A Piece Of The Pie: The Use Of Profits Interests And Carried Interests In Business And Estate Planning
General Tax Treatment and Popularity
For over 30 years, it has been relatively settled in the tax law that a “profits interest” in a partnership received in exchange for services performed is a non-taxable event. In 1993, the Internal Revenue Service codified its position in Rev. Proc. 93-27. In that Revenue Procedure, a profits interest is defined as an interest in a partnership that is not a capital interest. A capital interest, in turn, is defined as an interest in the partnership that gives the holder a share of the liquidation proceeds assuming that the partnership’s assets are sold at fair market value and distributed in complete liquidation of the partnership.
Example. Bill and Bob have a 50-50 partnership. They wish to hire Joe to perform services for the partnership. Joe negotiates a 20% partnership “profits” interest. On the date Joe receives his 20% partnership interest in Year 1, the value of the partnership is $10,000,000. Under the partnership agreement, if the partnership liquidated immediately following the receipt of Joe’s interest, Bill and Bob would each receive $5,000,000 and Joe would receive $0. In addition, in Year 2, if the partnership distributes profits to the partners, those profits will be distributed 40% to each of Bill and Bob and 20% to Joe. Moreover, if the partnership sells all of its assets in Year 5 for $20,000,000, Bill and Bob will each receive $9,000,000 and Joe will receive $2,000,000. The issuance of the partnership interest to Joe is non-taxable. (Note: Joe only receives 20% of the partnership’s growth ($10MM) from the time he entered the partnership.)
Notwithstanding the general rule, under Rev. Proc. 93-27, there are certain exceptions to the non-recognition treatment. Those exceptions are: (1) if the profits interest relates to a substantially certain and predictable stream of income, (2) if within two years of receipt, the partner disposes of the profits interest, or (3) if the profits interest is a limited partnership interest in a publicly traded partnership.
As a result of the favorable tax landscape, profits interests are a very popular vehicle for compensating service providers with equity-based compensation. Unlike the grant of stock in a corporation, issuing a profits interest allows the service provider to participate in both future profits and future growth of an enterprise without paying tax on the issuance of the interest. Moreover, the service provider should also obtain the benefit of recognizing capital gain (as opposed to ordinary income) on a liquidation event (i.e., sale of the partnership or its capital assets). Perhaps the most infamous context in which profits interests are used is private equity, where the fund management team is often awarded a profits or “carried” interest in the performance of the fund.
Vesting Conditions
After the publication of Rev. Proc. 93-27, questions remained as to whether partnership interests that were substantially nonvested (i.e., subject to a substantial risk of forfeiture) at the time of grant, but that later became vested, were taxable at such later date. In 2001, the IRS issued Rev. Proc. 2001-43 which held that if a partner receives a nonvested profits interest, that partner will be treated as receiving the interest on the date of its grant and not at the time the interest later becomes (if at all) substantially vested. Moreover, Rev. Proc. 2001-43 provides that no election under IRC § 83(b) will have to be made in order for this result to occur (unlike restricted stock which is generally taxed either upon vesting or upon the effective date of an 83(b) election). However, the partner receiving the profits interest must take into account partnership items of income, gain, loss and deduction (though, cash does not have to be distributed to the partner under the terms of the partnership agreement) and the partnership may not claim a deduction at any time for compensation income paid to the partner. Notwithstanding these authorities, the Treasury Department issued proposed regulations in 2005 which indicate that if profits interests are substantially nonvested upon issuance, the holder of the profits interest is not treated as a partner solely by reason of holding the interest, unless the holder makes an election with respect to the interest under Code Section 83(b). As a result, it is not uncommon for those receiving unvested profits interests to make a “protective” 83(b) election even though under Rev. Proc. 2001-43, such an election is not required.
Example. Bill and Bob have a 50-50 partnership. They wish to hire Joe to perform services for the partnership. Joe negotiates a 20% partnership “profits” interest, however, Joe’s profits interest will be forfeited unless Joe remains employed by the partnership for 5 years. Joe will not be subject to income tax on the grant of the profits interest nor after 5 years when the profits interest vests. Moreover, during Years 1 through 5, Joe will receive a Schedule K-1 from the partnership reporting 20% of the income, gain, loss, and deduction. If Joe quits before the end of Year 5, his profits interest will be forfeited. Joe can choose to make a protective 83(b) election (and there is no downside of doing so) upon grant.
