As seen in the Chicago Business Journal

Attracting and retaining talent is of paramount importance to professional services businesses in the current marketplace. As you consider forming your business and the options available to remain competitive, it is important to assess how creating a partnership and developing an attractive compensation structure can help you assemble a strong team and meet your goals to thrive under current conditions.

The partnership taxation rules provide professionals operating a service business with great flexibility in designing the economic arrangements they see fit while still enjoying the limited liability in the form of a limited liability company (LLC) or a limited liability partnership (LLP). An example of these arrangements is when a partnership grants interests to key personnel in exchange for services. Careful planning should be considered as the tax consequences depend on whether the interest is a capital or a profits interest, which is determined at the time of grant. Below we provide a brief overview of these two compensation arrangements.

Capital interest

Generally, a capital interest exists when the partnership grants the incoming partner a right to capital or liquidating distributions. There are several considerations to keep in mind when issuing capital interests. A partner who receives a vested (unrestricted) capital interest reports the compensation at the time of grant and the partnership deducts/capitalizes the fair market value (FMV) of the interest as appropriate.

A capital interest can also be nonvested (restricted) if it is not transferable and subject to substantial risk of forfeiture. Generally, the recipient of a nonvested interest does not report income until the interest vests and the forfeiture restrictions lapse.

The partnership might consider vesting the interest in stages to ensure that future services will be provided. As a result, income is recognized by the service partner when the interest is vested. Such arrangements may expose the award to risks of appreciation in value where the compensation recognized upon vesting the interest will exceed the FMV of the interest at the date of award.

To mitigate the risk, a service partner can elect to accelerate the income recognition when the interest is awarded. The benefit would be to recognize any post-award growth in value as capital gains taxed at preferential rates instead of compensation income which is taxed at ordinary rates. Some exceptions will apply.

Profits interest

While a capital interest grants the recipient with rights to liquidating distributions, a profits interest holder only shares in the future growth of the business.

Commonly, the issuance of a profits interest will include a hurdle provision that will only allow the service provider to share in profits or receive distributions after considering the other economic priorities of the partnership (e.g., increase in FMV of partnership, preferred return of partners’ contributed capital, return of capital contributed by members, etc.).

Grants of profits interests are generally not taxable, but rather, are taxed based on the liquidation value of the interest which should be zero at the time of award. However, if the interest is a vested profits interest, and is disposed of within two years of receipt, relates to a substantially certain and predictable stream of income, or is in a publicly traded partnership, the grant becomes a taxable transaction. If the FMV is not readily available, a valuation is needed to determine the amount of the compensation.

Additional requirements for a nonvested profits interest must be met to avoid income recognition when the interest vests. A service provider who receives a nonvested interest that is intended to be a profits interest should consider making a protective election to report the FMV of the interest as zero at the time of receipt.

The award agreement should be considered to document, among other things, the type of the award, the timing of the services, and any restrictions or contingencies. Additionally, every partnership should contemplate the operating agreement as to how the economic arrangement will change and how the partners’ intent behind the inclusion of capital or profits interests is reflected in its provisions. 

For more information on how Citrin Cooperman can support your business, contact Ibrahim Kousan at ikousan@citrincooperman.com.