Profits interests have become an increasingly popular type of equity-based award if the entity is taxed as a partnership, as they avoid income tax or FICA tax on grant and vesting, and yield long-term capital gains on sale if certain requirements are met.

1. Description i.    A profits interest is an interest in the value of a partnership or LLC taxed as a partnership. It has upside potential but no downside protection.
2. The granting of profits interests has become a preferred way of compensating management in buyouts or as partnership incentives.

            iii.   Profits interests may be structured as a separate class of ownership interests.

1. Profits interests typically provide a share of profits only once the original LP investors have received a return of their full capital investment and a certain rate of return (e.g., IRR).
2. The profits interests must be held for a certain period to receive favorable tax treatment, as discussed below.
3. Tax Treatment of Profits Interests
4.    Revenue Procedure 93-27 provides that the IRS will treat the receipt of a profits interest as non-taxable if the following conditions are met: (a) the profits interests do not relate to a substantially certain and predictable stream of income from partnership assets, (b) for two years after receipt of the profits interest the partner does not dispose of the profits interest, and (c) the partnership or LLC is not a publicly traded partnership as defined in Internal Revenue Code §7704(b). In addition, the profits interest cannot be a capital interest, which, according to Proc. 93-27 means that if the partnership’s assets would be sold at fair market value, and the proceeds would be distributed in a complete liquidation of the partnership, the profits interest holder would not receive a share of the proceeds.
5. Rev. Proc. 2001-43 provides that even if the profits interest is nonvested at the time of grant, the profits interests will be non-taxable at the time of grant and at vesting, provided that: (a) the partnership treats the recipient as a partner from date of grant, and the partner must take into account its distributive share of partnership income or loss, and (b) the partnership and other partners do not deduct such amounts as wages.

            iii.   Some make a Code § 83(b) “protective” election on nonvested profits interests so that even if they are found to be taxable profits interests, there would be no tax in any event until vested.

1. Upon the sale or liquidation of the profits interest (after the two-year hold period), the proceeds are taxed at the lower long-term capital gains rate.
2. Holding Periods for Profits Interests
3. Generally long-term capital gains require a one-year holding period. However, with regard to profits interests, Rev. Proc. 93-27 requires that the profits interest be held for at least a two-year period.
4. If there is a Code § 83(b) protective election, there may not be a need for a two-year holding period, since even a capital interest with a § 83(b) election can utilize long-term capital gains rates if held for one year or longer.

            iii.   There may be a three-year holding period if the partnership owns real estate for rental or investment, since Code § 1061, enacted by the Tax Cuts & Jobs Act of 2017 and effective in 2018, in an effort to clamp down on carried interest use of long-term capital gains tax rates for fund managers, provides that “applicable partnership interests” which includes professional investors as well as those developing real estate for rental or investment, have an increased holding period for long-term capital gains treatment for three years instead of one year.  In this regard, a § 83(b) election would not help to shorten the period.

1. Setting Up Separate Entities so that Employer Pays Wages and Partnership Distributes Profits Interests.
2. Grantees of profits interests would ordinarily become partners of the entity granting the profits interests with taxes based on Form K-1 partnership returns, and could not be both partners and employees, and therefore the grantees would lose the ability to participate in the cafeteria plan or other flex benefits and would owe self-employment social security tax.
3. To allow the grantees to continue to be employees, often a subsidiary of the partnership can serve as the employer, while the main partnership grants the profits interest.  For example, the main partnership grants the profits interest; an Employer LLC subsidiary (typically a partnership) is set up as the employer entity that pays wages and employee benefits (with a services agreement with the main partnership); and there is typically a need for a holding company, Employer Holdings taxed as a corporation, which needs to own a small amount (e.g., 1%) of the Employer LLC subsidiary for tax purposes so that the Employer LLC partnership is regarded as a separate entity.

            iii.   Alternatively, sometimes the profits interests are passed through a feeder entity to the grantees so that they can still be employees of the entity.

1. Keep in mind that setting up these structures does involve extra work to set up and administer.
2. Advantages of profits interests
3. Non-taxability at grant (or on vesting) until the grantee ultimately sells or liquidates the profits interests, and then generally only at the long-term capital gains rate.
4. As equity, the profits interest should not be subject to Code § 409A, and instead it is governed by § 83 principles.

            iii    Profits interests can have a flexible payout.

