Profits interests: The most tax-efficient equity grant to employees

Granting equity in a business is a common way for limited liability companies (LLCs) and other entities taxed as partnerships¹ to incentivize and encourage employees² to continue their efforts toward the company’s overall growth and success. The problem is that granting equity is taxable as ordinary income to the recipient.³ To mitigate tax consequences associated with granting equity, companies will grant their employees an economic interest known as a “profits interest.”⁴ A profits interest is known by different names,⁵ but rather than focusing on nomenclature, this article describes the economic rights and tax consequences associated with the granted interest.⁶

Unlike the holder of a capital interest, the holder of a profits interest would not have an immediate right to a share of the proceeds in the event the partnership’s assets were sold at fair market value (FMV) and the proceeds were distributed in complete liquidation of the partnership. This article discusses profits interests in detail, the tax consequences associated with issuing profits interests to employees, and a framework for partnerships interested in incentivizing and rewarding employees with equity with minimal tax consequences.

Equity grants generally

There are three ways for a company to grant equity to employees. The first method is to grant full equity in the company, which includes an interest in the current-year operating profits and losses of the business and a capital interest in the company that has not been limited or diminished. Under this first method, the employee recognizes income under Sec. 83 because the receipt of a partnership interest in exchange for services is taxable as ordinary income to the recipient.

The second method is to grant a profits interest that entitles the interest holder to only the current-year profits and losses of the business. That is, the employee recipient would have no right to any proceeds from the sale of the business or any other capital event. The recipient of such an interest would not recognize income because the IRS has deemed interests entitling the holder to only current-year profits and losses to not have value.⁷

The third method — and the subject of this article — is to grant a profits interest plus the rights to a portion of the liquidation proceeds to the extent that the liquidation proceeds exceed the value of the business on the date of the grant. The value of the business on the date of the grant is called a “hurdle” and must, at a minimum, be equal to the FMV of the business on the date of the grant. Hurdles are discussed in further detail below. This method of equity compensation deftly threads the needle between Sec. 83 on the one hand and Rev. Procs. 93-27 and 2001-43 on the other and, with proper structuring and planning, will not require income recognition upon receipt.

Statutory background

Gross income includes all income from whatever source derived.⁸ This includes the receipt of compensation (such as wages) in exchange for services.⁹ When a taxpayer receives noncash property as compensation for their services, they are required to include the FMV of the property received in their gross income less any amount paid for the property.¹⁰ The type of property received, whether real, personal, or intangible, is irrelevant to the analysis, as it is well settled that the receipt of equity or anything else of value in exchange for services constitutes income to the recipient under Secs. 61 and 83. However, neither the Code nor the regulations provide guidance for when the property received is a profits interest.

Uncertainties around the value of profits interests and the issuance of Rev. Proc. 93-27

Before the IRS issued Rev. Proc. 93-27, as clarified by Rev. Proc. 2001-43, the issue of whether the receipt of a profits interest for services is taxable was heavily litigated between the IRS and taxpayers. In general, the courts agreed that the receipt of a profits interest is a taxable event under Sec. 83¹¹ but often valued the interest on a liquidation basis (i.e., a value of zero) or ruled that such interests have speculative or no determinable value at the time of receipt¹² (unless sold shortly thereafter¹³). In an effort to conclude the seemingly never-ending valuation disputes it faced, the IRS issued Rev. Proc. 93-27, which provides that the Service will not treat the grant of a profits interest for services as a taxable event for the issuer or the recipient. Rev. Proc. 93-27 defines a profits interest as a partnership interest other than a capital interest. A capital interest is defined as “an interest that would give the holder a share of the proceeds if the partnership’s assets were sold at fair market value and then the proceeds were distributed in a complete liquidation of the partnership.”¹⁴ Rev. Proc. 2001-43 states that the determination of whether an interest is a capital or profits interest is made at the time of the grant.

