Many clients consult their tax attorney or business attorney about establishing an agreement with third parties or 
employees whereby the individual would receive a profits only interest in the business. In a typical profits only interest, the employee or a third party service provider receives a grant of a certain percentage of the business profits. The agency history of profits interests are outlined below by a Denver tax attorney at The McGuire Law Firm.
The Internal Revenue Service provided Revenue Procedure 93-27 which defines a profits only interest as an interest that would not provide the “holding party” with a right to the share of the LLC’s proceeds if the LLC liquidated and sold all of the partnership assets for fair market value. Thus, the “holding party” does not have an equity interest in the business because the “holding party” would not necessarily reap the benefits of appreciated property or assets held by the business.
Although many can understand why the individual or “holding party” would not have an equity interest in the business with a profits interest only, our business attorneys are often asked, how the profits only interest is taxed. In Revenue Procedure 93-27, the Internal Revenue Service provided that a parties receipt of a profits only interest would not be treated as an interest received for past or future services as a taxable event if the parties and circumstances meet certain conditions. One such condition is that the party must receive their interest in the capacity of a member, or in anticipation of becoming a member of the LLC, in exchange for their services to or for the granting LLC’s benefit. Further, the party can only receive a profits interest and not a capital interest. The receipt of a capital interest without the contribution of money or property is likely to be a taxable event. Additionally, the LLC cannot correlate the profits only interest to a certain and predictable income stream, or dispose of the interest within two years from the date the interest is received.
Eventually Revenue Procedure 2001-43 followed up and answered questions created by Revenue Procedure 93-27. The issues in Rev. Proc. 2001-43 involve profits interest that are subject to vesting restrictions, such as requirements for employment or service duration and how a non-vested holder would be treated for federal income tax purposes under the tax laws. The IRS does not consider either event (the granting of a profits only interest nor the vesting of a profits only interest) to be a taxable event. With certain exceptions, the IRS would tax the grant of the profits interest, but the issue remains value. The value of the interest may be hard to ascertain and have a value of zero. Further the “holding party” would be/will be taxed on the profits as they are received. Thus, without value, there is no income to the recipient or holder and there can be no deduction to the LLC.
A Denver tax attorney or business attorney at The McGuire Law Firm can discuss profits only interests with you and their potential application to your business. Additionally, we counsel and advise businesses on other tax law and business law questions and issues.
Contact The McGuire Law Firm to schedule your free consultation with a Denver tax attorney or business attorney.
