It is well-known that limited liability companies (“LLCs”) and partnerships are the vehicles of choice in acquiring real property. Generally, many owners select the LLC or partnership structure to provide asset protection. Furthermore, many owners form partnerships to take on joint investments with other real estate investment partners and reap the benefit of i) flexibility in distributing profits and losses, ii) combined portfolios for perspective lenders, iii) shared ownership and responsibilities, iv) valuable insight, and v) extensive networks and resources. As the partnership begins to develop and becomes profitable, owners seek out the best strategies to implement tax-savings and to provide added compensation to key members. The LLC and partnership structure provides flexibility that is incomparable to C-corporations and S-corporations. One key component in the partnership structure is in its ability to grant equity to key employees in the form of “profits interest.”
The term “profits interest” refers to an equity right, essentially a share of the profits and the appreciation of the assets of the partnership, based on the future value of a partnership awarded to an individual for their service to the partnership. In addition, the equity right awarded through a profits interest allows the recipient to receive a percentage of the profits from a partnership without having to contribute capital. A profits interest, as opposed to a “capital interest,” is an interest where the holder would receive his or her proportionate share of the partnership’s assets upon liquidation, and does not entitle the holder of the profits interest to any current rights to partnership property. Simply put, a profits interest holds no liquidation value upon date of grant.
A similar example to granting a partner a profits interest is granting stock options to a key employee. Stock-based compensation, where a corporation grants stock to its employees, is typically taxed as compensation upon grant (or vesting) and is almost analogous to profits interest, however, the major difference of course lies within the overall structural differences between the two entities. In addition, a profits interest may be structured in the same way as a stock option, however, it has a tendency to be more appealing to the recipient because, unlike a stock option, generally, a profits interest grant can provide that all appreciation in value be taxed as long-term capital gains rather than ordinary income. Furthermore, unlike an option, a profits interest holder does not have to pay an exercise price to obtain the equity interest in its share of the profits interest as the recipient is already viewed as a partner under the law. Granting a profits interest to a key employee can be a valuable compensation tool especially since it can be done in a tax-free manner if IRS conditions are met.
On its face, profit interests appear to be solely derived from the day-to-day business profits, however, it is worth noting that these profits can also be the result of the appreciation of any assets owned by the partnership, such as real estate.
The IRS’s position on profits interest, in accordance with Revenue Procedure 93-27, states that a person may receive a profits interest without current tax where the profits interest is received in exchange for the provision of services to or for the benefit of a partnership in a partner capacity (or in anticipation of being a partner). Under Revenue Procedure 93-27, the receipt of a profits interest is not treated as income upon its acquisition if a person receives it “for the provision of services to or for the benefit of a partnership in a partner capacity or in anticipation of being a partner.” To achieve that end and carry out its intent, the IRS provided safe harbors to respect purported profits interest if certain conditions are met. Under current IRS guidelines, the purported profits interest must satisfy the following requirements:
Once granted, the partnership entity should treat the recipient as a partner from the date of grant (even if the interest is not fully vested). Under the safe harbor rules, an election under Internal Revenue Code Section 83(b) is not required, although, as a precautionary measure, a recipient may still file the election as a protective measure in case one of the safe harbor requirements is not met (such as a sale or exchange of the interest during the 2-year holding period).
A partnership is a “pass-through” entity for federal income tax purposes. Therefore, any gain or loss recognized at the partnership level will retain that character when allocated to its partners. As a result, if a partnership’s income is generated by the sale or exchange of capital assets such as real estate, the gain recognized by the partnership generally will be treated as capital gain and will retain that character as it passes through to the partnership’s partners. Partners who received their partnership interest (either profits or capital interests) in exchange for services will also treat the gain as a capital gain that retains its character and passes through to the partner.
One of the added benefits for a partnership to grant profits interest to partners is to reward and further incentivize its partners to become proactive in pursuing the partnership’s growth. This is similarly the thought process behind offering company stock options to key employees and executives. For example, a partner in a partnership, who provides services to the partnership could receive cash compensation. Alternatively, he or she could receive a partnership profits interest. The latter incentivizes the partner to be proactive and offers significant tax benefits. Some of the dual tax benefits on the partner’s profits interest are as follows:
Profits interest offers an added tax benefit to its recipients. From this example, it is clear that the tax rate on partner’s compensation would be significantly lower if the partnership granted a profits interest versus paying the partner for his or her services outright through cash compensation. Further, all appreciation in value would be taxed as long-term capital gains rather than as ordinary income.
Due to the benefits and the ability to convert compensation into capital gains, profits interests have recently faced legislative scrutiny. In addition, there are many hurdles to consider in granting profits interests to ensure certain requirements are being met to reap its benefits. One factor to consider is the “hurdle” amount. To be considered a profits interest, a partnership must be structured so that the recipient essentially starts at a $0 liquidation value and only shares in the growth from there. This is known as a “hurdle” amount, and it must be the fair market value of the company if it were to be liquidated. Essentially, the hurdle rate requires that all value that have accumulated prior to when the profits interests were granted be allocated to non-profits interest owners before the owner of the profits interest receives any compensation.
In addition, if an employee receives a profits interest, under current IRS guidance, the employee of a partnership interest can no longer be an “employee” of the partnership for tax purposes. The IRS’s position is that a taxpayer cannot be both a partner and an employee of the same partnership. This is due to the self-employment tax. If a profits interest is granted to an existing employee, that employee then becomes self-employed for tax purposes. As a result, the new “self-employed” label may have some unintended consequences to the partnership such as rendering the new partner ineligible for certain benefit plans.
Ultimately, profits interests remain a strong tool to reward key employees. The added flexibility that comes with designing a partnership (or LLC) agreement and the favorable tax treatment upon granting profits interest, are strong factors in its favor. However, the hurdle amount and nature of the partnership structure require additional hoops that a taxpayer has to jump through. These risks, and others, should be considered in a partnerships evaluation before granting profits interest.
This article is informational and does not, and is not intended to, constitute legal advice; instead, all information, content, and materials available on this article are for general informational purposes only. Information in this article may not constitute the most up-to-date legal or other information.
