The Internal Revenue Service (IRS) recently issued guidance addressing the tax consequences of issuing so-called "restricted" profits interests in limited liability companies and partnerships. This guidance makes profits interests an even more attractive equity compensation alternative.
A "profits interest" is a type of equity instrument that is unique in the context of limited liability companies and partnerships (throughout this discussion, the terms "limited liability company" and "partnership" are used interchangeably). A profits interest is designed to give the recipient a predetermined share of future growth in an enterprise’s value. Unlike a grant of corporate stock, however, a profits interest does not entitle the recipient to a share of the enterprise’s current value. Thus, profits interests are often granted to service providers to provide an incentive to pursue enterprise growth.
A primary advantage of granting a profits interest is that, unlike a grant of corporate stock, the grant of a profits interest does not normally trigger taxable income. From the service provider’s perspective, profits interests can also possess tax advantages over "phantom stock" arrangements: because a profits interest represents actual equity in the partnership, the service provider can generally expect capital gains upon sale of the interest.
Federal courts initially examining the tax consequences of profits interests sent somewhat mixed signals. In Diamond v. Commissioner, decided in 1974, a federal court of appeals held that a taxpayer’s receipt of a profits interest gave rise to taxable income where the interest had a readily determinable market value. However, in Campbell v. Commissioner, decided in 1991, another federal appellate court strongly suggested that a service provider acting as a partner could receive a profits interest on a tax-free basis.
The IRS addressed the issue in 1993 with the issuance of Revenue Procedure 93-27. In this revenue procedure, the IRS defined a profits interest by means of a "hypothetical liquidation" test. Specifically, the revenue procedure effectively defines a profits interest as an interest in a partnership that would not give the holder a share of the partnership’s assets, if the assets were sold for their respective fair market values and the proceeds were distributed in a hypothetical liquidation of the partnership. This determination is generally made at the time of the receipt of the partnership interest. Such a hypothetical liquidation approach was designed to ensure that a profits interest only entitles the holder to a share of any future profits and appreciation in the partnership, rather than a share of the company’s current value.
In Revenue Procedure 93-27, the IRS stated that, if a person receives a profits interest for the provision of services to, or for the benefit of, the partnership in a partner capacity or in anticipation of being a partner, then the IRS will not treat the receipt of the interest as a taxable event. The "safe harbor" granted by Revenue Procedure 93-27 does not apply if the profits interest relates to a "substantially certain and predictable stream of income" from partnership assets, such as income from high quality bonds or net leases. The safe harbor also does not apply where the partner disposes of the profits interest within two years of receipt or if the interest is a limited partnership interest in a publicly traded partnership.
IRS Clarifies Treatment of "Restricted" Profits Interests
Revenue Procedure 93-27 provided taxpayers with assurance that profits interests could be issued tax free—at least "plain vanilla" interests like those described in the procedure. However, some questions remained unanswered. For example, many companies desired to issue "restricted" profits interests, that is, profits interests with strings attached. A service provider could, for example, be required to forfeit all or a portion of his or her interest if the person is terminated within a specified time period. Even after the issuance of Revenue Procedure 93-27, it was not clear whether a service provider could receive a restricted profits interest tax free from the date of grant or, instead, whether the service provider was required to recognize compensation income when the interest eventually vested.
In Revenue Procedure 2001-43, issued August 20, 2001, the IRS addressed some of these unanswered questions. In this pronouncement, the IRS stated it would treat both the initial grant of a restricted profits interest, and the event that causes the restricted interest to become substantially vested, as nontaxable events to the partner and the partnership. To qualify for this treatment, however, taxpayers must abide by the terms of the revenue procedure. First, the partnership and service provider must treat the service provider as a "real" partner for tax purposes beginning on the grant date (meaning, among other things, the service provider would receive a form K-1 from the partnership and would pay tax on his or her share of partnership income). Next, upon both the grant of the interest and its vesting, neither the partnership nor its partners may take a deduction for the value of the interest. Finally, the interest must otherwise qualify as a profits interest under Revenue Procedure 93-27.
The revenue procedure also addresses whether taxpayers need to file a section 83(b) election to qualify for the tax treatment described in the procedure. In general, if a taxpayer receives restricted property in exchange for services, a taxpayer does not recognize income until those restrictions are lifted. However, a taxpayer—by filing a section 83(b) election—may elect to recognize income based on the value of the restricted property when it is initially received (when the value is presumably lower) rather than when the property eventually vests. In the context of restricted profits interests, Revenue Procedure 2001-43 provides that taxpayers to which the procedure applies need not file a section 83(b) election to qualify for the tax treatment described therein. However, some risk adverse taxpayers may want to consider filing such an election should it later turn out that, for some unforeseen reason, the taxpayer falls outside the protection of the revenue procedure.
The revenue procedure does not address the tax consequences that arise when a service provider forfeits a restricted profits interest. However, the service provider generally should be entitled to a deduction upon forfeiture to the extent the service provider has been allocated undistributed income from the partnership.
Revenue Procedure 2001-43 provides taxpayers with welcome guidance as to the tax treatment of a form of equity compensation that is becoming increasingly common. While any company desiring to issue profits interests must consider a variety of business factors, including the tax situation of the participating parties, the IRS’ new pronouncement will make the use of restricted profits interests an even more attractive alternative for many companies.