The use of partnership equity compensation is a growing trend. Using equity in
a partnership or a limited liability company (LLC) to compensate and incentivize
executives and other service providers
involves giving them either a “capital interest” or a “profits interest” in the entity,
according to J. Troy Terakedis, an attorney
at law with Calfee, Halter & Griswold LLP.
The type of interest received will impact the
federal income taxes of the recipient.
“Over the last several years there has been
an increased focus on structuring equity
compensation arrangements in the partnership and LLC contexts,” says Terakedis.
“Thus, it’s important to understand these
arrangements so the recipient of the interest
is not surprised with unexpected taxes.”
Smart Business spoke with Terakedis
about partnership equity compensation
arrangements and the federal income tax
considerations related to such agreements.
Why are we seeing an increase in partnership equity compensation arrangements?
The reason for this increase is due in large
part to more companies being formed as a
partnership or an LLC (taxed as a partnership). These non-corporate entities enjoy
both tax and non-tax advantages over corporations. Another reason is a resurgence of
companies wanting to incentivize management teams by compensating them with
equity interests. This gives management the
ability to participate in the success of the
company, and better aligns management’s interests with those of the company’s owners.
What’s different about these arrangements?
IRC Section 83 governs the tax consequences of a transfer of property to a service
provider. In general, property (e.g., stock in a
corporation) issued in connection with the
performance of services is taxable to the
recipient as ordinary income in the first year
the property is transferable or not subject to
a substantial risk of forfeiture. The amount
included in income is the fair market value of
the property less any amount paid for such
property. Any future appreciation in the value
is taxed at capital gains rates when the property is sold. But, it was unclear how IRC Section 83 would apply to partnership interests. There was debate as to whether partnership interests were property and, if so,
how such interests were to be valued. The
IRS clarified how it would tax compensatory
partnership interests with two Revenue
Procedures: Rev. Proc. 93-27, 1993-2 C.B. 343
and Rev. Proc. 2001-43, 2001-2 C.B. 191.
What do those Revenue Procedures mean?
They recognized that there are two types of
partnership interests: ‘capital interests’ and
‘profits interests.’ A capital interest gives the
holder a share of the proceeds if, immediately upon receipt, the partnership’s assets were
sold at fair market value, all partnership liabilities were satisfied, and the proceeds were
distributed in a complete liquidation of the
partnership.
A profits interest is any interest that is not
capital interest. A profits interest only entitles
the recipient to income and appreciation in
the partnership that arises after the date the
interest is issued. The time to test whether
the interest is a capital interest or profits
interest is at the time of issuance, even if the
interest is subject to forfeiture. If the interest
is a profits interest, then an executive or service provider will not be taxed on the receipt
of the interest. IRC Section 83 will not apply
to the receipt of a profits interest, but will
apply to the receipt of a capital interest. This
is beneficial to the recipient of a profits interest because they do not have to pay for the
profits interest and they are not taxed on its
receipt. This treatment is not available if the
equity interest is stock or a capital interest.
Are there any other rules?
In May 2005, the IRS issued Notice 2005-43,
2005-43 IRB 1, and proposed Treasury regulations (Reg. 05346-03), which would make
Rev. Proc. 93-27 and Rev. Proc. 2001-43 obsolete. If adopted, the issuance of a partnership
interest in exchange for services will be subject to IRC Section 83, regardless of whether
the partnership interest is a capital interest or
a profits interest. The proposed rules would
permit the amount which must be included
as ordinary income by the recipient of the
partnership interest to be based on ‘liquidation value’ rather than ‘fair market value’ if a
special election is made by the partnership.
Generally, use of liquidation value will result
in a lesser amount being taxed to the recipient of a profits interest. The proposed rules
are complex and address many other aspects
of compensatory partnership interests. It is
not expected that these rules will be finalized
in 2008 and, until they are, Rev. Proc. 93-27
and Rev. Proc. 2001-43 will continue to apply.
What problems can arise from these
arrangements and the taxation of them?
The biggest problem is when the partnership interest issued is really a capital interest
and not a profits interest. Then, the executive
or service provider receiving the interest will
be taxed on its value. Thus, the partnership
agreement must be carefully drafted so the
interest is properly characterized as a profits
interest. Moreover, since it is expected that
the proposed rules will eventually be finalized, it’s necessary to make provisions for
electing the use of liquidation value so the
expectations of the company and the executive or service provider can be realized.
J. TROY TERAKEDIS is an attorney at law with Calfee, Halter & Griswold LLP. Reach him at (614) 621-7757 or
[email protected].
