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By: Richard Lieberman, Dykema Gosset PLLC
This article addresses fundamental considerations in structuring equity compensation for general and limited partnerships, as well as limited liability companies (LLCs) that are classified as partnerships for federal income tax purposes.
IT SUMMARIZES THE EQUITY-BASED ARRANGEMENTS USED by entities taxed as partnerships to provide key service providers the opportunity to become true equity owners of the business. (Synthetic equity arrangements, such as phantom equity and other cash-settled programs linked to equity appreciation, are not discussed here in detail.)
For simplicity, although this article generally uses the term partnership, the information is equally applicable to all entities classified as a partnership for federal income tax purposes, including general partnerships, limited partnerships, and LLCs.
There are several issues that are important to understand when advising clients on equity compensation matters for partnerships. Many of these issues are unique to partnership equity compensation, primarily because of the different tax regime applied to entities taxed as partnerships compared to entities taxed as corporations. For tax purposes, a partnership is a pass-through entity, meaning that income tax is generally not imposed at the entity level. Instead, a partnership’s income, gain, loss, deduction, or credit (tax items) are allocated to its partners based on a method agreed to among the partners in the partnership agreement. The partners are liable for paying income tax on their distributive shares of the partnership’s tax items as reported on their respective income tax returns. Importantly, partners are subject to tax on their distributive shares of a partnership’s tax items (a tax reporting concept) regardless of whether the partnership makes distributions of cash to its partners (an economic concept). As such, it is necessary to distinguish between a partner’s distributive (or allocated) share of the partnership’s tax items and distributions of partnership cash.
An equity interest in a partnership can be either a capital interest or a profits interest (including profits interests treated as so-called applicable partnership interests under new tax rules discussed further below). There are also synthetic forms of equity (e.g., phantom equity) that provide the appearance, but not the substance, of true ownership. Partnerships may consider synthetic equity alternatives due to the relatively higher costs and complexity of administering an incentive program that involves true equity interests.
When designing an equity compensation program, it is imperative at the outset to identify the organizational objectives. These will impact the choice of award type and the terms of the award. From a talent management viewpoint, the primary reason partnerships grant equity compensation is to attract, incentivize, and retain key service providers. By offering a service provider an equity stake, the partnership is able to align the economic interests of its existing partners with key service providers.
To strengthen the incentive and retention effects of equity grants, partnerships (like corporations) typically subject the award to vesting restrictions, which can incentivize service providers to remain with the business over a designated period of time (if vesting is time-based) or to enhance performance (if vesting is performance-based), or both. On the other hand, extended vesting periods or unrealistic performance standards can diminish the perceived value of an equity award.
Capital Contribution Requirement
The partnership will also need to determine whether service providers will be asked to contribute cash or other property to receive an equity interest in the partnership or whether the equity grant will be entirely compensatory. A service provider who is required to contribute cash or other property to the partnership will have skin in the game due to having capital at risk. The psychological effect of having capital at risk tends to incentivize performance in a manner consistent with a welldesigned program’s objectives.
Some service providers highly value receiving equity compensation because of the value attributed to being a business owner. Although becoming a business owner has important psychological benefits, the change in status from employee to partner has real economic consequences, not all of which are positive, as discussed later in this article.
Voting, Redemption Rights, and Transfer Restrictions
Partnerships often impose restrictions on equity awards that are intended to primarily serve a compensatory purpose. These restrictions are usually set forth in a partnership agreement that establishes the rights and obligations of the partners and may also be included in a separate equity award agreement.
Voting rights. Compensatory equity arrangements commonly restrict voting and management rights to allow existing owners to retain control of the business. Frequently, however, there will be negotiated exceptions for certain types of significant decisions for which the parties agree that award recipients should have a say or be able to act to preserve the value of their equity rights. Of course, voting restrictions must comply with the law of the state in which a limited partnership (or LLC) is organized.
Transfer restrictions. Almost all partnership equity awards are subject to transfer restrictions, as businesses often desire to control, or at least limit, the acquisition of its equity by unaffiliated third parties.
Redemption or buy-back rights. The partnership (or the other partners) typically has a right to redeem or acquire a service provider’s partnership interest at an established price based on the occurrence of specified events (e.g., a separation from service after vesting in all or a portion of the interest). This is especially important for partnerships that are closely held and do not want inactive partners or passive investors. Such provisions should be clear about how the transfer restriction will operate, including how the transferred interest will be valued upon disposition, whether transfer is optional or mandatory, the time period in which the transfer is permitted to occur, and terms of payment (e.g., payment partially in cash and partially with an installment obligation).
