Profits Interest

A profits interest is an ownership interest in a partnership, or in an LLC taxed as one, that entitles the holder to a share of the business's future profits and future increase in value, but to none of its existing value. The IRS's definitions, from Rev. Proc. 93-27 as restated in Rev. Proc. 2001-43, are built around a hypothetical sale: a capital interest "would give the holder a share of the proceeds if the partnership's assets were sold at fair market value and then the proceeds were distributed in a complete liquidation", and a profits interest is "a partnership interest other than a capital interest." The test is generally made at the time the interest is received.

Partnerships use profits interests to give employees, founders and other service providers a stake in growth without handing them part of what the existing owners have already built. LLC agreements may call them incentive units or profits units. Because the interest is worth nothing on a liquidation basis at the grant, the IRS's safe harbor treats its receipt as a non-event for tax, which is the main thing that distinguishes it from being handed shares of a corporation.

The safe harbor. Rev. Proc. 93-27 provides that if a person receives a profits interest "for the provision of services to or for the benefit of a partnership in a partner capacity or in anticipation of being a partner", the IRS "will not treat the receipt of the interest as a taxable event for the partner or the partnership." The IRS described its three exceptions in 2005: the safe harbor does not apply if the profits interest "relates to a substantially certain and predictable stream of income from partnership assets, such as income from high-quality debt securities or a high-quality net lease", if "within two years of receipt, the partner disposes of the profits interest", or if it "is a limited partnership interest in a 'publicly traded partnership'".

Unvested interests. Rev. Proc. 2001-43 extends the safe harbor to an interest that is substantially nonvested when granted. The IRS then treats the holder as receiving the interest on the grant date and will not treat either the grant or the vesting as taxable, provided the partnership and the holder treat the holder as the owner from the grant and the holder reports the distributive share of income, gain, loss, deduction and credit for the whole period; neither the partnership nor any partner deducts the interest's value; and the other conditions of Rev. Proc. 93-27 are met. Taxpayers it covers "need not file an election under section 83(b) of the Code."

Life as a partner. The holder's share of the partnership's income arrives on a Schedule K-1 and is taxable each year whether or not cash is distributed, and its character, ordinary income or capital gain, follows the partnership's own income. A partner's pay for services is handled as a guaranteed payment rather than a wage, and a partner may owe self-employment tax on business income, so an employee who receives a profits interest moves into a different tax and benefits position than a coworker who receives a bonus.

What is unsettled. In 2005 the Treasury and the IRS proposed regulations and a replacement revenue procedure that would change this framework once finalized, and said that until then taxpayers "may continue to rely upon current law, including" Rev. Proc. 93-27 and Rev. Proc. 2001-43. The proposals have not been finalized, so those two revenue procedures remain the guidance. Separately, a profits interest held in connection with services in a business that raises or returns capital and invests in or develops securities, commodities, rental or investment real estate and similar assets is subject to the three-year holding period of section 1061, the rule behind the carried interest debate.

1. The partnership sets the baseline. It values the business at the grant date, and the agreement gives the new interest a share only of value and profit above that baseline, so its liquidation value at grant is zero.
2. The interest is granted for services, often subject to vesting.
3. No tax at grant or vesting if the safe harbor's conditions are met, and the partnership takes no deduction for it.
4. Annual reporting. The holder is a partner from the grant, receives a Schedule K-1 and pays tax on the allocated share of income.
5. At a sale or liquidation, the holder receives a share of the growth, and gain on the interest is generally capital gain, subject to recapture-type rules for some partnership assets and section 1061 for fund managers.

Consider an example. An LLC taxed as a partnership is worth $5,000,000 when it grants Imani a 5 percent profits interest that shares only in value above that amount. If the business were sold and liquidated that day, she would receive nothing, so the interest qualifies and she owes no tax on receiving it. Five years later the business sells for $9,000,000. The growth is $9,000,000 − $5,000,000 = $4,000,000, and her share is 5% × $4,000,000 = $200,000, taxed according to the character of the gain the partnership realizes. Had she instead been given a 5 percent capital interest at the start, she would have received 5% × $5,000,000 = $250,000 of value at grant, taxable to her then as compensation, with nothing yet sold to pay the tax.

Pros

• Lets a partnership or LLC give key people a real ownership stake without an immediate tax bill, because the interest is worth nothing on a liquidation basis at grant.
• Gains on a later sale can be capital gain rather than wages, depending on what the partnership sells.
• It shares only in future growth, so existing owners keep the value they had already built.

Cons

• The holder becomes a partner: K-1 income is taxed each year even without a distribution, returns can be delayed by late K-1s, and estimated taxes may be needed.
• Partner status can change how the holder is paid and covered, since a partner is not treated as an employee for payroll and some fringe-benefit purposes.
• The safe harbor fails for a predictable income stream, a disposal within two years or a publicly traded partnership interest.
• Valuing the baseline correctly matters. An interest that would share in existing value is partly a capital interest and can be taxable at grant.