Rev. Proc. 93-27 provides that specific circumstances will require the recipient to recognize income at ordinary-income rates at the time a profits interest is received (i.e., making unavailable the avoidance of tax otherwise permitted by Rev. Proc. 93-27).¹⁵ The first situation is when income from the partnership is substantially certain and predictable, such as from high-quality debt securities or a high-quality net lease.¹⁶ The second situation is when the profits interest is a limited partnership interest in a publicly traded partnership.¹⁷ The third situation occurs only if the recipient disposes of the profits interest within two years of receipt.¹⁸

Tax treatment of a profits interest and hurdle

Whether an interest in a partnership is a capital interest or profits interest is a fact-specific inquiry based on the economic rights granted at the time of the grant. The first possible economic right is the right to current-year profits and losses, while the second possible economic right is the right to a share of the proceeds in the event the partnership’s assets were sold at FMV and the proceeds were distributed in complete liquidation of the partnership. As discussed above, when a partnership grants both economic rights (the right to current-year profits and losses and the right to future appreciation of the business in the form of a share of the liquidation proceeds), it grants a capital interest that is taxable to the interest’s holder upon receipt.¹⁹ Conversely, when a partnership grants only the right to the current-year profits and losses, it grants only a profits interest, which, in accordance with Rev. Procs. 93-27 and 2001-43, is not treated as a taxable event.²⁰

Careful planning and structuring will allow a partnership to grant a combination of the two economic rights without the imposition of immediate tax consequences. More specifically, the partnership may grant an interest that includes both (1) the right to current-year profits and losses and (2) the right to liquidation proceeds but only to the extent that the liquidation proceeds exceed the FMV of the interest on the date of the grant. While this grant of economic rights is commonly referred to as a “profits interest,” it is more accurately described as a profits interest plus rights to liquidation proceeds that are subject to a hurdle. The creation and implementation of the hurdle requires a separate class of equity because partnerships must treat a class subject to the hurdle differently than a class not subject to the hurdle.²¹

The hurdle is the mechanism that makes the value of the second economic right, the right to proceeds from a liquidation, worthless at the time of the grant. The key is to ensure that the hurdle is equal to or greater than the FMV of the partnership on the date of the grant.²² By setting the hurdle amount to a value that is equal to or greater than the FMV of the partnership on the date of the grant, the partnership ensures that the second economic right, the right to liquidation proceeds, has a value of zero to the holder upon grant and the holder receives no proceeds from the liquidation of the business assets unless the value of the partnership appreciates.²³

Under Rev. Proc. 2001-43, recipients of a profits interest do not need to make an election under Sec. 83(b) to be taxed on the value at the time of transfer because this tax treatment is available without the election. However, many practitioners recommend making the election to begin the statute of limitation in the event that the hurdle is set too low. An example of a situation in which a Sec. 83(b) election would be helpful is shown in Example 1:

Example 1: Partnership X values itself at $100 and grants individual Y a profits interest that entitles the holder to 10% of the current-year profits and losses as well as a 10% capital interest after the current owners receive the first $100. After an audit by the IRS, it is determined that the correct value of Partnership X was $500 at the time of the grant. As a result, the 10% interest was in fact worth $40 when granted, i.e., 10% of $500 (the correct value) after first subtracting $100 (the hurdle amount).

Current tax forms do not have a location for profits interest recipients to disclose the receipt of the interest. However, by making a Sec. 83(b) election, the recipient discloses receipt to the IRS and ensures the commencement of the statute of limitation, which may be valuable in a situation like in Example 1. Further, it is possible to have a profits interest vest over a period of time, therefore making a Sec. 83(b) election necessary to prevent both (1) the need to increase the hurdle as the value of the partnership increases and (2) recognition of income if the hurdle is not adjusted. As such, despite Rev. Proc. 2001-43, the authors generally encourage all recipients of profits interests to file a Sec. 83(b) election immediately upon receipt.

