Profit Interests

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. Profits interests share in the profits and residual value of the LLC (other than the initial value on the date of grant). In other words, the profits interest starts out with a zero dollar value and grows in value as the LLC grows in value. In this way, it is most similar to SARs (stock appreciation rights) in the corporate context.

A basic capital interest is similar to common stock — it has the right to a proportionate share of the capital, profits and residual value of the LLC. A basic profits interest is just like a capital interest, except that it gets a zero dollar interest in the value of the company on the date of grant. Profit interests are also referred as carried interest and is a typical piece of the compensation package for managers of private equity funds

Example #

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

Grant #

Profits interests can be fully vested upon grant or can vest over time. Whether or not to require vesting differs for each partnership and transaction. Profits interests that vest over time are used in order to incentivize the key employee or service provider to remain aligned with the partnership over a longer timeframe. The grant of the profits interest should not result in any taxable income to the recipient.

Vesting #

A profits interest grant can be either vested or unvested. Vested means that the worker immediately receives all rights provided by the grant. Unvested means that the worker must meet certain conditions before receiving full rights. You may accelerate vesting only for tax purposes by making a Section 83(b) election.

Taxation #

Properly structured grants are not taxable income to the worker, nor are they tax deductible to the partnership or LLC. Under IRS regulations, a vested profits interest is not taxable if (Safe Habors):

1. The recipient (the “Recipient”) must receive the profits interest in his or her capacity as a partner or in anticipation of becoming a partner;
2. The interest must not be a substantially certain and predictable stream of income from partnership assets (i.e., income from high-quality debt securities or high-quality net lease);
3. The Recipient must not dispose of the profits interest within two years of receipt;
4. The profits interest must not be an interest in a publicly traded partnership;
5. If the the profit interest is unvested, then it needs to meet two additional conditions
   • The entity granting the profits interest and the Recipient must treat the Recipient as a “real” partner for tax purposes (i.e., the Recipient must receive a Schedule K-1 and pay income tax on his or her share of taxable income — to the extent there is any); and
   • Neither the Recipient nor the entity granting the profits interest may take any compensation deduction in connection with the profits interest.

The taxation of a carried interest depends on whether or not an election under Section 83(b) is made. A section 83(b) election is a provision under the Internal Revenue Code (IRC) that gives an employee, or startup founder, the option to pay taxes on the total fair market value of restricted stock or partnership interest at the time of granting instead of vesting. It makes sense to do this if the value of the stock or partnership interest will rise substantially.

83(b) Election #

Under the safe harbors referenced above, no “Section 83(b) election” need be made upon the grant of a profits interest. In effect, the partnership and the recipient are treated as if a Section 83(b) election was made by the recipient and assessed the fair market value of the profits interest at zero. Despite this protection, it is still advisable to file a “protective” Section 83(b) election upon receipt of a profits interest in the event any of the safe harbor requirements are not satisfied (eg, there is a disposition of the interest within two years). Any downside to filing an 83(b) election is generally considered minimal.

The 83(b) election notifies the Internal Revenue Service (IRS) to tax the elector for the ownership at the time of granting, rather than at the time of stock vesting.

As the partnership earns income, it allocates income to the partners, including the carried interest holder. The 3-Year Rule, as described below, now requires a three-year holding period (instead of 1-year) in order for the partner with the carried interest to receive long-term capital gain treatment.

New Holding Period for Carried Interest #

As part of the Tax Cuts and Jobs Act, Sec. 1061 modified the taxation of carried interests. The Code provision contained some changes in taxation of carried interest, primarily concerning a new holding period necessary to obtain long-term capital gain treatment.

Summary of 3-Year Rule #

• Partners must wait three years before they can take advantage of long-term capital gains tax treatment.
• If the partner holds such interests for less than three years, recognized gains on those interests are treated as short-term capital gains, and the partner is taxed at ordinary income rates on such income.
• The three-year holding period seems to apply both to the sale of the partnership interest itself, as well as any gains distributed by the partnership in connection with the sale of assets.

To ensure the long-term capital gain treatment of a partner, both the partner’s interest in the partnership and the partnership’s assets must be held for at least three years.

Who is subject to the 3-year rule? #

This law was meant for private equity, venture capital, and hedge funds (IRC §1061(c)).

• The interest transferred is a profits interest and not a capital interest
• The profits interest is transferred in connection with the performance of substantial services by the taxpayer (or a related person) in certain specific trades or businesses
• Specifically, the trade or business must consist of (1) raising or returning capital and (2) investing, identifying, or developing specified assets including securities, commodities, real estate, cash or cash equivalents; and
• The trade or business must be conducted by the partnership on a regular, continuous and substantial basis.

A grant of a profits interest is not a taxable event for the service provider of a partnership.