Right of first refusal. For partnership agreements that permit partners to sell their interests to third parties, the partnership (and/or other partners) may also have a right of first refusal providing the remaining partners (or the partnership) with a first option to acquire any interests that a partner proposes to sell to a third party (usually at the same price and on substantially the same terms as the proposed sale).
Partnership equity compensation can take the form of either capital interests or profits interests.
For federal tax purposes, a capital interest in a partnership is a distinct type of equity interest. Specifically, a capital interest is defined as “an interest that would give the holder a share of the proceeds if the partnership’s assets were sold at fair market value and then the proceeds were distributed in a complete liquidation of the partnership.” Rev. Proc. 93- 27. That determination is made at the time of receipt of the partnership interest.
Similar to grants of equity in a corporation, partnership capital interests can vest immediately, over a period of time, or be based on performance. They can also be issued subject to restrictions, including transfer restrictions, redemption and buy-back rights, and rights of first refusal.
Tax Treatment of Capital Interest Grant
The tax treatment of an award of a compensatory capital interest in a partnership is governed by I.R.C. § 83 and turns on whether the interest is vested at the time of grant.
Vested capital interest. A service provider awarded a capital interest that is fully vested upon grant will immediately include as taxable compensation an amount equal to the excess of the fair market value of the capital interest over the amount paid, if any, for the interest (generally referred to as the spread).
Unvested capital interest. A service provider awarded a capital interest that is subject to a vesting provision (i.e., the interest is subject to a substantial risk of forfeiture) is not subject to tax upon grant (unless the service provider makes a Section 83(b) election). Instead, as the interest vests, the service provider will be subject to tax on the spread.
In either case, the partnership generally deducts an amount equal to the compensation reported by the service provider. That deduction is allocated to the existing partners as provided for in the partnership agreement.
Given that a capital interest is taxable on the spread at the time the award vests, consideration should be given to how the recipient would be expected to pay the tax. Since transfer and other restrictions limit the marketability of a vested capital interest, the award recipient may not have sufficient liquidity to pay the federal and state income tax imposed on the spread. To minimize the financial burden on the award recipient, some partnerships combine the award of a capital interest with another cash-settled incentive such as a bonus payment or arrange for a loan.
Holding periods are important for recipients of unvested capital interests. To obtain the preferential federal tax rate associated with long-term capital gains, an individual must hold a capital asset for a period greater than 12 months. The holding period for an unvested capital interest generally does not begin to run until the interest vests, and even then, full vesting may occur over an additional period of years. If the holder disposes of the interest (or a portion thereof) within 12 months of vesting, he or she would not qualify for long-term capital gain treatment. Although a recipient of an unvested capital interest could accelerate the holding period by making a Section 83(b) election, such an election is not without potentially adverse economic consequences if the value of the interest declines since the tax paid on the grant date value cannot be recouped.
A similar issue must be addressed when granting a compensatory option to acquire a capital interest in a partnership. To avoid being taxed on the spread at the time the option is exercised, many optionees delay exercise until there is clarity regarding the timing of a capital transaction. Since the holding period cannot start until the option is exercised, many award recipients would not qualify for the preferential long-term capital gain rate because the subsequent disposition of the capital interest often occurs within 12 months of the exercise date. Such grants of compensatory partnership options are rare, however. Profits interests are more common and more highly valued by key talent.
Other Tax Consequences of Capital Interests
A partner’s distributive share of tax items from a partnership is taxable as either ordinary income or loss, or capital gain or loss, depending on the character of the tax item in the hands of the partnership. A guaranteed payment made to a partner is treated as ordinary income subject to self-employment tax. The partnership is allowed a deduction equal to the amount of any guaranteed payments, which is passed through to its partners.
When a partner eventually disposes of a capital interest, he or she will generally recognize a capital gain equal to the net proceeds from the sale less the capital interest’s basis. However, in some instances, all or a portion of the gain can be recharacterized as ordinary income if certain hot asset rules apply pursuant to I.R.C. § 751.
For federal tax purposes, a profits interest in a partnership is another type of distinct equity interest. By definition, a profits interest is a partnership interest other than a capital interest. Rev. Proc. 93-27, Rev. Proc. 2001-43.
