Capital Interests

Key Concepts #

  • A capital interest is an interest in a partnership or LLC taxed as a partnership that entitles the recipient to share immediately in the proceeds of liquidation. In other words,
  • A capital interest normally results from a capital investment and provides recipients with participation in current and future equity value, a share of income and distributions.

Grant #

  • When someone receives a capital interest in an LLC 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.

Taxation #

A vested capital interest that a partner receives for services provided to the partnership creates taxable income for that partner. The transfer of a capital interest is taxed at ordinary income tax rates and the partnership gets to take a deduction on the entity’s income tax return.

If a capital interest is unvested at the time it is transferred to the partner, the partner should consider making an election under Section 83(b). The election will cause the taxpayer to be treated as a partner from the time of receipt of the interest. It will also cause the holding period on the gain to begin to run.

Example #

Mike is an employee of the XYZ Partnership. Partners John and Ryan each have a capital account of $100. Mike is granted a 10% capital interest. Mike is therefore entitled to $20 if XYZ Partnership liquidates (10% of the total capital of $200). Partners John and Ryan each now have capital accounts of $90 (their original $100 less their pro rata $10 of partnership capital transferred to Mike). Mike has an initial capital account of $20.

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