Question

If you own a “capital interest” (an equity stake) in a partnership, it generally means that you had made a capital contribution of some kind (typically cash or property) in exchange for your interest (Code § 721). By contrast, if you own a “profits interest” only, you have no equity stake (you’re not really a full owner even though entitled to some defined share of partnership profits) and therefore will not receive any payments in redemption of your interest when you decide to leave or retire.

In your own words, briefly compare and contrast the different result(s) of receiving (i) a capital interest vs. (ii) a profits interest (only) in a partnership in exchange for performing services to or on behalf of that partnership. And explain the very simple, very common-sense reason for that difference.

Answer 1

There are two basic types of equity interests that exist for partnerships and limited liability companies: capital interest and profits interests

A capital interest is an interest in the assets of the partnership. Upon sale or liquidation of the partnership assets, the holder of a capital interest would share in such distribution of assets or proceeds

A capital interest received in exchange for the performance of services can be vested or unvested. Vested means it can be freely transferred and it is not subject to a substantial risk of forfeiture. Unvested means it doesn’t meet one or both of those conditions. A service provider who receives a vested capital interest must recognize taxable compensation income at the time the interest is granted. The amount of compensation income is equal to the fair market value of the partnership interest granted. The partnership receives a corresponding tax deduction.

A service provider who receives an unvested capital interest does not recognize taxable income until the restrictions lapse and the interest become transferable. At that time, he or she has taxable compensation income equal to the fair market value of the partnership interest and the partnership has a corresponding tax deduction.

A profits interest is an interest only in the income of the partnership. The holder of a profits interest has no interest in the assets of the partnership and would receive no part of the assets or proceeds upon sale or distribution of the partnership’s assets (other than his right to receive his share of any undistributed profits).

• Profits interest is a way for partnerships to reward and retain employees in lieu of having equity to grant.
• Profits interest gives a key employee a share in the future growth in value of the partnership in return for his or her efforts in making that happen.
• Profits interest makes an employee a partner in the practice and will trigger some other changes in terms of tax filing and some benefit programs.

If a service provider receives a profits interest, then the grant of the profits interest is not a taxable event and the service provider will not have to recognize taxable income at the time of grant unless one of the following three exceptions applies:

The profits interest relates to a substantially certain and predictable stream of income from partnership assets, such as income from high-qualify debt securities or a high-quality net lease;
Within two years of receipt, the partner disposes of the profits interest; or
The profits interest is a limited partnership interest in a “publicly traded partnership”