Companies often grant stock options to incentivize employees and so that their interests are aligned with the future success of the company, and partnerships (and limited liability companies taxed as partnerships) are no exception. These interests are often issued to general partners as a “carried interest” to reward performance upon the liquidation of an investment, to persons who bring a transaction to the partnership in lieu of a finder’s fee, or to providers of services to the partnership. If there is value in the interest greater than the price paid or contribution made, then the value is immediately taxable; therefore, with proper attention to drafting, the issuance of a profits interest in a partnership is generally without immediate tax to the recipient, but without that consideration an employee can receive an unexpected shock at tax time.
A “profits interest” is not defined by the Internal Revenue Code or Treasury Regulations, but rather by a few revenue rulings and other administrative pronouncements. A “profits interest” is an equity interest that is not a “capital interest”; a “capital interest” is an equity interest for which the holder would be entitled to immediate receipt of cash or property if the partnership were to be liquidated on the day such interest is issued. Usually, a capital interest is acquired only by a partner in exchange for a capital contribution to the partnership. If an interest intended to be a profits interest would be entitled to a distribution on the date of issuance, then it has immediate value on the date of issuance, is a capital interest, and the receipt is taxable to the holder to the extent the value exceeds any consideration/contribution paid by the recipient.
A partnership profits interest is intended to be limited to a share in the potential economics of the partnership, with the added benefit that future tax may be based on capital gains rates rather than ordinary income rates if that is the character of the profits that flow through the underlying partnership. The key in the issuance of the interest is to define the interest so that the holder shares only in future profits. This is relatively easy if the profits interest is issued at the formation of the partnership, but gets tricky if the interest is issued during the term of the partnership. Careless drafting of a partnership agreement often converts a profits interest into a capital interest.
A partnership interest issued other than for a capital contribution is ostensibly compensation for services, and this might include the transfer for minimal or no consideration of an existing interest by a party controlled by the issuer or its general partner. As compensation, the value of the interest is taxable to the recipient in the year of issuance as ordinary income (and may be subject to the variety of employment-related taxes). This is not, however, typically the intent, as it requires the recipient to come out of pocket for the tax. Fortunately, the IRS and the courts currently take a position that generally benefits the recipient; an equity interest that is a profits interest may be deemed to have a value of zero at the time of issuance.
The issuance of a profits interest in the middle of a partnership’s life typically requires a current valuation of the partnership’s assets and often requires modification of the partnership agreement. The agreement, and any other documents prepared in connection with such issuance, must provide that the value of the partnership assets on the date of issuance of the profits interest is attributed solely to the partners other than the recipient of the profits interest and that the recipient only shares in future profits (e.g., a percentage of all distributions after aggregate distributions have been made equal to the then-current value).
Many profits interests are issued to employees or providers of future services and are forfeitable if the employee or service provider ceases to be involved with the issuer. Vesting or forfeiture provisions will not convert a capital interest into a profits interest or vice versa, but they could harm the recipient by delaying the recognition of income until the vesting occurs or the chance of forfeiture ceases, which often happens on a date prior to the realization of the underlying investment. Because the hope and expectation is that after issuance the interest will increase in value, the tax problem is greater because such vesting is not usually accompanied by cash to pay the tax. However, a safe harbor exists. Section 83(b) of the Internal Revenue Code permits an election for a taxpayer to take into income the value of property (e.g., a profits interest) as of the date that it is received by the taxpayer (presumably when the value is zero, if the agreement is properly drafted), without regard to any risk of future forfeiture. The important part of the election is that it must be filed within 30 days after the issuance of the interest; any delay in documenting the issuance runs the risk of missing the 30-day window.
Keep in mind that a profits interest is a contract and property right and that the holder of a profits interest is, and should be treated as, a partner for all purposes, including both state law and tax law. The proper treatment of the interest (i.e., no deduction taken by the issuer upon the issuance) and the proper tax forms (a K-1 rather than a W-2 or 1099) are important so that the issuance is not characterized as taxable compensation. However, a partner with only a profits interest is still a partner, so unless care is given to limit the rights of a non-capital partner in the partnership agreement, a profits interest partner is entitled to all information, to rights to examine books and records, and to otherwise fully participate in the rights afforded a partner under the partnership agreement and the applicable partnership statute. Some agreements characterize profits-interest partners as “special limited partners” or “class B limited partners” and limit rights and obligations under the partnership agreement.