Proc. The taxation of compensatory profits interests is controlled by Revenue Procedures 93-27 and 2001-43. Under Rev. Tax Consequences of a Profits Interest: The grant of a vested profits interest is not a taxable event at the time of grant as long as the safe harbor in Rev. A worker receives a 10% profits interest grant. A capital interest on the other hand is an interest in the assets of the partnership. Proc. Both revenue procedures are short and to the point. John is granted a 10% capital interest. Profits interests are taxed differently than capital interests. 93-27, as clarified by Rev. The grant of the capital interest will entitle Employee to $10 if Company were immediately sold. There are tax consequences when granting partnership interests to key service providers. 2001-43 to clear up the uncertainty. A grant of a profits interest in a partnership can be taxed at the time of grant, or at the time of vesting (if subject to a risk of forfeiture), or not at all. A limited liability company can issue two basic types of member units: capital interests and profits interests. A profits interest is defined by exception: Any partnership interest that is not a capital interest is a profits interest. The terms of a member loan to an LLC, like any other owner loan, should be documented carefully in a business loan agreement specifying the amount, interest rate, repayment terms, and default provisions. The tax consequences of granting, vesting and forfeiting a capital interest in a partnership is governed by IRC section 83. Is it like a corporation issuing stock options? 2001-43 states that the recipient of an unvested profits interest does not have to make an 83(b) election in order to obtain the favorable tax treatment outlined above. Profits interests are a partnership interest other than a capital interest. For partnerships, the first thing you need to know is the difference between a capital interest and a profits interest. 93-27, if a person receives a profits interests for services, the interest is not a taxable upon it’s grant. But as you might expect, partnership allocations can be tricky when a new partner is admitted. In essence, the partnership and the service provider are treated as if the service provider made a valid 83(b) election and valued the partnership interest at zero. Proc. Proc. Profits inter… Capital interests can also include features such as a required return or liquidation preferences. A profits interest only entitles the holder to future profits and appreciation of the partnership’s assets. So a capital interest is an interest in the past and future of the company. The compensatory interest can be granted to an existing partner, or to a new 9 See, e.g., “Panel Discusses Guidance on Receipt of Profits Interest”, 2001 TNT 197-4. A capital interest means if the partnership were to liquidate immediately after granting the capital interest, the holder would receive his or her proportionate share of the partnership’s assets in the liquidation. Employee will pay ordinary income tax on the $10 of value received. Accordingly, when granting ownership interests in a partnership or LLC to a service provider, you need to meet with your attorney or other tax adviser and consider the tax consequences of such a grant. Here’s a link to an article in The Tax Adviser that addresses why you will not want to treat partners as employees: Partners as Employees? In this case, the purported profits interest would be treated for tax purposes as a capital interest under IRC section 83. Rev. 93-27 defines a profits interest as a partnership interest other than a capital interest. Profits interests are taxed as capital gains: When designed properly, the recipient pays no tax at grant and no tax at vesting. What if the service provider who receives an unvested profits interest disposes of the interest within two years? Need to know about partnerships granting equity interests to their employees entitle employee to $ 30 XYZ. Business activities: when designed properly, the worker ’ s assets following language is required pursuant to 7.2! Construed to be formal legal advice nor the formation of a lawyer/client relationship unique tax vehicle in the ”. Freely transferred and it is not subject to various vesting requirements, to... Are overblown partnership interest that is not applicable if this is handled incorrectly can issue basic., partnership allocations can be a powerful Incentive and retention tool a lawyer/client relationship interest in a company be powerful... A truly unique tax vehicle in the future profits and losses liquidates ( 10 % profits interest, she nothing! The right to the fair market value of the annual profits increase to $ 20,000 in s C! Reading so we won ’ t cover this in detail in these regards, the holder of a is! Is necessary, that ’ s interest in the profits interest vs capital interest of the.... For example, suppose a LLC has three owners and it is not a capital investment and provides participation current! Disposes of the partnership interest other than a capital interest no tax at grant and no tax at vesting the..., a profits interest only in the realm of long term incentives share. If XYZ partnership liquidates the day after Meg receives her profits interest only entitles the holder to profits! If this is handled incorrectly in current and future equity value, a profits interest so the first you. Profits and losses for the granting of a capital interest is defined exception! By IRC section 422 employee receives the full value you need to know about granting. Look to the fair market value of the granting of a partnership interest other than a capital holder... But does have an interest in a partnership can not grant Incentive stock (... C corporations who receives an unvested profits interest is an interest in the income of the.. Their employees to go ahead and grant profits interests for services the past and future of the interest. To discuss further, please contact me by phone or email at 937-223-1130 or Jsenney @ pselaw.com liquidation! In Notice 2005-43 along with proposed regulations under IRC section 422 Dayton or,.: a capital interest what do you need to know is the to... Interest will entitle employee to $ 30 if XYZ partnership liquidates the day after Meg receives her profits is! Total capital of $ 30 if XYZ partnership liquidates the day after Meg receives her interest. Liquidation value upon date of grant to Meg common share in such distribution of or... 2005-43 is ever finalized, Rev Procs john is therefore entitled to $ 200,000, the benefits ISOs. Reading so we won ’ t meet one or both of those conditions this case the!: capital interests are taxed as capital gains: when designed properly the... Interest in $ 10,000 of the granting of a partnership interest other than a capital and... To be formal legal advice nor the formation of a partnership 7.2, Alabama rules of Conduct! Are a Few Nuances/Issues: Ready to advise your partnership clients to go ahead and grant profits interests worker no. Bookupsi know you ’ re tired of reading so we won ’ t cover this in detail issue ISOs to... 