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Client Alert: How "Profits Interest" Works And Why Knowing That Can Matter A Whole Lot

In many ways, the labor market is as competitive as ever. Businesses continue to explore compensation packages, in addition to ordinary salary, that will help them attract, hire and retain talent. One method of compensation that a business often considers is awarding employees equity in the business.
 
Businesses taxed as partnerships for federal income tax purposes (which often include limited liability companies) have the ability to issue equity styled as “profits interests,” which is a share of the future profits and the appreciation of the assets of a partnership.[1]  A company should understand the fundamental function and high-level tax consequences of a profits interest as part of its overall compensation strategy.

Partnership interests can be divided into capital interests and profits interests.
 

• Capital Interest.  A partnership interest that gives the owner an immediate right to a share of proceeds if the partnership assets are sold at fair market value and the proceeds distributed in a complete liquidation of the partnership. A capital interest is commonly granted to a partner in exchange for a contribution of cash or other property.

• Profits Interest.  A partnership interest that gives the owner the right to receive a percentage of future profits (but not existing capital) from the partnership. A profits interest is commonly granted to a “service partner” in exchange for his or her services.

Unlike the owner of a capital interest, the owner of a profits interest typically has not invested any money in the business and, usually, has no obligation to contribute funds in the future. The only thing an owner of a profits interest stands to lose is profits earned after the grant date of the profits interest.
 
A profits interest can arise in many contexts, but its most common application is to provide additional compensation to the service partner and incentivize that person to continue to grow the business and, in turn, his or her share of the profits.
 
What Rights does the Owner of a Profits Interest Have Beyond Profit Sharing?
 
A profits interest is a partnership interest. Consequently, it has all the rights and obligations that flow from having an ownership interest in the partnership, including rights provided under applicable state law.
 
To the extent permitted by state law, the terms of an operating agreement (or a limited partnership agreement) can limit the rights of a profits interest owner. Before a partnership issues a profits interest, it should consider what rights the service partner will have beyond economic rights. For example:
 

• Will the service partner have access to books and records of the partnership?

• Will the service partner be entitled to vote and participate in the overall management of the partnership?

• Will the service partner’s interest in the partnership be subject to vesting, forfeiture or repurchase?

 
What are the Tax Consequences of a Profits Interest Generally?
 
The grant of a profits interest is generally tax-free if structured properly. Under current IRS guidelines, the grant must satisfy four requirements:

1. The service partner must receive only a profits interest in the partnership in exchange for the contribution of services (meaning that the service partner cannot be given a share of current capital in exchange for the contribution of services).

2. The profits interest must not relate to a “substantially certain and predictable stream of income” such as high-quality debt securities or a high-quality net lease of the partnership.

3. The service partner must not dispose of the partnership interest within two years of receipt of the interest.

4. The partnership must not be a “publicly traded partnership.”

Note that the first requirement (no interest in the partnership’s current capital) means that if the partnership liquidated immediately after the profits interest is granted, the owner of the profits interest would receive nothing. If, however, the partnership remains in existence and then turns a profit, the owner of the profits interest is entitled to a share of the profit earned since the date of grant, subject to any vesting conditions that may be imposed.
 
Because a partnership is a “pass-through” entity for federal income tax purposes, any gain or loss recognized at the partnership level retains that character when allocated to the partners. So, if a partnership’s income is generated by the sale or exchange of capital assets such as stock, bonds, and most real estate, the gain recognized by the partnership generally will be capital gain and will retain that character as it passes through to the partnership’s partners. This is true even for those partners who received their partnership interest (either profits or capital interests) in exchange for services.
 
What are the Potential Benefits to Granting a Profits Interest to an Employees?
 
For a service partner who could have received cash compensation but instead received a partnership profits interest, this tax treatment has the dual benefit of:

1. Deferring income until gain is recognized by the partnership; and

2. Potentially converting compensation income (taxed at ordinary income rates which can be as high as 37%) into preferentially-taxed, long-term capital gain (currently taxed at a maximum rate of 20% for higher income individuals, plus a potential additional 3.8% tax for higher income individuals on “net investment income,” which generally includes gains).

To qualify as long-term capital gain, the assets of the partnership must be capital assets which were held for more than one year. However, under changes made by the 2017 tax reform legislation (the “TCJA”), a longer three-year holding period requirement applies to qualify for preferential long-term capital gains treatment on gains realized from certain profits interests. This special three-year holding period requirement was specifically designed to target profits interests in investment funds (i.e., hedge funds), as it applies to profits interests received for performing substantial services in a business that consists of both raising or returning capital and investing in, disposing of, or developing securities, commodities, real estate held for rent or investment, cash or cash equivalents, options or derivatives on any of these assets.
 
What are the Potential Downsides to Granting a Profits Interest to an Employee?
 
Under current IRS guidance, the owner of a partnership interest cannot simultaneously be treated as an employee of the partnership. If a profits interest is granted to an existing employee, therefore, the employee becomes self-employed for tax purposes. The new “self-employed” label may have some unintended consequences that the partnership and the service partner should consider.
 
Generally, what formerly was salary is converted into self-employment income. As a result, withholding of employment taxes cannot be done at the partnership level and instead the new partner/former employee is obligated to compute and remit quarterly estimated income tax payments and file returns in all jurisdictions where the partnership does business. The self-employed label has other consequences as well, including, rendering the new partner ineligible for certain benefit plans and no longer being entitled to receive unemployment insurance benefits if their service relationship with the partnership ends.
 
Practitioners have offered potential structures as a means to preserve a service partner’s status as an employee, while still holding a profits interest in the underlying enterprise. However, some of these structures have been rejected by the IRS, while others remain untested.
 
Consequently, if the profits interest is small as compared with the employee’s annual salary, the ancillary burdens and costs of the profits interest grant may exceed the benefits.
   
A partnership’s ability to issue profits interests presents unique compensation opportunities (and pitfalls for the unwary). Before forging ahead, companies should discuss with their attorneys and accountants whether a profits interest is the right compensation strategy for their business.

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