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Profits Interest
Practical Law Glossary Item 2-382-3715 (Approx. 3 pages)
Glossary
Profits Interest
A partnership interest (or interest in an entity that is treated as a partnership for tax purposes such as certain membership interests in an LLC) can be divided into a capital interest and a profits interest. A capital interest is an interest that would give the holder a share of proceeds if the partnership assets were sold at their fair market value and the proceeds distributed in a complete liquidation of the partnership. A profits interest is a right to receive a percentage of future profits (but not existing capital or accumulated profits) from a partnership.
Most commonly, a profits interest (sometimes called a "profits-only" interest or "mere profits" interest) is granted to a partner in exchange for a contribution of services (a service partner). In many cases, a service partner is an executive or senior manager at the partnership.
A partner who could have received cash compensation but instead receives a profits interest may get the dual tax benefit of:
- Deferring income until gain is recognized by the partnership.
- Converting compensation income (taxed at ordinary income rates which can be as high as 37%) into preferentially taxed, long-term capital gain (taxed at a maximum rate of 20% for higher income individuals). A potential additional 3.8% tax applies to "net investment income" (which includes gains) earned by higher income individuals. To qualify as long-term capital gain, the gains realized by the partnership must relate to capital assets that were held for more than one year. However, under changes made by 2017 tax reform legislation a longer three-year holding period requirement applies to qualify for preferential long-term capital gains treatment on gains realized from certain profits interests in investment partnerships (IRC § 1061).
For more information about profits interests, see: