Compensating partners Featured

8:00pm EDT June 25, 2008

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 JTerakedis@Calfee.com.