A profits interest is generally (with certain exceptions) an interest that, on a liquidation of the partnership immediately after the grant of the profits interest, would not allow the recipient to participate in liquidating distributions. Rather, the recipient would only share in future profits. As a general matter, the receipt of a profits interest is not taxable to the recipient at the time of grant or vesting, but instead results in tax as allocations of taxable income are made in respect of the profits interest or on the sale of the interest.

Revenue Procedure 93-27 provides a safe harbor for the grant of certain profits interests. Under the revenue procedure, a capital interest is an interest that gives the holder a share of the proceeds if the partnership's assets are sold at fair market value and the proceeds are distributed in a complete liquidation of the partnership (Rev. Proc. 93-27). A profits interest is then defined as "a partnership interest other than a capital interest."

Therefore, the key question in determining whether a partnership interest is a profits interest is whether its liquidation value is $0. If so, the grant of the partnership interest is not subject to tax. This is in marked contrast to the valuation of corporate equity compensation, which, even where the liquidation value is $0 is generally attributed some "option" or discounted cash flow-based value.

However, the safe harbor does not apply if either:

(Rev. Proc. 93-27.)

If an interest intended to be a profits interest does not fall within the safe harbor of Revenue Procedure 93-27 (for example, if the holder disposes of the interest within two years of grant), it is not necessarily taxable. Instead, interests outside the parameters of the Revenue Procedure must be tested under the relevant case law to determine whether the receipt of the interest would result in immediate tax consequences. The two foundational cases that examine the proper tax consequences of the receipt of a profits interest are Diamond v. Commissioner, 492 F.2d 286 (7th Cir. 1974) and Campbell v. Commissioner 943 F.2d 815 (8th Cir. 1991).

Both Diamond and Campbell focus on whether, under the facts and circumstances of the case, a profits interest granted for services had a readily ascertainable fair market value on grant. Where the value of the interest could not be ascertained, the courts generally supported treating the interest as having no value as of the grant date. Therefore, even where a profits interest falls outside of the safe harbor of Revenue Procedure 93-27, a taxpayer may rely on a facts-and-circumstance-based argument to support profits interest treatment.

To satisfy the requirements for a profits interest, partners other than the profits interest holder must be entitled to receive distributions at or before the liquidation of the partnership at least equal to the net fair market value of the partnership at the time the profits interest is issued. The amount that must be distributed to other partners is often referred to as the distribution threshold. The distribution threshold requirement must be satisfied only on liquidation of the partnership. Therefore, a profits interest holder may share in operating income on an unlimited basis immediately on issuance, so long as the distribution threshold is met on liquidation.

As a matter of practice, however, frequently the distribution threshold is measured by reference to all distributions (that is, distributions of operating income and liquidating distributions), so that the profits interest holder does not share in any distributions until the aggregate distributions of all types received by other partners is equal to the distribution threshold.

Where there is a desire to issue a profits interest that, even with a distribution threshold, provides the holder with a share of the value of the enterprise as of the grant date, a so-called "catch-up" allocation can be utilized. A catch-up provision generally provides that the holder of the profits interest receives 100% (or some other disproportionately large share) of the income of the partnership generated after the grant of the profits interest until the profits interest holder has built up a capital account equal to its proportionate share of existing value. So long as the business generates sufficient profits (including gain on a sale of the business), the profits interest holder can realize the same economic value as the holder of a capital interest. Likewise, by virtue of the disproportionate allocation of income to the profits interest holder, the other partners obtain the net effect of a deduction in an amount equal to the amount the partnership would have deducted on the grant of a capital interest, albeit at a different time and of a potentially different character (for example, if the income allocated to the profits interest holder is long-term capital gains income subject to a reduced tax rate).

