Granting profits interests is often an attractive, tax-efficient option for partnerships that want to build loyalty and greater productivity among their top workers. Partnership interests may be used to reward individuals for their past or future services to a business. Transferring an equity interest with a current ascertainable value is generally taxable as compensation at ordinary income tax rates. Granting an interest in future growth with only undeterminable or speculative value is not taxable.
In both cases, holders of partnership interests recognize mostly capital gains on disposition, a key reason why profits interests in partnerships are popular forms of equity compensation. This article provides a detailed overview of fundamental tax considerations that make profits interests a compelling and strategic tool for partnerships.
IRS Safe Harbor Rules for Profits Interests: What You Need to Know
IRS guidance defines profits interests as interests that are not capital interests. Capital interests are interests in a partnership that provide liquidating proceeds if the partnership were to sell all its assets for cash at fair market value (FMV), pay off its debts, and distribute the remaining cash to its partners. A capital interest represents an economic right to cash upon liquidation. A grant of a capital interest is taxable as compensation at ordinary income tax rates. Since there is value, the capital interest holder receives a positive capital account.
Profits interests do not grant ownership in partnership capital or accumulated earnings. Profits interests grant a right to share in future operating profits, in future capital or change-in control events, or both. As a result, profits interests are speculative, and the capital account a profits interest holder receives is zero upon receipt. The receipt of the profits interest for services is not taxable as long as the interest is received by a partner or by one who anticipates becoming a partner.
The IRS has provided guidance to reduce litigation around the taxable value upon issuance of profits interests. The grant of a profits interest is not a taxable event if:
- The interest is not disposed of within two years of the grant.
- The partnership does not receive a relatively predictable stream of income.
- The interest is not a limited partnership interest in a publicly traded partnership.
The IRS further clarified that the grant of nonvested profits interests is also not a taxable event if:
- The issuing partnership does not take a compensation deduction, and the recipient does not recognize gross income at the time of receipt.
- The partnership treats the interest holder as a partner from the date of grant. The above constitutes the current safe harbor for profits interests.
In many cases, recipients of nonvested profits interests are counseled to file a Section 83(b) election within 30 days of the grant. Section 83 covers the taxation of property received in exchange for services. In general, an employee who receives property in exchange for services recognizes into gross income the excess of the FMV of the property over the amount the recipient pays for it. For nonvested property, the inclusion into incomes comes earlier (when the property becomes transferable) or is no longer subject to substantial risk of forfeiture. Alternatively, a taxpayer may elect under §83(b) to include the excess FMV in gross income in the year of receipt of the property. The IRS has stated that an election under §83(b) is not required when the safe harbor applies. Nevertheless, advisors frequently recommend making the election as a protective measure in the event the interest does not meet the safe harbor requirements.
Note: The IRS recently published new Form 15620 to standardize the §83(b) election process. Alternatively, taxpayers may submit written statements that conform to regulation §1.83-2.
How Profits Interests Are Treated: Employee vs. Partner
Under the safe harbor, a profits interest holder becomes a partner upon receipt of the interest, even if the interest is substantially nonvested. Employees who receive profits interests must be treated as partners for tax purposes upon grant. The IRS has long taken the position that bona fide partners are not employees of a partnership for Federal Insurance Contributions Act (FICA), Federal Unemployment Tax Act (FUTA), and federal income tax withholdings. Consequently, a partnership should inform its profits interest holders of their new status as equity holders and changes in tax compliance.
To avoid income and payroll tax complications, companies may choose from various organizational structures to enable an individual to continue to receive compensation as an employee and to also hold a profits interest. Note that current IRS guidance does not allow a disregarded entity owned by a partnership to be treated as a separate entity for self-employment tax purposes.
Some examples of these structures used to separate employment and partnership profits interests include:
- Form an upper-tier management aggregator or HoldCo as a tax partnership to hold profits interests in a lower-tier Opco where the individual remains an employee.
- Where a disregarded Opco is wholly owned by Holdco, provide a small partnership interest in OpCo to a C corporation to spring Opco into existence as a regarded tax partnership. Grant profits interests in Holdco to employees of Opco to preserve the individual’s status as an employee.
- Form a C corporation employee leasing company wholly owned by the Opco. Profits interests may be granted directly in the Opco while preserving employee status for those individuals working in the C corporation leasing company.
Reporting Profits Interests: From W-2s to Schedule K-1s
If an alternative structure is not used, former employees, who previously received an IRS Form W-2, Wage and Tax Statement, reporting payroll taxes and federal income tax withholdings, now receive a Schedule K-1. Schedule K-1s report distributive shares of income and loss, guaranteed payments, contributions, and distributions to and from the partnership. Profits interests no longer receive salaries, but instead, receive guaranteed payments. A new partner is responsible for submitting income and self-employment taxes quarterly.
Fringe Benefits for Partners: What Changes With Profits Interests?
There are additional differences between partners and employees regarding fringe benefits. In many cases, some fringe benefits paid to or for the benefit of partners are included in guaranteed payments, where they may otherwise be excluded from gross income for employees. Such items include:
- Accident and health insurance coverage
- Group term life insurance coverage up to $50,000
- Disability insurance
- Qualified transportation fringes
- Qualified adoption assistance
- Qualified employee achievement programs
- Health savings account (HSA) contributions
If partners participate in §125 cafeteria benefit plans, the plan may be disqualified, and participants may be subject to tax. Typically, qualified retirement plan contributions, self-employed health insurance premiums, and HSA contributions may be deducted as an above-the-line deduction on a partner’s individual income tax return.
How Forvis Mazars Can Help
With no taxable income at grant and mostly capital gain treatment at disposition, profits interests can be an excellent tool to incentivize a partnership’s employees’ productivity and loyalty. Since many profits interests are subject to vesting arrangements, partnership owners, managers, and employees are often caught off guard by the tax ramifications of ownership. It’s helpful to understand the tax implications up front so that appropriate processes are put in place for fringe benefits, payroll taxes, withholdings, quarterly and annual reporting, etc. It’s also critical that the changes in treatment are communicated as early as possible in the transition so that new partners can anticipate their new federal tax obligations. Alternatively, working with legal and tax advisors may reveal other organizational structures that offer viable options for granting ownership to standout employees.
These tax challenges, reporting requirements, and compliance considerations can be complex. Forvis Mazars offers tailored services to help partnerships structure, report, and manage profits interests effectively. Our experienced professionals can assist with everything from IRS safe harbor compliance to fringe benefit planning to help you prepare for what’s next.
If you have any questions or need assistance, please reach out to our Tax team at Forvis Mazars.