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What is the difference between a "Profits Interest" and a "Capital Interest"

In general, when a person contributes cash or property to a LLC in exchange for a LLC interest, the person (now a member) generally receives a "capital" interest. A "capital" interest represents ownership in both the LLC’s future profits and the LLC’s current and future capital (i.e., net assets), generally upon liquidation. By contrast, a profits interest represents ownership in only the LLC's future profits.

A profits interest is often referred to as a "carried interest". A profits interest is typically given as a reward for the performance of services, or as a way for the LLC to secure the future services of an individual. A grant of a profits interest means that the recipient receives an interest in the future profits of the LLC without being required to contribute any capital to the LLC.

THE TAXATION OF A PROFITS INTEREST

Revenue Procedure 93-27

In Revenue Procedure 93-27, the Internal Revenue Service said that it would not treat the receipt of a profits interest in exchange for past or future services as a taxable event for the profits interest recipient or the LLC if certain conditions were met:

1. The service provider must receive the interest in his capacity as a member, or in anticipation of becoming a member, in exchange for the provision of services to or for the benefit of the LLC granting the LLC interest.

2. The interest must be a profits interest and not a capital interest.

3. The interest (A) does not relate to a substantially certain and predictable stream of income from LLC assets, such as income from high-quality debt securities or a high-quality net lease, (B) is not disposed of by the LLC within two years of receipt, and (C) is not a limited partnership interest in a publicly traded partnership.

Revenue Procedure 93-27 generally exempts service recipients from compensation income upon the receipt of a qualifying profits-only interest. Under Revenue Procedure 93-27, a profits interest is defined as an interest that upon grant would not provide the member with a right to a share of the proceeds, if the LLC sold all of its assets for fair market value and immediately liquidated. This is generally referred to as the "liquidation value" approach. Therefore, Revenue Procedure 93-27 establishes the Internal Revenue Service’s position that the grant of a profits interest to an employee in exchange for services is generally not a taxable transaction. However, Revenue Procedure 93-27 did not answer all the questions. One of the unresolved issues involved the grant of profits interests that are subject to vesting restrictions (i.e., duration of employment requirements). Another issue that existed was whether the holder of a nonvested profits interest should be treated as a member of the LLC for federal income tax purposes and allocated a distributive share of profits and losses associated with the unvested interest just like other members.

Revenue Procedure 2001-43

Revenue Procedure 2001-43 supplied the answers to both questions. It specifically provided that no Internal Revenue Code Section 83(b) election need be made and that neither the granting of the profits interest nor the vesting of the profits interest will be treated as a taxable event. In essence, the grant of the profits interest is a tax realization event, but the profits interest has no value; thus, it does not give rise to any income to the recipient or to any deduction to the LLC. This conclusion holds true, however, only if the LLC and the profits interest recipient treats the profits interest recipient as the owner of the entire profits interest from the date of its grant and the profits interest recipient takes into account his distributive share of LLC net profits and net losses associated with that interest in computing his, her, or its income tax liability for the entire period during which he or she has the interest. In other words, the LLC and the profits interest recipient must treat the profits interest recipient as a member of the LLC for tax purposes prior to the vesting of the profits interest. In addition, upon the grant of the profits interest or at the time the profits interest recipient acquires the entire profits interest granted (the interest becomes substantially vested), neither the LLC nor any of the other members may deduct any amount (as wages, compensation, or otherwise) for the fair market value of the interest. All the other conditions of Revenue Procedure 93-27 must also be satisfied.

In other words, to qualify for tax-free treatment on the grant of a profits interest, taxpayers must abide by the terms of the revenue procedure. First, the LLC and the profits interest recipient must treat the profits interest recipient as a "real" member for tax purposes with respect to the entire profits interest granted (vested or nonvested) beginning on the grant date (meaning, among other things, the service provider would receive a form K-1 from the LLC and would pay tax on his or her share of LLC income). Next, upon both the grant of the interest and its vesting, neither the LLC nor its members may take a deduction for the value of the interest. Finally, the interest must otherwise qualify as a profits interest under Revenue Procedure 93-27. Thus, if the profits interest satisfies all of these requirements, the service provider will avoid income recognition on both the receipt and the vesting of a profits interest. In addition, if all of those requirements are satisfied, it is unnecessary for the service provider to make an Internal Revenue Code Section 83(b) election in order for subsequent appreciation of the LLC to be taxed at capital gains rates; however, service providers receiving a profits interest subject to vesting restrictions should file "protective" Internal Revenue Code Section 83(b) elections in case a requirement is not satisfied.

Revenue Procedures 93-27 and 2001-43 did not, however, address all questions regarding treatment of profits interests. For example, they did not address what happens when the individual holding an unvested interest terminates employment prior to vesting - what happens to the build-up of previously taxed but unvested and undistributed income?

Notice 2005-43

The Internal Revenue Service and Treasury recently issued proposed regulations and a notice of a proposed revenue procedure (Notice 2005-43) relating to the federal income tax treatment of the receipt of an interest in a LLC in connection with the performance of services (a “profits interest”). Although not effective until they are published in final form, Notice 2005-43 attempts to provide guidance as to the tax treatment of the receipt of a profits interest.

Determining the fair market value of a LLC profits interest is often difficult. Thus, the proposed regulations provide a “Safe Harbor Election” that may be made by the LLC and its members to value the LLC interest at its “liquidation value,” which for a true profits interest would generally be equal to zero.

So long as the LLC interest received does not entitle the recipient to any distribution if the LLC’s assets were sold at fair market value and the LLC was liquidated immediately after the grant of the profits interest, a “Safe Harbor Election” would ensure that the issuance of the profits interest would not result in any income recognition to the recipient. Without the “Safe Harbor Election”, it may be possible for the IRS to argue that the LLC profits interest has some value and that the recipient must include this amount in gross income.

In order to be eligible for the “Safe Harbor Election”, several requirements must be satisfied: (1) the LLC and all of its members must consent to make the “Safe Harbor Election”, either in the LLC operating agreement or other document signed by all of the members; (2) the election must be filed with the IRS; and (3) no member or the LLC may report income or fail to file information reports in a manner inconsistent with the election. Moreover, the “Safe Harbor Election” will not apply if the profits interest is sold or disposed of within two years of the date of receipt, the interest is in a publicly traded partnership, or the interest is in a LLC with a substantially certain and predictable stream of income (these limitations are similar to those contained in Revenue Procedures 93-27 and 2001-43).

Finally, unlike current law which permits the services for which the LLC interest is issued to be to, or for, the benefit of the LLC, the “Safe Harbor Election” requires that the services be rendered directly to the LLC.

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