Proposed regulations issued by the IRS place new burdens on partnerships and entities that are taxed as partnerships (such as limited liability companies) that grant interests to their employees or contractors.
Under current tax law, when a partnership interest is granted as compensation for services, its treatment for tax purposes depends upon whether the partnership interest is characterized as a “profits interest” or a “capital interest”. A “profits interest” is an interest which allows the partner to receive a share of the future profits of the company, but no interest in any of the assets of the company. Under current law, a partnership may grant a “profits” interest to an employee or a contractor as compensation for services, without income tax consequence to the partnership, employee or contractor if:
a) The employee or contractor does not sell the interest within two years;
b) The interest does not relate to a substantially certain and predictable stream of income from the company’s assets; and
c) The profits interest is not a limited partnership in a publicly treated partnership.
If an employee or contractor receives a “capital interest” as compensation for services, the employee or contractor is treated as having received compensation equal to the value of that interest, less the amount, if any, paid for the interest. A “capital interest” is commonly understood to mean an interest that would allow the owner of the interest to receive a share of the partnership’s assets if the partnership was liquidated immediately after the receipt of the interest.
Under the proposed IRS regulations, the receipt of a profits interest would be treated in the same manner as the receipt of a capital interest. This means that the receipt of a profits interest by an employer or contractor will be considered the receipt of compensation equal to the excess of the fair market value of the interest over the amount paid for it. This approach would require a profits interest to be valued and taken into account as income as of the date it is granted or, if later, the date the interest becomes substantially vested. If an interest is not substantially vested for any reason, the employee or contractor may elect to value the interest as of the date of receipt and take it into account as income at that time. This might occur if an employee or contractor believes the interest is going to increase in value by the time it becomes substantially vested.
Employers who grant a profits interest under the proposed regulations will have to make sure that: (a) the profits interest is properly valued; (b) the proper amounts are withheld from the wages of the recipients to cover income tax withholding and payroll taxes for the appropriate year; and (c) the grant of interest is timely reported to the IRS.
To ease the burden of valuing an interest, the proposed regulations do allow for a partnership to make a “Special Valuation Election.” If this election is made, the fair market value of an interest is deemed to be the amount of cash a contractor would receive if, immediately after the transfer of the partnership interest, the partnership sold all of its assets solely for cash for fair market value and then liquidated. This approach offers certainty to the parties involved that the grant of a profits interest will have zero value. If no election is made, the parties need to prove the profits interest had no value. Unfortunately, not all interests qualify for the Special Valuation Election, which applies only to compensatory grants of so-called “Safe Harbor Partnership Interests.” In many circumstances, the “Safe Harbor Partnership Interest” election may not be available or the best choice. In addition, partners who have a written Buy-Sell Agreement are not able to take advantage of the safe harbor election. This may be either positive or negative for the partners.
Partnerships that contemplate granting interests to employees or contractors need to carefully consider the impact the proposed regulations will have on both parties and whether the making of a Special Valuation Election is in their best interest. If you have any questions regarding this proposed regulation, please contact John Waters of our office.
