Profits Interests vs Capital Interests

Introduction

Partners of partnerships, including limited liability companies (LLCs) taxed as partnerships, hold either “profits interests” or “capital interests,” each being deemed to be a “partnership interest.” The main situation that causes tax issues with these has to do with interests that are granted in exchange for service. Unlike C Corporations, partnerships cannot grant Incentive Stock Options (ISOs) When a capital interest is granted in exchange for services rendered, the default rule is that the recipient has ordinary income equal to the fair market value of the property received.

Example

Mike and Evan form partnership ME LLC. Evan contributes $50,000 and Mike contributes $0 but will run and operate the business. Mike and Evan are not sophisticated and they agree to a 50/50 split of everything. Mike may very well have income of $25,000 immediately after the formation of the partnership, which is likely not the intent. Most likely, Mike and Evan intended to share 50/50 in the future profits only, not in Evan’s initial investment.

What’s a Capital Interest?

A capital interest means if the partnership were to liquidate immediately after granting the capital interest, the holder would receive cash or other assets. The value of the capital interest is the amount of cash and the net fair market value of property that would be received in this hypothetical liquidation.

Example

Continuing with the example above, if immediately after receiving Mike’s interest in ME LLC the partnership were to liquidate and Mike was entitled to receive cash, his interest is a capital interest that would subject him to payment of income taxes on $25,000.

What’s a Profits Interest?

A profits interest is defined by exception: Any partnership interest that is not a capital interest is a profits interest. A profits interest only entitles the holder to future profits and appreciation of the partnership’s assets.

Example 1

Continuing with the example above, if Mike and Evan’s operating agreement were drafted in a manner such that Evan’s investment of $50,000 were preserved and kept in Evan’s capital account and that Mike would only be entitled to 50% of future profits, Mike’s interest is a profits interest with a fair market value of $0. Why? Because if the LLC were to liquidate immediately after the grant, Mike would be entitled to $0, and Evan would receive $50,000.

Example 2

Carried interest (or a promote) is a form of profits interest. GP establishes Fund LP and, in exchange for its managerial services, GP is entitled to receive 20% of the profits of Fund LP. Immediately after the grant, GP’s interest is worth $0 (based on a hypothetical liquidation). This is a form of profits interest.

Section 83 of the Code

Section 83 of the Code requires that, if a taxpayer receives property in exchange for services, the taxpayer has income equal to the net fair market value of the property received. If a plumber received payment for services in the form of a car, the plumber would be required under Section 83 to include the fair market value of the car as income.

Therefore, another way to think about a profits interest is to define it as a partnership interest that, immediately after the grant, has a fair market value equal to $0.

Exceptions

If any of the following apply, the interest will not be a “profits interest” even if the above applies:

• The profits interest relates to a substantially certain and predictable stream of income from partnership assets, such as income from high-qualify debt securities or a high-quality net lease;
• Within two years of receipt, the partner disposes of the profits interest; or
• The profits interest is a limited partnership interest in a “publicly traded partnership” within the meaning of IRC section 704(b).

See Rev. Proc. 93-27.

Vesting of Interests

The default rule under Section 83(a) is that property received is taxed at the time it is no longer subject to a “substantial risk of forfeiture,” based on the net fair market value of the property at the time and to the extent that it is no longer subject to a substantial risk of forfeiture.

Example

Samantha receives a profits interest in an LLC valued at $0 on the date of receipt where 50% vests immediately and the remainder vests the following year. The results are as follows:

• Year 0:
  • FMV of portion that vests at grant: $0
  • Amount includible in income: $0
• Year 1:
  • FMV of portion that vests in Year 1: $100
  • Amount includible in income: $100

Section 83(b) Election

Instead, the recipient of property that is subject to a substantial risk of forfeiture may elect to include the entire fair market value of the property in their income in the year of the initial grant. Had Samantha made an 83(b) election in the above example, the entire interest would have been included at $0 in Year 0 and no income would have been included in Year 1.

While there may be situations where the Section 83(b) election would be unwise, in most cases it makes sense to make the election for a profits interest that is subject to a substantial risk of forfeiture.

The IRS is very picky about the Section 83(b) election. It MUST be filed within 30 days of the grant. NO EXCEPTIONS.

Conclusion

Partnerships can grant profits interests or capital interests for services (or a combination of the two). It is important to understand the differences between these two types of interests, as the tax consequences can be very different. Profits interests are generally preferable from a tax perspective, as there is no tax liability at the time the interest is granted, whereas a capital interest can result in immediate taxable compensation income for the service provider. However, there are certain conditions that must be met in order for a profits interest to be treated as such for tax purposes. It is always wise to consult a qualified tax advisor to ensure the interests are being granted correctly.

As always, check with your own tax professional and do not rely on the above to make any legal or tax decisions.