Taxpayers are often surprised to learn there is a way to provide non-taxable compensation to key employees as a form of incentive, known as profits interests. After all, many people are generally familiar with stock-based compensation, where a corporation grants stock to employees typically taxed as compensation upon grant (or vesting). However, for businesses conducted in the partnership form for tax purposes (including LLCs taxed as partnerships), certain types of equity can be granted without triggering any immediate tax consequences, even if the equity is fully vested upon date of grant. This type of equity is referred to as a “profits interest,” and it represents rights to future income and/or appreciation in a business.

What is the difference between profits interest vs. capital interest? A profits interest, as opposed to a “capital interest,” does not entitle a holder any current rights to partnership property. In other words, a profits interest holds no liquidation value upon date of grant.

The IRS has provided a safe harbor for the granting of a profits interest. Taxpayers meeting the safe harbor’s requirements can treat the grant of a profits interest as a non-taxable event, meaning no compensation for the recipient and no deduction for the partnership. Two IRS Revenue Procedures (Rev. Procs. 93-27 and 2001-43) set out certain general requirements for meeting the profits interest safe harbor. These requirements apply to both vested and unvested profits interests. These requirements include:

1. Receiving the profits interest in exchange for services to or for the benefit of a partnership in a partner capacity or in anticipation of being a partner
2. Having the profits interest not relate to a substantially certain and predictable stream of income from partnership assets
3. Holding the partnership profits interest for 2 years

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). An election under Code section 83(b) is not required, although often a recipient still files 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). The election must be filed within 30 days of grant to qualify for profits interest tax treatment under IRS rules

A profits interest can take many forms. It Profits interests can represent a current right to partnership income, or it can represent a right to future appreciation that is realized on a liquidity event. Further, the character of the income from a profits interest could be capital gain or it could be ordinary income (possibly subject to self-employment tax). Given this flexibility, it is possible, in many cases, to structure a profits interest that achieves the business goals of both the issuing partnership and the recipient service provider.

There are several procedural points to keep in mind when considering the grant of a profits interest. If the recipient has an employment contract with the partnership, IRS guidance dictates they can no longer be treated as an employee, and any payments for services could be considered a guaranteed payment or an allocation of partnership income (possibly subject to self-employment taxes). Also, certain employee benefits may no longer be available to the newly admitted partner. Finally, future partnership profits or appreciation may generate taxable income that will be passed through to the partner.

A profits interest can represent a flexible and tax-efficient tool for granting equity compensation to a service provider. However, it’s always best to consult with a professional that understands the ins and outs of partnership interest within a limited company. Partner with an Eide Baily expert who can advise on issues relating to performance, risk management and corporate liability, and any legal requirements for granting a profits interest. For more information, please contact Adam Sweet, Todd Laney, or your local Eide Bailly tax professional.