If I am given a profits interest in a partnership or limited liability company, how am I taxed? It is relatively common for an LLC (for purposes of this article, a partnership and LLC may be considered the same type of business) to give an interest to a service provider. The taxation of the interest is different depending upon the type of interest as a capital interest can be different than a profits interest. The article below has been prepared by a Denver business attorney and discusses a profits interest. A profit’s interest is a type of equity in the applicable business, and is designed to give the individual a predetermined share of future growth in the value of the business. A profits interest can be differentiated from a grant of stock within a corporation because the profits interest would not entitle the holder of the profits interest to share in the businesses current value. Rather the profits interest provides for a share of future profits and appreciation within the business, as opposed to an interest or share in the company’s current value. This position, is what dictates the tax treatment of a profits interest when provided to the holder of the interest.
Initially, courts appeared to have mixed feelings regarding the taxation of a profits interest. In 1974, a federal court of appeals held that the receipt of the profits interest should be considered taxable income when the interest had a readily determinable market value. However, later another federal court made a determination that would appear to suggest the service provider receiving a profits interest and acting as a partner within the company could receive the interest without the interest being taxed upon receipt.
Revenue Procedure 93-27 was issued by the Internal Revenue Service in 1993 to provide guidance regarding the taxation and treatment of a profit’s interest in a partnership. The Internal Revenue Service used a hypothetical liquidation test in the Revenue Procedure 93-27 analysis. Under the hypothetical liquidation analysis, a liquidation would not give the profits interest holder a share of the partnership assets if the partnership liquidated all assets and distributed cash to the partners. In terms of the timing of the liquidation, the liquidation is deemed to occur at the time of the partner receives the profits interest, and thus there would have been no real increase in the value of the business from the time of receipt to the time of the deemed liquidation. This analysis entitles the holder of the profits interest only to a share of future profits and appreciation in the business, rather than an immediate interest in the partnership’s current value. Thus, when a partner receives a profits interest for services, or for the benefit of the partnership in a partner capacity, or even in anticipation of being a partner, the IRS will likely not treat the receipt of the interest as a taxable event. It is important to note that the IRS may not treat the receipt of a partnership interest as a non-taxable event if in fact the profits interest would bring about a substantially certain and predictable amount of income to the recipient.