We have client owners who have approached us who want to provide equity to key employees or minority owners as a performance incentive. One way to accomplish this is by granting a carried interest to the recipient (also called a “profits interest”); essentially a right to participate in any gain on the sale of the company if and when it is sold.
Like options, carried interests offer the two-fold advantage of deferring taxation for several years and then only at the capital gains rate. Now that the legislative climate in Washington is such that capital gains treatment for carried interests may be in jeopardy, consideration might be given to the use of capital interests: an outright grant of equity to the employee or minority owner.
A capital interest is an equity interest in a partnership. LPs, LLCs, LLPs are all treated as partnerships for federal income tax purposes. The IRS regards it 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. This determination generally is made at the time of receipt of the equity interest. See Rev. Proc. 93-27. A carried interest, on the other hand, is any interest that is not a capital interest.
Assuming it is not subject to a substantial risk of forfeiture, the value of a capital interest is considered to be income to the recipient in the year in which it is received. The income is taxable at ordinary rates, and is not eligible for capital gains treatment at that time. The dollar amount of income realized is equal to the fair market value of the interest on the date of grant. The partnership can recognize a deduction for the value of the granted interest (again, assuming it is not subject to a substantial risk of forfeiture). The recipient of the capital interest must make a timely election to claim the interest is not subject to a substantial risk of forfeiture and is therefore vested for tax purposes.
The grant of a capital interest to someone who does not or cannot contribute assets in an amount equal to the current fair market value of the interest will have a negative impact on the other partners’ capital accounts. The other partners’ accounts will have to be debited in an amount sufficient to reflect the adjusted percentages of ownership. For example, two existing partners with capital account balances of $100 each will see $5 of their balances transferred to the recipient of a 10% capital interest who does not contribute cash or assets valued at $10.
Unlike a capital interest, the receipt of a carried interest by itself does not result in the recognition of income on the date of grant. However, if the recipient of a carried interest who was an employee of the partnership becomes a partner, there will be tax consequences for the new partner. The new partner will receive a Schedule K-1 reflecting the partner’s allocable portion of the partnership’s income and deduction items and any guaranteed payments for capital or services rendered. Carried interests can participate in distributions of current earnings, but such participation is usually limited to vested interests.
The reasons for granting capital interests instead of carried interests may include a desire to have minority partners participate in profits (and losses). The founding or majority partners must not be adverse to dilution and should have received a return of invested capital in the form of distributed profits long before a sale. We have found that capital interests may be better suited for a service business rather than a capital intensive one where the founder or sponsor contributes a large amount of cash or the asset in a single-asset or capital-intensive business.
Capital interests and carried interests both currently enjoy capital gains tax treatment. So LLC, LP and LLP owners who favor making key personnel owners and who do not mind the dilution of their own equity interest may find capital interests worthwhile.
The wisdom of granting capital interests as a reward for employee or minority owner performance, which should be discussed in depth with the attorney and accountant, will depend on many factors and is inherently fact-sensitive. These include the value of the interest on the date of its grant, the recipient’s ability to pay tax on the value of an illiquid asset and the distributive share of profits, a relatively low basis and future gain on disposition which will be taxed at the lower capital gain rate if sold after one year. Since the result will be a low cost basis, the amount of realized gain will be similar to that resulting from the liquidation of a carried interest.
CIRCULAR 230 NOTICE. Any advice expressed above as to tax matters was neither written nor intended by Egbert & Barnes, P.C. to be used and cannot be used by any taxpayer for the purpose of avoiding tax penalties that may be imposed on the taxpayer. If this document is delivered to any person or party other than to our client to whom the advice is directed, the recipient may not and should not rely upon any advice expressed above for any purpose and should seek advice based on the recipient’s particular circumstances from an independent tax advisor.
