When we talk about a business compensating its service providers — which can include employees, attorneys, brokers and real estate developers, to name a few — it can mean more than just paying wages, bonuses or fees. Many providers want more than a check; they want to share in, and have a hand in creating, a company’s good fortune over the long-term. Similarly, many companies hope that their providers will share in the upsides and downsides of the business, staying with them for longer than a singular project. Consequently, service providers are often offered some sort of ownership stake in exchange for their work.
Specific to partnerships, what ownership options are available when it comes to compensating providers? There are several choices to evaluate, including profits interest, capital interest, options and unit appreciation rights.
1. Profits Interest
A profits interest offers a future profit in the company and, as defined in Revenue Procedure 93-27, is an interest other than a capital interest (described in more detail in the next section). A grant of a profits interest is not a taxable event for the service provider of a partnership. However, Rev. Proc. 93-27 does not apply, therefore making it a taxable event, if:
- The profits interest relates to a substantially certain and predictable stream of income from partnership assets (such as income from high-quality debt securities or a high-quality net lease),
- The profits interest is disposed of within two years, or
- The profits interest is an LP interest in a publicly traded partnership.
Revenue Procedure 2001-43 provides guidance on the tax treatment of a profits interest that is subject to vesting requirements, stating that Rev. Proc. 93-27 applies at the time of grant of the profits interest even if not vested if:
- The service provider and the partnership treat the service provider as the owner of the partnership interest from the date of grant and the service provider takes into account allocations of income, loss, etc. in determining tax liability, and
- Neither the partnership nor partners claim a deduction upon grant or vesting of the profits interest.
There are multiple structures for issuing a profits interest. A few examples include:
- Cash distribution to a profits interest partner only upon an event like a sale of property or a refinancing of property once a certain fair market value threshold has been met,
- Cash distribution to a profits interest partner upon sale of property or business at a certain price,
- Cash distribution to a profits interest partner based on operating cash flow – possibly once the other partners have received their capital back or once capital partners have received their preferred annual return each year.
As you can tell, there is a lot of flexibility when issuing profits interest. However, there are several considerations as well:
- How do you allocate taxable income to the profits interest partner once that partner receives cash? This is not always an obvious calculation — cash may be issued and the entity may have a taxable loss. Should there be a special allocation of income to the profits interest partner? It depends on the debt allocation and whether or not the profits interest partner has a recourse debt allocation (often the case in the real estate developer world). The operating agreement should be reviewed closely and all facts gathered to make the proper allocation of taxable income/loss.
- The issuance of a profits interest creates a book-up event. The book-up is outside the scope of this article but it should be reviewed with your tax adviser and noted that multiple issuances of profits interests over the years could create multiple layers for 704(c) allocations.
- How do you allocate taxable income if the cash distribution is made upon a sale event? Does the profits interest partner get a taxable income allocation based on operations (ordinary income) or capital gain or both? This should be addressed in the operating agreement.
- Once a profits interest is issued, the service provider will receive a K-1. If there is an allocation of income to the profits interest partner, this makes their tax filings more cumbersome. It could create additional state filings and estimate tax calculations and payments.
2. Capital Interest
A capital interest entitles the holder to a share of the liquidation proceeds as of the date of the grant. It also entitles the capital interest to a share of future profits. On the date the equity interest is issued, the holder of that interest receives value in the partnership (unlike the profits interest, which is based on a future event). Therefore the capital interest award is required to recognize taxable income. The amount of income recognized is equal to the fair market value of the interest unless it is subject to a substantial risk of forfeiture. The service provider can, however, make an 83(b) election to include in income the value of the capital interest at the time of the grant. The partnership deducts as compensation equal to the amount of income recognized by the partner.
As with a profits interest, there are also multiple issues to address when a capital interest is issued:
- How do you value the capital interest? Use liquidation value? An arm’s length sale price? Should discounts be used?
- There will be a capital shift among all current partners. Often one of the concerns relates to the other owners and not the service provider, as the original owners now own less of the partnership.
- What effect does forfeiture have on the issuance? Should an 83(b) election be made if there is a substantial risk of forfeiture? Then what are the effects if the interest is subsequently forfeited?
- There is a downside to the service provider — the service provider is recognizing taxable income but is not receiving cash to pay the taxes on this income. Should there be a true-up to cover taxes?
- If the service provider was previously an employee and received a W-2, they should now be issued guaranteed payments. This will complicate their personal tax filings for estimated tax purposes as well as create additional state filings depending on the operations of the partnership. In addition, the partner will no longer be able to participate in a cafeteria plan and there is no group term life insurance income exclusion, among other items that need to be considered.
The third offering to consider issuing is an option. An option can be issued to the service provider to acquire a capital interest. The tax treatment is the same as the issuance of a capital interest. It is a deduction to the partnership and taxable income to the service provider equal to the fair market value of the interest less the option price. The same issues relating to a capital interest issuance listed above need to be considered when deciding whether to issue an option.
4. Unit Appreciation Rights
The last alternative and probably the simplest for the partnership and service provider is the issuance of phantom interests or unit appreciation rights. This is a promise to employee/service provider that the partnership will track the value of the units and any increase in value will be paid out as compensation upon the event. This can be contingent upon an event such as a sale. The service provider recognizes ordinary income when the income is paid and the partnership gets a deduction for the same amount. The downside to the employee/service provider is that all of the income is ordinary income, compared to a potential for capital gain income if the service provider were issued a profits interest or equity interest. The benefit to the service provider, though, is they will not receive a K-1, there are no additional state filings and no estimated tax calculations. The benefit to the partnership is that there is not a dilution in ownership and the partnership receives an ordinary deduction for the amount paid.
As an owner, it makes sense to want a service provider who will share in the good health and fortune of your partnership. You want a partnership, so to speak, for your partnership. These equity-based offerings can help you do just that by incentivizing providers.
Contact Kim Palmer at email@example.com or a member of your service team to discuss this topic further.
Cohen & Company is not rendering legal, accounting or other professional advice. Any action taken based on information in this blog should be taken only after a detailed review of the specific facts and circumstances.