Discussion:Profits Interest in LLC/Partnership

Profits interests are frequently used as equity-based compensation arrangements similar to corporate stock option plans. They provide an incentive to those members that are “doing the work” (i.e., sweat equity) - if the results of their efforts result in cumulative profits for the LLC then they will get a piece of the action. If their efforts result in the losses, such losses will be borne by the capital interest members (it's their money that's being lost). Issues can arise when the profit interest holders receive allocations of profits without a corresponding allocation of cash (i.e., the ”phantom income” problem) which usually happens when cash distributions are paid first to the capital members as a return of capital. In this case, the profits interests will become capital interests.

I don't want to even think now if this has substantial economic effect, as, quite frankly, I don't think anyone knows what the heck that means...

LOL - in the case of the profits interests, there should be no issue with substantial economic effect as long as any positive capital accounts are zeroed out via cash distributions at liquidation.

You are getting a piece of the action because you are contributing services to the partnership in exchange for a percentage of the partnership's profits - in other words, the current partners agree to share the partnership's profits with the “service partner” (note: the profits that we are talking about in this context are the “future” profits (if any) of the partnership - NOT past profits).

Will they establish this person's capital account after he has proven he can earn the profit?

I think you may be hung up on the notion that a partner must have a capital account in order to be a partner - such is not the case. How a service partner's interest is structured, however, could have different tax consequences. The following are a few examples of different equity compensation arrangements for service partners:

1. Unrestricted Capital Interest - here the service partner receives an immediate right to share in the partnership's capital. In other words, if the partnership is liquidated the day after the service partner is admitted, such service partner would be entitled to share in the liquidation proceeds. A Riley noted above, this type of interest is generally taxable to the service partner at the time it is received.

2. Restricted Capital Interest - under this type of interest, the service partner is typically subject to a vesting requirement such as a years-of-service requirement. For example, a service partner might receive a partnership interest that entitles such partner to 10% of the partnership's capital after three years of service. Assume the value of the partnership at the date of admittance is $100,000 and the value at the end of the three year period is $500,000. If the service partner does not make a Sec. 83(b) election, the capital interest is not taxable until the fourth year at which point the service partner will have $50,000 of income ($500k x 10%) and the partnership will have a corresponding deduction. If the partner makes a Sec. 83(b) election, then the service partner's taxable income will be computed based on the value of the partnership at the time the interest was granted, which in this case is $100,000 - so the taxable income would be $10,000.

3. Unrestricted Profits Interest - under this type of interest, the service provider is only entitled to share in the future profits/appreciation accruing after the date of grant. The granting of a profits interest is generally not a taxable event (also not deductible by the partnership); however, there are some exceptions - see Rev. Proc. 93-27 and Rev. Proc. 2001-43.

Also worth mentioning - since a partner cannot have dual status as a partner and an employee of the same partnership, the granting of a any interest in a partnership (including a profits interest) will result in many changes with respect to how income is reported [e.g., K-1, potential guaranteed payment vs. W-2, self employment taxes on guaranteed payments, may need to make estimated tax payments (i.e., no more withholding), etc.].

I am leaning toward classifying the interest of the members contributing services as a non-taxable profit interest. Anybody agrees with me? any guidance or insights is greatly appreciated!

Does that mean that the managing members' income will be taxed as capital gains and not ordinary income? It seems the profit interest is carried interest, and carried interest is taxed as capital gains.

Can anybody confirm that the members not contributing any money to the partnership, but only their services, and are getting a profit interest for it, will be taxes at capital gains rates?

thank you all for your help!

Stef

An interest in the partnership is going to mostly produce capital gains on a sale.

There are some differences between granting an LLC interest versus granting a profits interest plus phantom stock, such as voting rights and other contractual or legal rights, but they seem somewhat minor considering the stark differences in tax treatment.

The big change will be that, absent an 83(b) election, the recipient of an unvested partnership interest won't be treated as a partner; this, of course, is consistent with sec. 83, but not Notice 2001-43. Thus, the holder of the unvested interest will have no income from partnership profits, and any distributions on his interest will be compensation.

Any partnership agreement under which somebody's interest has no initial liquidation value evidences a profits interest.

That has nothing to do with the tax distinction between profits and capital interests.

Under most circumstances, the member should still be treated as the owner of the interest for tax purposes, so income should still be taxable to him, not the creditor.

I just confused myself.

I have a client who sold his interest in his partnership, but retained a "profits interest" for the remainder of his life. Because the partnership owns property encumbered with debt, the partnership generates "phantom income" for the first 5 years since all the cash goes directly to the lender. To my understanding, his capital account builds until the partnership debt is paid off (in year 5) and the partnership has actual cash to make distributions. Once it has the cash and pays out the partners, only then will his capital account be reduced.

My question is, what happens to his capital account when he does? Lets say his capital account is at $500k on the date of his death. Would it transfer to his estate and will the partnership be liable to pay it out on the date of his death? I'm worried because the partnership would have no cash and the other partner's do not want to be liable for his capital account if he dies before the debt is satisfied.