LLC/Partnership--Profits Interest vs. Capital Interest

Partnerships can grant profits interests or capital interests for services.  LLCs taxed as partnerships are proliferating.  So what do you need to know about partnerships granting equity interests to service providers? Is it like a corporation issuing stock options? In most cases, yes, but there are some differences.

One limitation is that partnerships cannot grant Incentive Stock Options (“ISOs”). Only corporations can issue ISOs pursuant to IRC section 422. But in my experience, the benefits of ISOs over non-qualified stock options are overblown. For partnerships, the first thing you need to know is the difference between a capital interest and a profits interest.

What’s a Capital Interest?  A capital interest means if the partnership were to liquidate immediately after granting the capital interest, the holder would receive his or her proportionate share of the partnership’s assets in the liquidation.

John is an employee of the XYZ Partnership. Partners X, Y, and Z each have a capital account of $100. John is granted a 10% capital interest. John is therefore entitled to $30 if XYZ Partnership liquidates (10% of the total capital of $300). Partners X, Y, and Z each now have capital accounts of $90 (their original $100 less their pro rata $10 of partnership capital transferred to John). John has an initial capital account of $30.

What’s a Profits Interest? A profits interest is defined by exception: Any partnership interest that is not a capital interest is a profits interest. A profits interest only entitles the holder to future profits and appreciation of the partnership’s assets.

Meg is an employee of DEF Partnership. DEF Partnership’s new assets are valued at $100 at the time Meg is granted a 10% profits interest. All future profits and growth in value of DEF Partnership above $100 would be allocated 10% to Meg.  If DEF Partnership liquidates the day after Meg receives her profits interest, she gets nothing. If, however, DEF Partnership sells its assets at a later time for $200, then Meg would receive $10 ($200 – $100 x 10% = $10).

Capital Interest vs. Profits Interest (Tax Consequences): The tax consequences of a grant of a profits interest in a partnership has evolved over the years.  Entire treatises have been written about the tortured history and theoretical underpinnings of the granting of a profits interest in a partnership. 

The good news is that right now, absent further revisions, there is a safe harbor that is relatively easy to adhere to. Rev. Proc. 93-27, as clarified by Rev. Proc. 2001-43, is all you need to know. Both revenue procedures are short and to the point.

Here are the takeaways:

Definitions of Capital Interest vs. Profits Interest: Whether a partnership interest issued to a service provider is a capital interest or a profits interest is determined at the time it is granted.

The liquidation analysis described above is the key to ascertaining whether the interest granted is a capital interest or a profits interest. Look to the LLC Operating Agreement or Partnership Agreement to determine how liquidation proceeds are allocated to the partners of the partnership.

Tax Consequences of a Capital Interest: A capital interest received in exchange for the performance of services can be vested or unvested. Vested means it can be freely transferred and it is not subject to a substantial risk of forfeiture. Unvested means it doesn’t meet one or both of those conditions. Most of the time, partnership interests granted for services are unvested, since part of the objective is to incentize the service provider to stick around. A service provider who receives a vested capital interest must recognize taxable compensation income at the time the interest is granted. The amount of compensation income is equal to the fair market value of the partnership interest granted. The partnership receives a corresponding tax deduction.

A service provider who receives an unvested capital interest does not recognize taxable income until the restrictions lapse and the interest become transferable. At that time, he or she has taxable compensation income equal to the fair market value of the partnership interest and the partnership has a corresponding tax deduction. If the service provider makes an 83(b) election within the required 30 days of being granted the unvested capital interest, then he or she recognizes taxable compensation income equal to the fair market value at the time of grant and the partnership has a corresponding tax deduction.

Tax Consequences of a Profits Interest: The grant of a vested profits interest is not a taxable event at the time of grant as long as the safe harbor in Rev. Proc. 93-27 applies.  The safe harbor in Rev. Proc. 93-27 is pretty easy to meet. Basically, if a service provider receives a profits interest, then the grant of the profits interest is not a taxable event and the service provider will not have to recognize taxable income at the time of grant unless one of the following three exceptions applies:

The profits interest relates to a substantially certain and predictable stream of income from partnership assets, such as income from high-qualify debt securities or a high-quality net lease;
Within two years of receipt, the partner disposes of the profits interest; or
The profits interest is a limited partnership interest in a “publicly traded partnership” within the meaning if IRC section 704(b).

The grant of an unvested profits interest was unclear under Rev. Proc. 93-27. Fortunately, the IRS eventually issued Rev. Proc. 2001-43 to clear up the uncertainty. The bottom line is that the grant of an unvested profits interest is treated similarly to the grant of a vested profits interest as long as certain conditions are met:

Both the partnership and the service provider treat the service provider as a partner beginning with the date of grant;
The service provider picks up the K-1 items associated with the partnership interest on his or her Form 1040;
No compensation deduction is taken by the partnership or any partner in connection with the grant of the partnership interest; and
All of the requirements of Rev. Proc. 93-27 are satisfied.

Rev. Proc. 2001-43 states that the recipient of an unvested profits interest does not have to make an 83(b) election in order to obtain the favorable tax treatment outlined above. In essence, the partnership and the service provider are treated as if the service provider made a valid 83(b) election and valued the partnership interest at zero.

A Few Nuances/Issues: Ready to advise your partnership clients to go ahead and grant profits interests to their employees? I admire your enthusiasm, but there are a few cautions and caveats.

Recipient is No Longer an Employee: Partners in a partnership cannot be employees! So from the date of the grant of the partnership interest, whether it’s a capital interest or a profits interest, a former employee no longer has “wages” and can no longer participate in employee benefit plans (except to the extent permitted as a partner). The safe harbor of Rev. Proc. 93-27 is not applicable if this is handled incorrectly.

Here’s a link to an article in The Tax Adviser that addresses why you will not want to treat partners as employees: Partners as Employees? Properly Reporting Partner Compensation.

Get It in Writing:  Make sure the grant of a profits interest is in writing and references that it is meant to comply with Rev. Proc. 93-27 (if that is your intent).   While Rev. Proc. 2001-43 says no 83(b) election is necessary, that’s only true if all the other conditions are met. What if the service provider who receives an unvested profits interest disposes of the interest within two years? What if the service partner does not pick up the K-1 correctly on his or her 1040? 

BookupsI know you’re tired of reading so we won’t cover this in detail. But as you might expect, partnership allocations can be tricky when a new partner is admitted.  A bookup is often called for in order to insure that future partnership allocations have substantial economic effect under IRC section 704(b).

The Future:  In 2005, the IRS issued Notice 2005-43 along with proposed regulations under IRC sections 83, 704, and 721. If the proposed revenue procedure contained in Notice 2005-43 is ever finalized, Rev Procs. 93-27 and 2001-43 will become obsolete.

Conclusion: Granting employees “skin in the game” can be a powerful incentive and retention tool. Partnerships are not shut out when it comes to issuing equity interests to service providers. There are tax consequences when granting partnership interests to key service providers.  I hope this article is helpful in navigating these waters.

Bowman Law Firm
Gene M. Bowman, Tax Attorney & CPA