Thursday, March 3, 2022

Profits Interests

 A Primer on Profits Interests

Charles C. Shulman, Esq.,
Teaneck, NJ, 201-357-0577

Profits interests have become an increasingly popular type of equity-based award if the entity is taxed as a partnership, as they avoid income tax or FICA tax on grant and vesting, and yield long-term capital gains on sale if certain requirements are met.

      a.   Description
            i.    A profits interest is an interest in the value of a partnership or LLC taxed as a partnership. It has upside potential but no downside protection.

            ii.   The granting of profits interests has become a preferred way of compensating management in buyouts or as partnership incentives.

            iii.   Profits interests may be structured as a separate class of ownership interests.

            iv.  Profits interests typically provide a share of profits only once the original LP investors have received a return of their full capital investment and a certain rate of return (e.g., IRR).

            v.   The profits interests must be held for a certain period to receive favorable tax treatment, as discussed below.

      b. Tax Treatment of Profits Interests

            i.    Revenue Procedure 93-27 provides that the IRS will treat the receipt of a profits interest as non-taxable if the following conditions are met: (a) the profits interests do not relate to a substantially certain and predictable stream of income from partnership assets, (b) for two years after receipt of the profits interest the partner does not dispose of the profits interest, and (c) the partnership or LLC is not a publicly traded partnership as defined in Internal Revenue Code §7704(b). In addition, the profits interest cannot be a capital interest, which, according to Proc. 93-27 means that if the partnership’s assets would be sold at fair market value, and the proceeds would be distributed in a complete liquidation of the partnership, the profits interest holder would not receive a share of the proceeds.

            ii.   Rev. Proc. 2001-43 provides that even if the profits interest is nonvested at the time of grant, the profits interests will be non-taxable at the time of grant and at vesting, provided that: (a) the partnership treats the recipient as a partner from date of grant, and the partner must take into account its distributive share of partnership income or loss, and (b) the partnership and other partners do not deduct such amounts as wages.

            iii.   Some make a Code § 83(b) “protective” election on nonvested profits interests so that even if they are found to be taxable profits interests, there would be no tax in any event until vested.

            iv.  Upon the sale or liquidation of the profits interest (after the two-year hold period), the proceeds are taxed at the lower long-term capital gains rate.

      c.   Holding Periods for Profits Interests

            i.    Generally long-term capital gains require a one-year holding period. However, with regard to profits interests, Rev. Proc. 93-27 requires that the profits interest be held for at least a two-year period.

            ii.   If there is a Code § 83(b) protective election, there may not be a need for a two-year holding period, since even a capital interest with a § 83(b) election can utilize long-term capital gains rates if held for one year or longer.

            iii.   There may be a three-year holding period if the partnership owns real estate for rental or investment, since Code § 1061, enacted by the Tax Cuts & Jobs Act of 2017 and effective in 2018, in an effort to clamp down on carried interest use of long-term capital gains tax rates for fund managers, provides that "applicable partnership interests" which includes professional investors as well as those developing real estate for rental or investment, have an increased holding period for long-term capital gains treatment for three years instead of one year.  In this regard, a § 83(b) election would not help to shorten the period.

      d.   Setting Up Separate Entities so that Employer Pays Wages and Partnership Distributes Profits Interests.

            i.    Grantees of profits interests would ordinarily become partners of the entity granting the profits interests with taxes based on Form K-1 partnership returns, and could not be both partners and employees, and therefore the grantees would lose the ability to participate in the cafeteria plan or other flex benefits and would owe self-employment social security tax. 

            ii.   To allow the grantees to continue to be employees, often a subsidiary of the partnership can serve as the employer, while the main partnership grants the profits interest.  For example, the main partnership grants the profits interest; an Employer LLC subsidiary (typically a partnership) is set up as the employer entity that pays wages and employee benefits (with a services agreement with the main partnership); and there is typically a need for a holding company, Employer Holdings taxed as a corporation, which needs to own a small amount (e.g., 1%) of the Employer LLC subsidiary for tax purposes so that the Employer LLC partnership is regarded as a separate entity.    

            iii.   Alternatively, sometimes the profits interests are passed through a feeder entity to the grantees so that they can still be employees of the entity.

            iv.  Keep in mind that setting up these structures does involve extra work to set up and administer.

      e.   Advantages of profits interests                 

            i.    Non-taxability at grant (or on vesting) until the grantee ultimately sells or liquidates the profits interests, and then generally only at the long-term capital gains rate.

            ii.   As equity, the profits interest should not be subject to Code § 409A, and instead it is governed by § 83 principles.

            iii    Profits interests can have a flexible payout.

            iv.  Profits interests can be granted without voting rights.

      e.   Disadvantages of profits interests

            i.    Profits interests must be held at least two years to receive favorable tax treatment (or likely one year if a § 83(b) election is made).

            ii.   The employer will not receive any deduction from the profits interest.

            iii.   The payout formulas are often complicated to administer.

            iv.  There is no downside protection if there are not sufficient profits, and in this way profits interests are more similar to stock options than to restricted stock.

            v.   Grantees may become partners instead of employees of the entity granting the profits interests unless separate structures are set up to separate the employer from the entity granting the profits interests (see above).

      f.    Accounting Treatment for Profits Interests – Profits interests, depending on the facts, would be treated for accounting purposes as either performance compensation or stock compensation. Performance compensation costs may be expenses when the payment is probable and reasonably estimable. Stock compensation is expensed based on its fair value over the period of service (but sometimes revalued each accounting period).