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How is a Profits Interest in an LLC Taxed?

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 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.

 

The article above has been prepared by John McGuire of the McGuire Law Firm.  As a tax attorney and business attorney, John’s practice focuses primarily on taxation issues and business transactions.

Denver Tax Attorney

Denver Tax Attorney

Denver Business Attorney Discusses a Profits Only Interest in a Business

Many clients consult their tax attorney or business attorney about establishing an agreement with third parties or Denver Small Business Attorney 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.