In the often-intense competition to recruit and retain top talent, many partnerships and limited liability companies turn to grants of ownership. On the surface, they appear to be an easy and flexible way to provide an attractive benefit without affecting current cash flow. But there are tax traps for the uninformed. Proper structuring of these transactions is critical to achieve the most advantageous results for both partnership and recipient.
Partnerships and LLCs have the opportunity to make grants of ownership interests tax-efficient under Internal Revenue Code Section 83(b). They may offer these ownership interests either in the form of profits-only interests or capital interests.
Profits-only interests
In Rev. Proc. 93-27, the IRS defines a partnership capital interest as an interest that would entitle the recipient to liquidation proceeds from the partnership, determined at the time of the recipient’s receipt of the interest. A profits-only interest was defined as an interest other than a capital interest, and the IRS determined that the receipt of a profits-only interest in exchange for services generally will not be regarded as a taxable compensation to the recipient. To be eligible for such treatment, the following must apply:
• The profits-only interest does not relate to a substantially certain and predictable stream of income from the partnership.
• The partner does not dispose of the profits-only interest within two years of receipt.
• The profits-only interest is not a limited partner interest in a publicly traded partnership.
The IRS later expanded and clarified these provisions in Rev. Proc. 2001-43 to address the question of whether the recipient had received property in exchange for services and was therefore subject to taxation under Code Section 83. Specifically, the IRS addressed situations where the profits-only interest is substantially nonvested at the time of grant, such as those involving a recipient’s requirement to continue providing services to the partnership for a period of time in order to avoid forfeiture of the interest (i.e., a substantial risk of forfeiture). Without Rev. Proc. 2001-43, the value of the recipient’s interest would be tested at the time it becomes substantially vested, at which time the value may be substantially higher than it was as of the grant date. Such appreciation would be regarded as a capital interest transferred to the recipient on the vesting date, and taxed accordingly.
Under Rev. Proc. 2001-43, the receipt of a nonvested profits-only interest will not be regarded as a taxable transaction, nor will the event that causes the profits-only interest to become substantially vested. To be eligible for this treatment, the grant must satisfy both the conditions of Rev. Proc. 93-27 and the following:
• The recipient is treated as the owner of the partnership interest by the partnership and the recipient as of the date of grant, whereby such recipient takes into account the distributive share of partnership items associated with the interest in computing the recipient’s income tax liability for the entire period during which the recipient has the interest.
• Neither the partnership nor any of the partners deducts an amount (as wages, compensation, or otherwise) for the fair value of the recipient’s profits-only interest, either at the date of grant or at the time that the interest becomes substantially vested.
The taxpayer can elect to treat the receipt of a nonvested profits-only interest as the receipt of a fully vested profits-only interest by filing a Section 83(b) election. The section 83(b) election must be made within 30 days of receipt of the interest. Generally, the election provides that the taxpayer immediately report as income the fair market value of what he or she has received over what he or she paid for it. In the case of a true profits-only interest, the value of the interest should be zero on the date of grant, thereby making the income to be recognized pursuant to the section 83(b) election also zero. One of the criteria necessary to take advantage of Rev. Proc. 93-27 and Rev. Proc. 2001-43 is that the recipient must not dispose of the profits-only interest within two years of receipt.
Next week’s column focuses on the other form of ownership grant, capital interests.
Robert Kerr is a managing director in the Tax Group at CBIZ Tofias.