1. Profits interests can be granted without voting rights.
2. Disadvantages of profits interests
3. Profits interests must be held at least two years to receive favorable tax treatment (or likely one year if a § 83(b) election is made).
4. The employer will not receive any deduction from the profits interest.

            iii.   The payout formulas are often complicated to administer.

1. There is no downside protection if there are not sufficient profits, and in this way profits interests are more similar to stock options than to restricted stock.
2. Grantees may become partners instead of employees of the entity granting the profits interests unless separate structures are set up to separate the employer from the entity granting the profits interests (see above).
3.    Accounting Treatment for Profits Interests – Profits interests, depending on the facts, would be treated for accounting purposes as either performance compensation or stock compensation. Performance compensation costs may be expenses when the payment is probable and reasonably estimable. Stock compensation is expensed based on its fair value over the period of service (but sometimes revalued each accounting period).

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As discussed in my earlier post on Profits Interest at https://ebeclaw.blogspot.com/2022/03/profits-interests.html , profits interests have become an increasingly popular type of equity-based award if the entity is taxed as a partnership, as they avoid income tax or FICA tax on grant and vesting, and yield long-term capital gains on sale if certain requirements are met. However, in 2017 this was limited in the case of profits interests (carried interest) for professional investors and real estate development for rental or investment to where the holding period is three years. A 2020 legislative proposal in the pending Inflation Reduction Act to increase the holding period for such carried interest from three years to five years and to only begin only once substantially all the partnership interest subject to IRC § 1061 are acquired by the partnership. However, in further negotiations this carried interest tax proposal is apparently being taken out of the legislation.

Pre-2017 Holding Period for Profits Interests – Two Years from Grant and One Year from Vesting. Prior to the enactment of the Tax Cuts & Jobs Act of 2017, generally long-term capital gain treatment for profits interest would require the general one-year holding period requirement (from the date the profits interests are vested). In addition, Rev. Proc. 93-27 would require that the profits interests be held for at least two-years after the date of grant.

Extended Holding Period for Professional Investors and Real Estate Investment to Three Years Under TCJA of 2017. Legislative changes imposed by the Tax Cuts & Jobs Act of 2017 (effective January 1, 2018) enacted a new IRC § 1061, which imposes a three-year holding period (instead of one year for ordinary capital gains) for an “applicable trade or business,” if the partnership owns real estate for rental or investments, since IRC § 1061, enacted by the Tax Cuts & Jobs Act of 2017 and effective in 2018, in an effort to clamp down on “carried interest” use of long-term capital gains tax rates for fund managers, provides that “applicable partnership interests” which includes professional investors as well as those developing real estate for rental or investment (IRC § 1061(c)(2)), have an increased holding period for long-term capital gains treatment for three years instead of one year. IRC § 1061(a).

2022 Proposed Legislation to Further Extend Holding Period for Such Carried Interest to Five Years, was Removed from the Bill to Win Approval from Sen. Krysten Sinema. Further legislative changes had been proposed in the Inflation Reduction Act in July 2022, H.R. 5376, to amend IRC § 1061 in the following ways: (i) the holding period for “applicable partnership interests” which, under IRC § 1061(c)(2), includes carried interest for professional investors (e.g., private equity firms and hedge funds) and real estate development for rental or investment, would be increased from three years to five years (except with respect to taxpayers with adjusted gross income of less than $400,000); (ii) the five-year holding period would begin only once substantially all the partnership interest subject to § 1061 are acquired by the partnership; and (iii) the holding period would now apply not just to profits interest but also to other income taxed as long-term capital gains, including qualified dividend income included in net capital gain for purposes of IRC § 1(h)(11), gain from the sale of active business assets under IRC § 1231 and regulated futures contracts subject to IRC § 1256. However, it has now been reported on August 4, 2022 that Democrats are revising their Inflation Reduction Act in order to will approval from Senator Kyrsten Sinema (D. Arizona), which, among other things, would drop the proposed tax increase on carried-interest income.