There has recently been a great deal of interest in the grant of a profits interest. A profits interest is a beneficial form of incentive for an individual who performs services for a partnership or other pass-through entity, like a limited liability company. Bottom line, a profits interest (also commonly known as a “carried interest”) is a non-capital interest in the profits of a partnership or a membership interest in a limited liability company taxed as a partnership.
Neither the grant or vesting of a profits interest is treated as a taxable event — i.e., the profits interest is valued at zero. The IRS has issued safe harbor guidance to this effect. Rev. Proc. 93-27; Rev. Proc. 2001-43. The safe harbor requirements are as follows:
- The recipient (the “Recipient”) must receive the profits interest in his or her capacity as a partner or in anticipation of becoming a partner;
- The interest must not be a substantially certain and predictable stream of income from partnership assets (i.e., income from high-quality debt securities or high-quality net lease);
- The Recipient must not dispose of the profits interest within two years of receipt;
- The profits interest must not be an interest in a publicly traded partnership;
- The entity granting the profits interest and the Recipient must treat the Recipient as a “real” partner for tax purposes (i.e., the Recipient must receive a Schedule K-1 and pay income tax on his or her share of taxable income — to the extent there is any); and
- Neither the Recipient nor the entity granting the profits interest may take any compensation deduction in connection with the profits interest.
The profits interest may be designed to include a vesting schedule – either time-based or performance-based. If there is a vesting schedule, Rev. Proc. 2001-43 clarifies that the grant of an unvested profits interest is not a taxable event, and the subsequent vesting of such profits interest is also not a taxable event. The profits interest may also be designed to provide profits in excess of a hurdle rate.
A profits distribution received by the Recipient has the same characterization in his or her hands as it does in the hands of a partner and may be eligible for taxation at capital gains rates, esp. upon the sale or redemption of the profits interest. If the distribution is taxable as ordinary income, it should be possible to pay tax distributions to the Recipient and other partners to cover their income taxes. Note that the partnership or LLC receives no deduction in connection with the grant or vesting of the profits interest.
Although no Section 83(b) election is required or necessary, it is still advisable to file a “protective” election upon receipt of the profits interest.