Consider the following example that demonstrates how a hurdle works:

Example 2: Partnership P has two members, X and Y, and they each own four units of Class A membership. Partnership P grants Z two units of Class B membership. Class A membership entitles X and Y to current-year profits and liquidation proceeds, whereas Class B membership entitles Z to current-year profits and losses and liquidation proceeds, subject to a hurdle. At the time of the grant, Partnership P was valued at $1,000, so the hurdle is $1,000. If Partnership P’s current-year profits total $1,000, then X and Y, as Class A members, would each get $400, and Z, as a Class B member, would get $200 in current-year profits. In the event Partnership P sold for $1,200, the Class A members would allocate the liquidation proceeds among themselves pro rata until they receive allocations equal to $1,000, i.e., $500 each. The remaining $200 would then be allocated among the Class A and Class B members as if they were a single class and in accordance with the operating agreement, i.e., X and Y would receive $80 each, while Z would receive $40. Alternatively, if Partnership P sold for $900, then Z would not receive allocations from the liquidation proceeds, and X and Y would receive $450 each.

Common issues with profits interests

Common issues that arise with profits interests are the product of a general misunderstanding of Secs. 61 and 83 and the purpose and function of the IRS’s position in Rev. Proc. 93-27.

Post-hurdle catch-up

A feature often seen with the grant of a profits interest is a catch-up provision. A catch-up provision entitles the profits interest holder to additional allocations and distributions after the hurdle is exceeded, thereby mitigating the effect of the hurdle. In certain instances, such a provision may lead the IRS or a state revenue agency to challenge the tax treatment of the equity grant.

Example 3: Partnership P has two members, X and Y, and they each own four units of Class A membership. Partnership P grants Z two units of Class B membership. Class A membership entitles X and Y to current-year profits and liquidation proceeds, whereas Class B membership entitles Z to current-year profits and losses and liquidation proceeds subject to a hurdle. At the time of the grant, Partnership P was valued at $1,000, so the hurdle is $1,000. In the event Partnership P sold for $1,750, the Class A members would allocate the liquidation proceeds among themselves pro rata until they received allocations equal to $1,000, i.e., $500 each. Using a catch-up provision, Z would receive the next $250, which enables Z to receive 20% of the first $1,250, and then the $500 remaining would be allocated pro rata, i. e., $200 each to X and Y, and $100 to Z.

While this catch-up complies with the literal concept of a hurdle, the authors view this allocation as being overly aggressive because it largely frustrates the purpose of the hurdle, i.e., preventing the recipient of the profits interest from receiving value that was created prior to the receipt of the profits interest. Generally, we recommend slower catch-up provisions, such as the one in the following example, if at all:

Example 4: Partnership P has two members, X and Y, and they each own four units of Class A membership. Partnership P grants Z two units of Class B membership. Class A membership entitles X and Y to current-year profits and liquidation proceeds, whereas Class B membership entitles Z to current-year profits and losses and liquidation proceeds subject to a hurdle. At the time of the grant, Partnership P was valued at $1,000, so the hurdle is $1,000. In the event Partnership P sold for $4,000, the Class A members would allocate the liquidation proceeds among themselves pro rata until they received allocations equal to $1,000, i. e., $500 each. Using a catch-up provision, Z would receive 30% of the next $2,000, which would enable Z to receive 20% of the first $3,000 (i.e., $600), with both X and Y receiving 35% of the next $2,000 (i. e., $700 each), and then the $1,000 remaining would be allocated pro rata, i.e., $400 each to X and Y, and $200 to Z. The slower catch-up provision helps to mitigate the adverse effect of the hurdle without eviscerating its efficacy.

Hurdle in the current year

Another common mistake is when the interest that is granted has a hurdle in current-year profits and losses. This mistake creates two issues. First, having a hurdle in current-year profits and losses is at odds with the technical underpinning of Rev. Proc. 93-27, which provides that the value of the profits interest at the time of the grant is entirely tied to the liquidation value. Second, the functional result is to convert the character of income from ordinary, which would be recognized as current-year profits and losses, to capital gains, which predominate proceeds from liquidation of a business, and tax law is filled with examples where this is not permitted.²⁴

Lack of proper valuation

Perhaps the most significant mistake is to not have a contemporaneous valuation of the partnership prepared at the time of the grant. Merely having a post hoc valuation or a valuation that lacks proper methodology or substantiation will be a problem should the IRS or state revenue agency audit the transaction or the partnership. While an independent third-party valuation is best, the most important thing is that the valuation be prepared based on proper economic principles.

