Say you own one half of an LLC that is taxed as a partnership. You and your partner invested the initial capital that was necessary to get the business up and running, and you both built the business with the help of a few key employees. With the business still in the growth phase, you want to make sure that you motivate and retain these key employees who are helping you grow your company. What should you do? You and your partner might want to consider causing the LLC to issue the key employees a profits interest in the LLC.
What is a Profits Interest?
From a tax standpoint, a partnership and an LLC taxed as a partnership can issue two basic types of equity interests: capital interests and profits interests. A capital interest is an interest in a partnership or LLC taxed as a partnership that entitles the recipient to share immediately upon receipt in the proceeds if the entity’s assets were sold at fair market value and the proceeds were distributed in a complete liquidation. A capital interest normally results from a capital investment and provides the recipient with the right to participate in current and future equity value, a share of income and distributions. When someone receives a capital interest in a partnership in exchange for a corresponding capital contribution, this is typically a tax-free event. When someone receives a capital interest in exchange for services, this is taxable compensation to the service provider.
Profits interests (also sometimes called “carried interests”) are distinct from capital interests, providing no current right to share in the proceeds of liquidation as of the date of grant. Instead, they typically only provide a recipient with the right to share in those future profits and appreciation of the business that arise after they acquire the interest. The primary goal of issuing profits interests is typically to give a service provider the ability to participate in the growth of the enterprise without incurring tax on the receipt or vesting of the interest, and, if held for more than one year, to potentially enjoy at least some long-term capital gain treatment (instead of ordinary income treatment) on proceeds they receive on a sale of the interest or a liquidity event (subject to certain re-characterization rules under Section 1061 of the Internal Revenue Code, which may require treatment as a short-term capital gain).
Structuring a Profits Interests
Usually, as long as the profits interest is structured properly and capital accounts are “booked up” on entrance of the profits interest member, the IRS should not treat the grant of a vested or unvested profits interest as a taxable event. Most practitioners design profits interests so that they meet IRS safe harbor standards for ensuring profits interest treatment. These standards include:
- The profits interest must not relate to a substantially certain and predictable stream of income from the entity’s assets, such as income from high quality debt securities or a net lease;
- The recipient of the profits interest must not dispose of it within two years of receipt; and
- The profits interest may not be a limited partnership interest in a publicly traded partnership.
Things to consider with respect to newly issued profits interests include whether such recipients should have voting rights similar to that of members who contributed capital to the enterprise and whether such profits interests are vested at the time of issuance or will vest over time subject to certain time, or performance-based requirements. The issuing entity’s partnership or operating agreement should be closely examined upon the issuance of a profits interest to ensure consistency and should be updated to clearly define how the profits interests will be valued relative to capital interests under current buyout or redemption provisions. Oftentimes, practitioners ensure that a profits interest has no right to share in liquidation proceeds on the grant date by valuing the partnership’s capital interests as of that date, and providing that a profits interest recipient will not share in distributions except to the extent a threshold established based on the value of the capital interests is exceeded. Also, booking up capital accounts is generally critical to ensuring that the profits interest does not entitle the recipient to any proceeds of liquidation if the entity was liquidated on the grant date.
To the extent the profits interest issued is unvested at the time of issuance, most recipients opt to make an “83(b) election” to ensure tax-free treatment upon vesting. When a profits interest is issued, it has no value. If the profits interest is vested, there is no question that it is taxed at the time of receipt, at $0. Unvested property is taxed at the time of vesting, on the property’s value at the time of vesting. Hence, if the profits interest has appreciated in value since the time of grant, then there would be ordinary income at the time of vesting. To avoid this treatment, recipients of profits interests can make an 83(b) election, which is an election to treat the profits interest as vested for tax purposes at the time of grant and to be taxed on the value of the profits interest at the time of grant. There is some IRS guidance that states that an 83(b) election is not necessary if certain safe harbors are met. However, that issue is beyond the scope of this article, and a so-called “protective 83(b) election” is usually still made to assist in easing the minds of profits interest recipients who want to ensure that the interest is not taxable when it vests.
Tax Consequences of a Profits Interest
The recipient of a properly structured profits interest is not taxed on receipt because the IRS views the profits interest’s value as $0. Because the profits interest is treated as having no value, there is no deduction that corresponds to the issuance of the profits interest for the entity. The profits interest will be treated as having a $0 basis, and no capital account. Going forward, the recipient should be treated as an equity owner under the terms of the governing partnership or operating agreement for the entity starting on the date on which the profits interest was granted. The recipient should receive a K-1 and pay taxes on income that is passed through from the entity (whether or not the recipient actually receives cash distributions from the entity). Capital accounts should be adjusted accordingly, just as is the case for any other partner. It is also important to note that, given the IRS’ stance that one cannot be both a partner and an employee of the same partnership, an employee of a partnership or an LLC taxed as a partnership who receives a profits interest should no longer be treated as an “employee” of the entity for tax purposes. This generally means that any payment from the partnership received for services should be subject to self-employment taxes, and the recipient may be ineligible to participate in certain employee benefit programs not available to partners.
The Future of Profits Interests
Overall, profits interests are a unique and creative way to give people who are rendering services to a partnership or LLC taxed as a partnership a stake in the enterprise. With the increased use of LLCs for startup operations, the use of profits interests as an incentive compensation mechanism has grown in the past years. If you are interested in learning more about profits interests and the complications that must be navigated when profits interests are issued to service providers, please contact your Varnum attorney.
This advisory was originally published August 4, 2016. Updated July 21, 2023.