June 2020
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A Profits Interest Opportunity

Partnership profits interests are a very tax-efficient way to provide equity-based compensation to service providers without cash cost. However, they work best if they can be issued when the value of the underlying business is low. In difficult times, businesses that did not issue profits interests when they previously had low value may have an opportunity to make up for the omission.

  How Profits Interests Work.

A profits interest in a partnership (including an LLC taxed as a partnership) is an ownership interest in the partnership that shares only in income or capital appreciation after issuance.

  • For example, if a partnership has a value of $10M when it issues a 1% profits interest to a service provider, if it later is sold for $15M the service provider will receive 1% of only $5M, which is the appreciation that took place after issuance of the interest.
  • Issuance of a 1% capital interest would entitle the service provider to 1% of the full $15M, but the recipient would not receive the favorable tax treatment discussed below.

Equity-based compensation is intended to let service providers share in businesses' success. Since they are working for their shares, their income is ordinary income (taxed at higher rates than capital gains). The income is normally realized upon receipt of the equity, or, if the service provider must perform future services to become "vested" (that is, fully entitled to the benefit), upon vesting. (An election is sometimes available to take the value of unvested equity into income upon receipt, paying tax currently but converting future appreciation to capital gain. Corporate stock options normally are taxed upon exercise or disposition, not grant or vesting.)

Profits interests are useful because the IRS has decided to accord them extremely favorable tax treatment: they can be treated as owned property immediately upon receipt, meaning there no income upon later vesting and they give rise to capital gain. Nevertheless, they can be valued at zero for purposes of income inclusion at the time of receipt. That is a great advantage, and much more favorable than any form of equity-based compensation a corporation can issue.

  Late-issued Profits Interests.

The problem with profits interests is that they can only share in future appreciation. The recipient cannot receive any interest in existing partnership capital: it must be true that if the partnership were liquidated on the date the profits interest was issued, the profits interest holder would receive no proceeds.

In a start-up partnership that is not troublesome. However, a well established partnership may want to issue equity-based compensation. In many cases the service providers who are to receive the compensation have been working since the beginning of the business, and for some reason (often simple laziness about paperwork or unawareness of the opportunity) they did not receive profits interests when it would have been easiest for the partnership to issue them.

In such a case, it may not seem fair to allow the service provider to participate only in future appreciation. One approach is to use "catch-up allocations" in which the service provider does not receive any capital interest but receives special allocations of future appreciation to catch up.

  • For a partnership with a value of $10M that would like to issue a 1% capital interest to a service provider but needs to make it a profits interest, the partnership agreement may provide that the service provider will be entitled to 2% of capital appreciation between $10M and $20M and 1% after that, so that if the partnership reaches a value of $20M or more the service provider will be entitled to a full 1% of value.
  • If the partnership is sold for $15M the service provider will receive 2% of the $5M of appreciation, or $100K, which is worse than 1% of $15M but better than 1% of $5M.

Catch-up allocations can be helpful, but they present some difficulties. A profits interest must involve real risk that the profits will not be achieved, so the service provider is not assured of appreciation. Too rapid a catch-up may be viewed as amounting to an assured benefit, in which case the benefit will be viewed as a payment for services, not as proceeds from ownership of an asset.

  Bad Times Create Opportunities.

A bad business year can reduce the value of a business. That can provide an opportunity to issue profits interests based on a relatively low valuation.

Businesses are typically valued based on appraisals. Appraisals certainly take into account future prospects, but a bad year combined with an uncertain future can result in a low valuation even if there is substantial hope of later recovery.

Issuing equity interests in a difficult business climate can solve many problems: it can improve service provider motivation and improve worker retention (especially if issued with a delayed vesting schedule), but it does not cost the business any cash.

If you have questions about these issues or their effect on you or your business, please feel free to contact TaxGroup Partners at (213)873-1200 or e-mail us at info@TaxGroupPartners.com or visit our website at TaxGroupPartners.com.
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