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.
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:
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:
There are multiple structures for issuing a profits interest. A few examples include:
As you can tell, there is a lot of flexibility when issuing profits interest. However, there are several considerations as well:
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:
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.
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 firstname.lastname@example.org 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.
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