The simplest way to distinguish a profits interest from a capital interest is to ask whether, in a hypothetical liquidation of the partnership on the grant date, the recipient would be entitled to receive anything of value. If so, then the interest is a capital interest and the spread is taxable to the recipient, as discussed above. If not, then the interest is a profits interest, the receipt of which is not treated as a taxable event for either the recipient or the partnership. In other words, if the recipient of the interest only has a right to share in future profits (i.e., profits arising subsequent to the grant date) and in the future enterprise value (i.e., the fair market value of the partnership arising subsequent to the grant date), the interest is a profits interest.
Rev. Proc. 93-27 provides that if a person receives a profits interest for the provision of services to or for the benefit of a partnership in a partner capacity or in anticipation of being a partner, the IRS will not treat the receipt of that interest as a taxable event for the partner or the partnership. However, that revenue procedure does not apply, and the receipt of a profits interest will be taxable to the recipient, if any of the following are true:
Rev. Proc. 2001-43 provides an important clarification regarding the time for determining whether an unvested interest is a profits interest or a capital interest. The required determination is made at the time the interest is granted, regardless of whether it is vested or unvested at that time, provided that, if the interest is to be treated as a profits interest, all of the following must be true:
Thus, a profits interest must not violate the safe harbor requirements. For example, if a profits interest must be disposed of upon a change in control, which occurs prior to expiration of the two-year holding period, the interest would be reclassified as a capital interest carrying the corresponding tax consequences.
Traps to Avoid
Unless the award agreement provides otherwise, most recipients of profits interests are subject to the provisions of the partnership agreement in the same manner as holders of capital interests. If the partnership agreement provides for final liquidating distributions to be made in accordance with the partners’ positive capital balances (in order to have economic effect), the recipient of a profits interest would not receive any proceeds from the hypothetical liquidation of the partnership on the grant date because the recipient would not have a capital account balance as of that date.
Many current partnership agreements, however, do not provide for liquidating distributions to be made in accordance with the partners’ positive capital account balances. Instead, these agreements provide for liquidating distributions to be made in the same manner as non-liquidating distributions. In the view of many investors, distributing liquidation proceeds according to the partners’ positive capital account balances may interfere with the deal economics, which is of higher importance to them than complying with the economic effect requirement. Such provisions can create a serious tax issue for recipients of a profits interest.
As discussed above, the holder of a profits interest must not participate in the proceeds from a hypothetical liquidation on the grant date. However, if liquidation proceeds are distributed according to the agreement’s general distribution provision, an award recipient may be hypothetically entitled to receive something of value following a hypothetical liquidation of the partnership on the grant date. The receipt of anything of value on that date would cause the interest to be classified as a taxable capital interest.
This issue can easily be avoided by building a distribution threshold or similar distribution hurdle into the partnership agreement. A distribution threshold provision requires that a minimum amount of cumulative distributions would be made with respect to other interests before the holder of a newly granted profits interest would receive a distribution arising from the hypothetical liquidation. The threshold merely provides a mechanism to avoid the unintended reclassification of a non-taxable profits interest into a taxable capital interest.
Other Tax Consequences of Profits Interests
As with capital interests, profits interests result in partnership allocations that are taxable at either ordinary income or capital gain rates, depending on the characterization of the income or gain to the partnership, and guaranteed payments received by a partner are taxed as ordinary income. Upon the redemption or sale of a profits interest, the holder will have a short-term or long-term capital gain, depending on how long the interest was held. In some instances, all or a portion of the gain can be recharacterized as ordinary income if certain hot asset rules apply pursuant to I.R.C. § 751.
Applicable Partnership Interests
The tax reform legislation enacted in late 2017, known as the Tax Cuts and Jobs Act (Pub. L. No. 115-97), added new I.R.C. § 1061, which impacts the tax treatment accorded to a special type of profits interest referred to as an applicable partnership interest. These rules apply when the following conditions are met, subject to the limitations discussed further below:
SPECIAL HOLDING PERIOD FOR APPLICABLE PARTNERSHIP INTERESTS
If a profits interest is an applicable partnership interest, the gain or loss reported by its holder is subject to a special holding period. Specifically, gains passed through to a service partner from the sale of a partnership’s portfolio investments, in addition to gains related to the disposition of the applicable partnership interest itself, qualify for long-term capital gain treatment only if held by the partnership or partner, respectively, for more than three years. As a result, gain associated with an applicable partnership interest will be classified as short-term capital gain subject to tax at ordinary income rates unless the new three-year holding period requirement is satisfied.
