return penalties could apply to both the incorrect filing and furnishing of Forms W-2 and Schedules K-1, which can add up over multiple years especially if there were several profits interests recipients. Alternatively, monthly penalties could be imposed for the partnership return being incorrect (as a result of missing or incorrect Schedules K-1) and for the Schedules K-1 as furnished to the partner being incorrect (or missing).

Misconception #9: The risk of detection of partner misclassification is low so you can ignore this issue

Reality: Also untrue in two areas. The IRS’s partnership self-employment tax initiative and focus on wealthy individuals could increase exams in this area. It is also likely that profits interests issuances and treatment of the recipients will be scrutinized during buyside diligence, which could have an impact on sales proceeds.

Misconception #10: If some or all profits interests held by a partner are exchanged for different profits interests or another type of equity as part of a transaction, that’s a non-taxable event

Reality: It depends. There are many factors that need to be analyzed when determining the tax treatment of a profits interest in a transaction, for example, the structure of the transaction, whether the profits interests meet the requirements for deferred tax treatment under IRS rules, and the value of the interest held relative to the value of what is being received. These are some of the issues that should be considered prior to an exchange or conversion of a profits interest.  

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