Granting profits interests

Profits interests are complex, from drafting the implementing language in the partnership’s operating agreement, to setting the hurdle properly, to drafting a catch-up provision, and finally to making sure that all the relevant stakeholders agree 24. E.g., Sec. 1239; Arrowsmith, 344 U.S. 6 (1952). To and understand the terms of the operating agreement. The authors strongly recommend that anyone seeking to grant a profits interest subject to a hurdle hire experienced tax advisers with sufficient knowledge of partnership tax to ensure related issues are not missed.

Footnotes

¹This can be done for any entity taxed as a partnership and to some extent for businesses taxed as C corporations, but it cannot be done for S corporations.

² It is possible to grant equity to anyone who provides services to a business, which would include both employees and independent contractors, as well as to anyone who was already a partner and performed services.

³Sec. 83.

⁴ It must be noted that while the grant of equity is taxable upon receipt, the granting business will receive a corresponding deduction in the same amount (Sec. 162).

⁵Such as a profit-only interest.

⁶Most profits interests do not include any noneconomic rights, e.g., voting rights, and the majority come with socalled drag-along rights that require the holder to sell if owners of other classes agree to sell a business.

⁷Rev. Proc. 93-27, clarified by Rev. Proc. 2001-43.

⁸Sec. 61; Glenshaw Glass Co., 348 U.S. 426 (1955).

⁹Sec. 83.

¹⁰Sec. 83(a).

¹¹E.g., St. John, No. 82-1134 (C.D. III. 11/16/83).

¹²Id.; Campbell, 943 F.2d 815 (8th Cir. 1991).

¹³Diamond, 56 T.C. 530 (1971), aff’d, 492 F.2d 286 (7th Cir. 1974).

¹⁴Rev. Proc. 93-27, §2.01.

¹⁵The exact consequences of situations in which Rev. Proc. 93-27 is inapplicable are somewhat unclear, but it can be assumed that tax will be imposed retroactively with penalties, though there are questions regarding the statute of limitation under Sec. 6501, which are beyond the scope of this article and will not be discussed further.

¹⁶Rev. Proc. 93-27, §4.02(1). It must be noted that high-quality debt securities or a high-quality net lease are not defined and serve as examples, and therefore it must be assumed that assets that produce highly regular returns without significant operational activity would be problematic as well.

¹⁷As defined in Sec. 7704(b).

¹⁸Rev. Proc. 93-27, §4.02(2).

¹⁹Secs. 61 and 83.

²⁰A partnership may grant rights to (1) profits only or (2) profits and losses. In theory, a partnership can grant the right to losses only, which could be problematic, as the interest holder may never have a positive capital account. This discussion is outside the purview of this article and will not be discussed further.

²¹While there is no requirement that all equity holders must be treated the same or have pro rata allocations, as is a requirement for S corporations, all partners that hold the same class of equity must be treated equally, hence the need for a separate class of equity to facilitate the hurdle.

²²To determine the value of the hurdle, the authors strongly recommend that the partnership obtain a professional valuation for the date of the grant, as the IRS or a state revenue agency could audit the valuation.

²³It must be reiterated that neither Rev. Proc. 93-27 nor Rev. Proc. 2001-43 mentions a liquidation value or a hurdle, but they do deal with the receipt of an interest that entitles the holder to profit from the activities in the current year.

²⁴E.g., Sec. 1239; Arrowsmith, 344 U.S. 6 (1952).

Contributors

Matthew E. Foreman, J.D., LL.M., is a partner, and Michelle S. Kabel, J.D., is an associate, both at Falcon Rappaport & Berkman LLP in New York City. For more information about this article, contact thetaxadviser@aicpa.org.

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