Holding Period
As noted above, one advantage of a profits interest over other compensation arrangements is the ability to recognize long-term capital gain upon a future liquidity event. Generally, a one-year holding period is required for the application of the long-term capital gains rates. However, the Tax Cuts and Jobs Act, effective for tax years after December 31, 2017, adopted Code Section 1061 which increased the holding period to three years for certain “applicable partnership interests.” An “applicable partnership interest” is generally an interest in a partnership transferred to a taxpayer in connection with the performance of substantial services by the taxpayer in any “applicable trade or business.” An “applicable trade or business” is any activity conducted on a regular, continuous, and substantial basis which consists of (1) raising or returning capital; and (2) either (i) investing in (or disposing of) “specified assets” (or identifying “specified assets” for investing or disposition), or (ii) developing “specified assets.” Specified assets include securities, commodities, real estate held for rental or investment, and cash or cash equivalents (among others). Although a full review of Section 1061 is outside the scope of this article, whenever a partnership interest is being issued or disposed of, special attention to the holding period and application of Code Section 1061 is needed.
Estate Planning
Given that the value of a profits interest upon grant is generally thought to have little value because the profits interest does not share in any current capital of the partnership, profits interests are a great tool to use for wealth transfer planning. Indeed, any asset with a low current value but a high appreciation potential is a good candidate for planning due to the efficiency associated with gifting such an asset. The gift should use little gift tax exemption relative to the future growth potential and allow the shifting of a great amount of future wealth outside of the taxable estate. In addition, as with any closely-held business interests, discounts for lack of marketability should apply, and these discounts act as a hedge against poor performance in the profits interest.
Although a full review of Code Section 2701 is outside the scope of this article, in certain cases where a person owns both a capital interest and a profits interest in an entity, gifting a profits interest will likely trigger the provisions of Code Section 2701 which, in turn, results in a significant increase in the gift-tax value of the profits interests. Code Section 2701, when applicable, effectively imputes the value of the capital interest to the gifted profits interest. To avoid this result, the gift needs to be comprised of a so-called “vertical slice” of the partnership interests, which means a gift of both capital and profits interests. If that construct is not desirable due to the value of the capital interest or for other legal reasons, another option is to craft a derivative agreement whereby the donor “sells” a derivative of the profits interest to an intentionally defective grantor trust. The trust effectively purchases the economic performance of the profits interest which may be subject to a hurdle, a cap, and/or a sharing ratio. Since the sale is to a “grantor trust”, the sale transaction is a “non-event” for income tax purposes. Thus, this structure allows the donor to design the economic return for the trust and use the profits interest as a basis for the trust’s economic return. In order to implement this structure, the derivative contract must be valued, and the trust must pay the fair market value of the derivative to the donor at the time the contract is executed (in cash or other form of payment). In addition, if the profits interests are substantially non-vested, the gift of non-vested profits interests may be considered an “incomplete” gift that would result in completion, and therefore exemption usage by the donor, at the later date when vesting occurs and the profits interests are significantly more valuable. The derivative contract structure is also a solution for transferring the economic performance of a non-vested profits interest. The higher the risk profile of the given situation (i.e., the more likely application of Code Section 2701 and the magnitude of the imputed value of the capital interests), the more dissimilar to the profits interest the derivative contract should be.
Example. Joe owns a 20% partnership “profits” interest that is unvested for 5 years. Joe also owns a capital interest in the partnership. Joe enters into a contract with a grantor trust to sell the economic performance of the profits interest in exchange for cash. Under the contract, Joe sets a hurdle of $5,000,000, a sharing ratio of 75%, and a cap of $15,000,000. The trust pays Joe $200,000 for the derivative contract. Later, when the partnership liquidates, Joe is entitled to receive $20,000,000 from the partnership. Under the derivative contract, Joe is required to pay the trust $7,500,000 (75% of the excess over the hurdle of $5,000,000, up to the cap of $15,000,000). The net transfer out of Joe’s taxable estate is $7,300,000. The wealth transfer is further bolstered by the fact that Joe is required to pay all of the income tax associated with the partnership liquidation.
Conclusion
In sum, profits interests remain a strong vehicle to reward employees and other service providers. The flexibility that comes with designing a partnership (or LLC) agreement, the ability to impose vesting conditions, and the favorable tax treatment upon grant, are strong factors in favor of the use of profits interests in many contexts. However, the flow-through nature of partnerships which require “phantom” income to be reported by the holder, even if the profits interests are unvested, can create challenges in certain situations. Nonqualified deferred compensation (phantom stock, etc.) may be an alternative to profits interests in many situations, with the downside being the recognition of ordinary income upon vesting (but with an offsetting deduction for wages available to the employer). Finally, for clients with estate tax concerns, profits interests may be a very efficient wealth transfer tool, but caution is warranted to avoid the application of Code Section 2701.
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