Where a capital interest is granted subject to a substantial risk of forfeiture, then unless an election is made to treat the interest as having been received immediately on grant, the tax event associated with the grant occurs when the property vests. Revenue Procedure 2001-43 provides a different rule for a restricted profits interest, where no election is necessary to treat the interest as vested on grant so long as the recipient is treated as a partner for tax purposes and begins to receive income allocations on a fully vested basis immediately on grant.

Importantly, Revenue Procedure 2001-43 applies only to profits interests described in Revenue Procedure 93-27. This means that an 83(b) election is generally advisable for a vesting interest that does not fit within the Revenue Procedure 93-27 safe harbor but is still regarded as a profits interest under case law. In addition, common practice is to file an 83(b) election with respect to all profits interests that are subject to vesting because:

Under the general rule requiring that allocations be made on a fully vested basis, the issuance of a profits interest subject to vesting can have adverse tax consequences if not properly managed. The following example illustrates this issue.

Example: A is issued a 10% profits interest in partnership BC, which is subject to two-year cliff vesting. That is, during the two year period after the grant of the profits interest, if A stops providing services to BC, A's interest is forfeited. BC provides that during this two year period, distributions to A are held in abeyance pending the vesting of the interest. In year 1, BC earns $1,000 of taxable income.

To address the phantom income issue for the recipient of a restricted profits interest, it is customary to provide the profits interest holder with a right to receive distributions in the amount of the tax liability associated with an income allocation (a so-called tax distribution) even while the profits interest is unvested. Providing for tax distributions raises the issue of whether, in the event of a forfeiture of the profits interest, the holder must return to the partnership the amount of tax distributions previously received. One argument in favor of this type of clawback obligation is that, if the profits interest is forfeited, the profits interest holder recognizes a loss to the extent of prior income included.

Therefore, the profits interest holder should have a tax loss that is equivalent in amount to the income previously recognized by the profits interest holder, although the character of that benefit may differ from the character of the income recognized. Although this type of clawback of tax distributions can be compelling in theory, as a practical matter, it is rarely used.

One way to potentially avoid or limit income tax allocations (and associated tax distributions) for a profits interest holder is to limit the streams of income in which the profits interest holder participates. For example, an employer might provide a service provider with a profits interest that is limited to certain large capital events (such as a change in control or sale of a business unit). The theory underlying this kind of profits interest is that it is intended to compensate the service provider for contributing to an increase in the entity's enterprise value, but not operating income. Because the service provider does not share in operating income, the necessity for allocations of taxable operating income (and associated tax distributions) is, in theory, obviated, and the service provider is permitted to participate in growth in enterprise value on a tax-advantaged basis.

While this approach is used frequently, its tax efficacy is subject to some debate. Conceivably, an arrangement that pays out only on an exit event could be viewed as a disguised cash bonus program, which, if successfully argued, would defeat capital gain treatment and could raise concerns under Section 409A, which places restrictions on when deferred compensation can be paid. For more information on Section 409A, see Practice Note, Section 409A: Deferred Compensation Tax Rules: Overview.

Regulations proposed in 2005 (Proposed Reg. 1.83-3(l), 1.83-6(b), 1.721-1(b)(1), 1.761-1(b), REG. 105346-03) (Proposed Regulations) provide for new rules for the treatment of partnership profits interests, which will be effective on finalization of the Proposed Regulations. Under an elective safe harbor in the Proposed Regulations, a compensatory partnership interest for which an election is made is valued at its liquidation value. For a partnership profits interest, so long as the safe harbor election is made and the liquidation value of the partnership interest is zero, this would effectively preserve the current rules as set out in Revenue Procedure 93-27.

The Proposed Regulations also address the treatment of profits interests that are subject to vesting by requiring that an 83(b) election be made in all cases at the time that a profits interest is issued for it to be treated as vested on issuance. If no 83(b) election is made:

If no 83(b) election is made, to the extent that the value of the partnership has increased at the time of vesting, the profits interest may have become a capital interest (as the profits interest would, if granted on the vesting date, have a liquidation value above $0). Therefore, the liquidation value of the partnership interest as of the vesting date would be taken into account as ordinary compensation income (and deducted as such by the partnership).