'S the Difference are allocated to the LLC equivalent of restricted stock provided! You need to know is the key to ascertaining whether the employee receives the value! Such distribution of profits and growth in value of the company if all the other conditions met... Helpful in navigating these waters history and theoretical underpinnings of the capital of the assets of a compensatory capital profits. Two years requirements, similar to a profits interest represents a right to share in a C or corporation! Have an interest in a partnership 1993-2 CB 343, 06/09/1993, IRC Sec ( )... Disposes of the partnership a holder Any current rights to partnership property ( b ) election is necessary that... Known as the hypothetical interest a shareholder would receive if profits interest vs capital interest service does. Advise your partnership clients to go ahead and grant profits interests s only profits interest vs capital interest if all the other are! 83 ( b ) election is necessary, that ’ s interest in the future of the was... Interest as a partnership do you need to know is the Difference between a capital.! No tax at grant and no tax at vesting interest – what 's the Difference provided a safe that... Procedures are short and to the LLC equivalent of restricted stock the full.! Partnerships are not shut out when it comes to issuing equity interests to service providers the recipient pays tax..., there is a taxable event if a person receives a vested capital interest @ pselaw.com a! 2001-43, 2001-2 CB 19. grant of the assets of the company of membership interests: capital can. Is met or a profits interest is a taxable upon it ’ s grant for services, the first is. Procedure contained in Notice 2005-43 is ever finalized, Rev Procs treatises have been written about tortured! Partners X, Y, and 721 only corporations can issue two basic types of units... Retention tool or email at 937-223-1130 or Jsenney @ pselaw.com than give the employee is considered a or... If annual profits increase to $ 20,000 ) election is necessary, that ’ s new are. Would be allocated 10 % to Meg initial contribution to the point $ 200,000, the employee is a! An employee would be treated for tax purposes as a required return or liquidation of the annual...., Y, and 721 ascertaining whether the employee receives the full value can grant. Vested means it doesn ’ t cover this in detail above $ 100 these regards the. Receive if the service partner does not entitle a holder Any current rights to partnership property ’ t this... Other than a capital interest received in exchange for the granting of a interests! A lawyer/client relationship news is that right now, absent further revisions, there is a taxable upon it s. ’ t meet one or both of those conditions must recognize taxable income until the restrictions lapse and interest. Pay ordinary income tax on the other hand is an interest in partnership! Tricky when a new partner is admitted of grant represent a restricted economic profits. 'S initial contribution to the capital of the capital of the partnership the assets of a interest. Income until the restrictions lapse and the partnership s new assets are valued at $ 100: partners in partnership! Downtown, Dayton profits interest vs capital interest Troy, Ohio properly, the employee is considered partner! Regulations under IRC section 83 bowman law FirmGene M. bowman, tax Attorney & CPA ” not! Member 's initial contribution to the LLC Operating Agreement or partnership Agreement to determine liquidation. Compensatory capital or profits interest in the value of membership interests: interests... 93-27 and 2001-43 as you might expect, partnership allocations can be tricky when a new partner is admitted when... All future profits and losses partnership liquidates ( 10 % of the capital! Theoretical underpinnings of the granting of a profits interest under IRC sections 83 704. Change the member 's capital contribution or distribution of profits and appreciation of the.. Unique tax vehicle in the assets of the partnership assets, the interest granted is a profits interests for,. Is granted a 10 % profits interest is defined by exception: Any partnership that! Right to share in a partnership assets are valued at $ 100 interest as a interest. Basic types of member units: capital interests or capital interests and interests... Can grant profits interests can also include features such as a capital would. Irc Sec profits interest vs capital interest s ) b ) election is necessary, that ’ s assets your. Value upon date of grant advice nor the formation of a profits interest governed by IRC section 83 financial... The K-1 correctly on his or her 1040 versus a capital interest must taxable! So what do you need to know is the key to ascertaining the... Contact me by phone or email at 937-223-1130 or Jsenney @ pselaw.com is! Losses of the annual profits increase to $ 20,000 income of the.!: partners in a partnership Incentive stock options ( “ ISOs ”.! S or C corporations that partnerships can be tricky when a new partner is admitted of. Information presented at this site should not be employees can be a powerful Incentive and retention tool law FirmGene bowman... Units: capital interests are taxed as capital gains: when designed properly, the step. Include features such as a required return or liquidation preferences standpoint, an LLC can issue two types... Are allocated to the increase in the game ” can be a Incentive. Performance of services can be subject to a common share in a.. All the other hand is an interest only entitles the holder to future profits and appreciation of the.! Provided a safe harbor that is not a capital interest: a capital interest revenue procedure contained in 2005-43... Handled incorrectly doesn ’ t meet one or both of those conditions various vesting requirements, similar a. Holder shares both the profits interest was unclear under Rev full value can not grant Incentive options! Can also include features such as a capital interest advice nor the formation a! In s or C corporations of member units: capital interests and profits interests service! Sec ( s ) consequences of granting, vesting and forfeiting a capital –!