The grant of an equity interest by a partnership to one of its key employees should be approached with great caution because it may result in unintended tax consequences, both for the partnership and the partner.1
Many corporate employers use equity-based compensation in the form of stock or stock options to motivate their employees. Individuals who are employed by partnerships may expect compensation in the form of partnership interests. A partnership is flexible enough to accommodate equity-based compensation, but the arrangements may have different tax consequences than in similar corporate plans. There are three common forms in which a partnership may transfer an interest to an employee:
- a full partnership (capital/profits) interest;
- a profits interest only; and
- an option to acquire an interest.
Transfer of a Full Partnership Interest
Surprisingly, there is no consensus as to the tax consequences for a partnership if a transfer of a full or capital interest takes place when the partnership has unrealized appreciation in its assets. The preferred analysis is to treat the partnership as transferring to the employee a proportional interest in all its assets. This would trigger recognition to the partners of the unrealized appreciation in the partnership assets at the time of the transfer under Code Section 1001.
Under Code Section 83, if property (including a partnership interest) is issued to an employee in exchange for services, the excess of the fair market value of the property at the lapse of any substantial risk of forfeiture over any amount paid for the property will be taxable compensation at the time of the lapse, and the excess may be deductible by the partnership at that time.
In sum, the value to the partnership of any deduction can be diminished by gains recognized on the transfer of partnership interests for services. A corporate employer, on the other hand, is allowed a deduction for the full amount of the compensation, but does not recognize any gain on issuance of its own shares (under Code Section 1032).
Transfer of a Profits Interest
In contrast to a capital interest, there is no current compensation to the partnership employee who receives a profits interest, because of the speculative value of such an interest. If the profits interest is subject to a substantial risk of forfeiture, it would seem advisable for the employee to make a protective Code Section 83(b) election to ensure that any capital that may accumulate with respect to the interest before the restriction lapses is not then taxable to the partner.
Consistent with the foregoing, the IRS has held that the receipt of a vested profits interest, and the vesting of a unvested profits interest, generally will not result in a taxable event for either the partnership or the employee provided two requirements are satisfied:
Both the partnership and the employee must treat the employee as the owner of the partnership interest from the date that the profits interest is granted and the employee must take into account the distributive share of partnership income, gain, loss, deduction and credit associated with that interest in computing the employee’s income tax liability; and
Upon the grant of the interest, or when it becomes substantially vested, neither the partnership nor any of the partners may deduct any amounts for the fair market value of the interest.
It should be noted that under rules proposed by the IRS in 2005, there would be no distinction in the treatment of capital and profits interests. If a partnership interest were transferred in connection with the performance of services, the employee-recipient would not be treated as a partner until the interest became substantially vested or a Section 83(b) election was made. In addition, taxpayers could treat the “liquidation value” of a compensatory partnership interests as the interest’s fair market value. Until these regulations are finalized, however, taxpayers may rely upon the IRS’s earlier holdings.
In addition, until additional guidance is issued, for purposes of Section 409A, taxpayers may treat the issuance of a partnership interest granted in connection with the performance of services under the same principles that govern the issuance of stock. For example, taxpayers may treat an issuance of a profits interest that is properly treated under applicable guidance as not resulting in inclusion of income by the employee at the time of issuance, as also not resulting in the deferral of compensation.
Transfer of an Option to Acquire an Interest
In lieu of a partnership interest, a partnership can issue nonqualified options to purchase partnership units. In general, the grant of an option to purchase partnership units to an employee in exchange for services does not have a taxable consequence for the partnership. Presumably, any such option would not be freely transferable, but might be subject to a substantial risk of forfeiture to ensure that the holder of the option satisfactorily performs services under the option agreement. Under the regulations proposed in 2005, no gain or loss would be recognized by a partnership upon a transfer of a partnership interest from the exercise of a compensatory option.
This means that Code Section 83 would come into play as in the normal context of the employer-employee relationship, and income would result to the option holder at the time of exercise, equal to the excess of the fair market value of the partnership interest at that time over the exercise price.
he value of the partnership interest relative to the option’s strike price also needs to be closely examined because it may implicate Section 409A. An option to purchase an interest in the employer-partnership does not provide for a deferral of compensation if the exercise price may never be less than the fair market value of the underlying interest on the date the option is granted.
Partnerships that want to incentivize key employees by compensating them with partnership interests face some unique challenges. With proper planning and structuring, they should be able to do so without triggering significant, or unexpected, tax costs for the partners or for the employees.
FN 1. Most LLCs that have at least two members are treated as partnerships for income tax purposes.