For tax purposes, there are three types of equity that can be issued in a partnership or an LLC taxed as a partnership: capital interests, profits interests, and carried interests. Knowing what type of interest you own or are being granted is important, because there are different tax consequences with respect to receiving, holding, and selling each type of interest. Also, since operating agreements often just refer to equity interests generally as units, membership interests, or sometimes even shares, it may take some analysis to determine the tax status of your interest.
Capital Interests
A capital interest is an interest either not issued for services, or if issued for services, an interest which would result in the holder receiving part of the liquidation proceeds if a liquidation occurred immediately after grant.
If capital interests are sold to a non-service provider (i.e., an investor), there is no tax on issuance, the interest will be allocated profit and loss during their holding period in accordance with the operating agreement, long-term capital gain can pass-through immediately, and a sale of the interest will generally result in long-term capital gain if held for more than 1 year (subject to the hot asset rules, etc.).
If a capital interest is issued to a service provider, and the interest is either vested, or if unvested but a tax code Section 83(b) election is filed, then the tax consequences are as follows:
- On the grant date: Taxable income equal to the difference between the fair market value of such units and the amount paid, if any.
- On the vesting date: No tax.
- During holding period: Allocated profit and loss in accordance with the operating agreement starting on the date of grant. If immediately after the capital interest was granted, the partnership sold a capital asset it held for more than one year, any gain passed through with respect to the interest would be long-term gain.
- On Sale: Generallys result in long-term capital gain if held for more than 1 year (subject to the hot asset rules, etc.).
If an unvested capital interest is issued to a service provider and no Section 83(b) election is filed, then the tax consequences are as follows:
- On the grant date: No tax.
- On the vesting date: Taxable income equal to the difference between the amount paid for such units and the fair market value on the vesting date.
- During holding period: Allocated profit and loss in accordance with the operating agreement starting on the date of vesting. If immediately after the capital interest vested, the partnership were to sell a capital asset it held for more than one year, any gain passed through with respect to the interest would be long-term gain.
- On Sale: Generally results in long-term capital gain if held for more than 1 year after vesting date (subject to the hot asset rules, etc.).
A Section 83(b) election is required if the capital interest is unvested and you want to accelerate tax to the date of grant. In addition, capital interests are not considered as outstanding for K-1 or profit and loss allocation purposes until vested unless a Section 83(b) election is filed.
Profits Interests
A profits interest is an interest granted for services that that would result in the holder receiving $0 if a liquidation occurred immediately after grant. Sometimes this occurs simply by virtue of the economics in the operating agreement’s waterfall, but often this requires setting a “distribution hurdle” for the profits interest, much like an option exercise price.
The tax consequences of profits interests that are not “carried interests” are as follows:
- On the grant date: No tax.
- On the vesting date: No tax.
- During holding period: Allocated profit and loss in accordance with the operating agreement starting on the date of grant. If immediately after the profits interest was granted, the partnership sold a capital asset it held for more than one year, any gain passed through with respect to the interest would be long-term gain.
- On Sale: Generally result in long-term capital gain if held for more than 2 years (subject to the hot asset rules, etc.).
A Section 83(b) election is not required to achieve the above result, but for unvested profits interests I recommend filing a protective election anyway in case the hurdle was set too low and thus the interest is actually a capital interest, and possibly to bolster an argument that long-term capital gains is available after just 1 year. Profits interests are considered as outstanding for K-1 and profit and loss allocation purposes immediately regardless of vesting status.
Carried Interests
These are technically a subset of profits interests. Specifically, they are profits interests in entities who regularly raise capital and invest in portfolio assets.
The tax consequences of carried interests are as follows:
- On the grant date: No tax.
- On the vesting date: No Tax.
- During holding period: Allocated profit and loss in accordance with the operating agreement starting on the date of grant. These can receive pass-through long-term capital gain only if the asset being sold has been held for more than 3 years (this is unclear under the new law, some think only after the interest has been held more than 3 years).
- On Sale: Generally result in long-term capital gain if held for more than 3 years prior to sale (subject to the hot asset rules, etc.).
A Section 83(b) election is not required to achieve the above result, but for unvested carried interests I recommend filing a protective election anyway for the same reasons noted under Profits Interests above. Carried interests are considered as outstanding for K-1 and profit and loss allocation purposes immediately regardless of vesting status.
Mike Baker frequently advises with respect to partnership equity. He possesses a breadth and depth of experience in tax and employee benefits & compensation law that spans multiple decades. For additional information, please contact mike@mbakertaxlaw.com.