An LLC’s profits interests are very similar to those of a corporation. They allow shareholders to participate in the company’s growth immediately upon formation. When the company begins to grow, the profits interests provide a way for shareholders to receive a portion of the income generated by the company without being taxed on the income itself. This occurs because profits and interests are treated differently under IRS rules than shares of common stock. 

This article below has been prepared by a Denver business attorney and discusses a profits interest.

Profits Interests Taxes for LLCs

Equity incentives are necessary to compensate employees at a business’s start-up stage. They are especially important at the early stages of a business because most entrepreneurs do not have sufficient capital to offer cash compensation. Instead, equity incentives provide a way to compensate employees without taking out loans or issuing debt instruments. In addition, equity incentives allow owners to retain control over their companies while giving employees ownership interests in the firm.

When considering equity incentives, it is crucial to understand how different forms of equity compensation work. For example, restricted shares are similar to common stock except that the holder cannot sell the shares unless he or she sells his or her interest in the company. Stock options give the owner the right to buy shares at a set price within a certain period. Finally, SARs entitle the employee to receive additional shares based on the company’s performance.

In general, the tax consequences of each type of incentive depend on whether the recipient receives income or gains from the sale of the shares.

Profits Interests In LLCs

How am I taxed if given a profits interest in a partnership or limited liability company?  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.  

 A profit’s interest is a type of equity in the applicable business. It 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 business’s current value. Instead, 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 profit’s interest when provided to the holder of the interest.

Understanding the Background of Profits Interests

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 decision 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.

The Hypothetical Liquidation Analysis

Revenue Procedure 93-27 was issued by the Internal Revenue Service in 1993 to guide 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.  Regarding the timing of the liquidation, the liquidation is deemed to occur when the partner receives the profits interest. Thus there would have been no actual 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, 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 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 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.  John’s practice focuses primarily on taxation issues and business transactions as a tax attorney and business attorney.

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.