A special rule applies for the sale of an applicable partnership interest to a related party. For such transactions, all or a portion of the resulting gain will be characterized as short-term capital gain to the extent portfolio assets of the partnership do not separately satisfy the three-year holding period requirement. A related person is a member of the transferring partner’s family (within the meaning of I.R.C. § 318(a)(1)), or any person who performed a service within the disposition year or the preceding three calendar years in any applicable trade or business in which or for which the transferring partner performed a service.
LIMITATIONS ON WHAT QUALIFIES AS AN APPLICABLE PARTNERSHIP INTEREST
The three-year holding period associated with applicable partnership interests is not as broadly applicable or impactful as may initially appear. The special holding period does not apply to:
Employment Status and Benefits Issues
Individuals who perform services on behalf of a partnership and receive either (1) vested capital interests (and, presumably, non-vested capital interests for which a Section 83(b) election has been made) or (2) profits interests (whether vested or unvested) must be treated as partners for tax purposes from the date of grant. That is, under long-standing IRS policy, a service provider cannot be treated as both a partner and an employee of the same partnership simultaneously. This has several important consequences.
First, due to the pass-through nature of partnership taxation, partners report and pay income tax on their distributive share of partnership tax items (reported on Schedule K-1 to Form 1065) on their separate tax returns, regardless of whether the partnership makes an economic (cash) distribution to the partners. As noted previously, this can result in a timing issue, where a partner must currently pay tax on partnership tax items while receiving a distribution of the corresponding cash in a subsequent tax year. The income recognized in the current year is added to the partner’s basis in his or her partnership interest, thereby avoiding a second tax on the same income when later distributed. Most partnerships address the timing issue by including a provision in the partnership agreement allowing for a so-called tax distribution, which is simply an advance against future distributions that are used by the partners to pay current tax.
In addition, partners are not considered employees covered by payroll (FICA) tax, unemployment insurance, or wage withholding rules. Instead, they are taxed as self-employed individuals, who are generally subject to self-employment tax under I.R.C. § 1402(a). The self-employment tax liability is generally equal to the combined employee and employer portions of FICA taxes for employees, although an above-theline deduction for half the amount is usually available. Also, since there is no withholding by the partnership, partners must make quarterly estimated tax payments. Further complicating the tax situation, partners are often required to file income tax returns in each state in which the partnership has income tax nexus. In most states, the partnership is required to withhold and remit tax on behalf of non-resident partners.
Also, a service provider’s status as a partner adversely affects eligibility for certain tax-favored employee benefit plans and arrangements, such as tax-free employer-paid health and life insurance benefits and pre-tax health plan premium, FSA, and HSA contributions.
The foregoing is a brief overview of the primary issues involved when designing partnership equity compensation plans. Before embarking on a compensatory equity plan, a partnership should carefully consider its driving compensation goals (e.g., incentivizing performance and talent retention), its goals for (and the effects of) creating partner-service providers, the specific terms of the plan and interests (e.g., vesting, redemption rights, and transfer restrictions), and the tax and securities law consequences for equity-based compensation. In some cases, partnerships may find that a synthetic equity or other cash-based incentive programs may be a suitable alternative.
Richard Lieberman is a senior counsel in the Chicago office of Dykema and a member of the firm’s Tax Practice Group. With more than 30 years of broad transactional and structuring experience, Mr. Lieberman concentrates his practice on the use of corporations, partnerships, and limited liability companies in domestic and cross-border acquisitions, restructurings, mergers, and financing transactions. He also advises Dykema’s clients on tax issues related to executive compensation arrangements, including designing and advising on the implementation of executive, equity, and deferred compensation programs.
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For an examination of the non-qualified deferred compensation rules under I.R.C. § 409A, see
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For information on the 2017 tax reform legislation, see
> 2017 TAX ACT IMPACT ON EMPLOYEE BENEFITS AND EXECUTIVE COMPENSATION
For an overview of the rules governing the executive compensation deduction limitation under I.R.C. § 162(m), as amended by the 2017 tax reform legislation, see
> IRC SECTION 162(M): NAVIGATING TAX DEDUCTION LIMITATIONS FOR EXECUTIVE COMPENSATION
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