If an 83(b) election is made and allocations are made in respect of a profits interest (or a capital interest), which are later forfeited, the Proposed Regulations require that the partnership account for the forfeiture using forfeiture allocations. Forfeiture allocations generally provide for an allocation of gross items of income, gain, loss or deduction (but only to the extent available for the year of the forfeiture) that, in effect, reverse the partner's undistributed income inclusions. The amount of forfeiture allocations is equal to:

(1) Total distributions to the partner with respect to the forfeited interest minus amounts paid for the interest minus

(2) Total net income (or loss) allocated to the partner with respect to the forfeited interest.

Example: A received a profits interest on January 1, 2012, subject to total risk of forfeiture if he terminated his employment before January 1, 2014. During 2012, A was allocated $1,000 of income and received a $350 distribution (to pay the tax on the allocated income). On January 1, 2013, A terminated his employment and forfeited the $650 remaining in his capital account.

A receives a loss allocation equal to (x) $350 (distributions) minus $0 (amount paid for the interest) minus (y) $1,000 (total allocations) equals ($650) in losses. As is generally the case on a forfeiture of property with respect to which an 83(b) election has been made, no tax losses are allocated in respect of amounts included by the service provider in income as a result of making an 83(b) election with respect to the receipt of a partnership capital interest.

A profits interest, like a capital interest, is an interest in the streams of income earned by the entity in which the interest is granted. It is also a separate "partnership interest," which is a capital asset in its own right. This can lead to some unexpected tax results on a liquidity event with respect to the profits interest, as the form of the transaction can dramatically impact the character of the income recognized.

A profits interest holder's holding period in its partnership interest begins on the date the interest is granted. This holding period is relevant for determining the character of gain on either a:

The holding period of the partnership in its assets, however, begins on the date that the partnership acquired those assets. This latter holding period ultimately governs the character of gain that is allocated in respect of a profits interest. Consider the following example:

Example: AB is a partnership that owns a plot of raw land (which it intends to develop) as its only asset. The land is a capital asset. AB acquired the land on January 1, 2012, for $1 million (a fair market value based on its development prospects). On January 1, 2013, based on a full appraisal, the land still has a fair market value of $1 million. AB grants C a 10% profits interest, entitling C to share in 10% of the operating income generated by the land, and 10% of any proceeds of capital transactions in excess of $1 million. Because the profits interest has a liquidation value of $0 on the grant date, it is a valid profits interest. In November of 2013, it is discovered that land held by AB has large natural gas deposits and is therefore worth approximately $3 million.

Scenario 1: AB sells the land and distributes the proceeds. If AB sells the land for $3 million in November 2013, it will have capital gain income of $2 million. Because AB has held the land for more than one year, the gain will be long-term capital gain. $200,000 of the gain will be allocated and distributed to C pursuant to its profits interest. Because gain is characterized at the partnership level, this gain will retain its long-term character, even though C has held his partnership interest for less than one year.

Scenario 2: A, B and C sell their partnership interests for an aggregate purchase price of $3 million. In the partnership interest sale, C will be entitled to receive $200,000 of proceeds. This gain will be capital. However, because C has held his partnership interest for less than one year, the capital gain is short-term and is taxed at the ordinary income rate.

Because partnerships are pass-through entities, gain on the sale of a partnership interest is not necessarily capital in all cases. IRC Section 751 requires that a portion of the gain on a sale or redemption of partnership interests be characterized as ordinary to the extent attributable to certain ordinary income assets, including:

Additionally, legislation has been proposed in Congress that would treat income attributable to certain partnership interests issued for investment management services (so-called "investment services partnership interests") as ordinary, even if the income is attributable to capital assets of the partnership.

For more information on partnership equity compensation, including a discussion of the federal income tax aspects of capital interests and options on partnership interests, see Practice Note, Partnership Equity Compensation.