A partnership is not subject to Federal income tax. Instead, an item of income or loss of the partnership retains its character and flows through to the partners, who must include such item on their tax returns. Generally, some partners receive partnership interests in exchange for contributions of cash and/or property, while others receive partnership interests in exchange for services. Accordingly, if and to the extent a partnership recognizes long-term capital gain, the partners, including partners who provide services, will reflect their shares of such gain on their tax returns as long-term capital gain. If the partner is an individual, such gain is taxed at the reduced rates for long-term capital gains. Gain recognized on the sale of a partnership interest, whether it was received in exchange for property, cash, or services, is generally treated as capital gain. Under current law, income attributable to a profits interest of a general partner is generally subject to self-employment tax, except to the extent the partnership generates types of income that are excluded from self-employment taxes, e.g., capital gains.
The Administration’s 2015 Budget Proposal seeks to change the tax treatment of profits interests issued by certain investment partnerships. Shortly after the issuance of the Budget Proposal, a number of writers commented on the profits interest provision, pointing out that it bode well for real estate and other businesses by leaving them the ability to take advantage of profits interests to reward employees. This implicit blessing of the use of profits interests by the Administration, plus the increased federal income tax rate applicable to compensation income (39.6%), makes the issuance of a profits interest all the more likely where the issuer’s goal is to attract and/or retain talented executives. 
It also highlights the need to structure such an interest with care, and to revise certain LLCs’ operating agreements accordingly, so as to avoid the inadvertent creation of a capital interest. The Tax Court’s recent decision in Crescent Holdings, LLC v. Comm’r provides an instructive discussion of the distinction between profits and capital interests.
Crescent Holdings
Crescent Holdings, LLC issued a 2% membership interest to a key executive. The executive agreed to stay on for three years, failing which he would forfeit the membership interest. In addition, the interest was nontransferable. The executive was required to pay his employer an amount sufficient to cover all withholding and other taxes before the lapse of the forfeiture restriction. The agreement also provided that the executive was entitled to the same distributions as other LLC members and that any distributions were not subject to forfeiture. The agreement explicitly stated that the 2% interest was being granted subject to Section 83 of the Internal Revenue Code (the “Code”).
The executive did not make an election under Section 83(b) of the Code.
For each of 2006, 2007 and 2008, the executive received a Schedule K-1 from the LLC that allocated income to him. He objected each time, claiming that because he was not vested in his LLC interest, he was not a member of the LLC for tax purposes. In 2009, prior to the expiration of the three-year forfeiture period, the executive resigned from his position and forfeited his LLC interest.
The IRS audited the LLC and determined that the executive should be treated as a partner for the 2006 and 2007 tax years. The executive argued that he was never vested in the 2% interest under Section 83 and, as a result, should not be allocated any LLC income.
The tax matters partner for the LLC argued that Section 83 did not apply, contending that the 2% interest was a profit interest under Rev. Proc. 93-27 and, so, the executive was liable for the tax on his allocable share of LLC profits.
The Court Finds a Capital Interest
The Court determined that the executive had been granted a capital interest, not a profits interest. Starting with Rev. Proc. 93-27, the Court stated that a “capital interest is 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 complete liquidation of the partnership.” This determination is made at the time the interest is granted, even if, at that time, the interest is substantially non-vested. Rev. Proc. 2001-43. A profits interest, on the other hand, is “a partnership interest other than a capital interest.” The recipient of a non-vested LLC interest can still be recognized as a member for tax purposes.
In examining the LLC’s operating agreement, the Court found that the executive would have shared in the proceeds of a hypothetical liquidation of the LLC. Thus, consistent with the analysis called for by Rev. Proc. 93-27, the executive had been granted a capital interest, albeit one that was not yet vested.
Section 83
Having found that the executive’s interest was a capital interest, the Court next turned to the application of Section 83. The Court re-affirmed that Section 83 applies to the grant of a capital interest in an LLC. Since the interest was not substantially vested, and since the executive did not make an election under Section 83(b), the membership interest should not be treated as issued and outstanding. Accordingly, the remaining members of the LLC should have been allocated the LLC income previously reflected on the K-1’s issued to the executive.
Takeaway
There are several lessons to be drawn from the decision in Crescent. First, LLCs must take care in drafting the terms of profits interests, lest they inadvertently create a capital interest. The former shares only in future earnings and appreciation attributable to the interest; the latter participates immediately in some portion of the LLC’s existing value. Thus, if the Crescent agreement had provided for liquidating distributions in accordance with capital account balances (as opposed to membership percentage interests), the characterization of the 2% interest as a capital interest may have been avoided. From the executive’s perspective, it was fortunate that the interest was not vested. If it had been, the executive would have realized taxable compensation in an amount equal to the value of the interest. An employer’s inadvertent issuance of a capital interest could, therefore, turn into an expensive proposition. This brings us to the second lesson; specifically, because it may be difficult at times to distinguish between a profits interest and a capital interest, if may behoove the recipient of what purports to be an unvested profits interest to make an election under Section 83(b) of the Code and thereby cut off the compensation element that would be associated with the interest in the event it turned out to be a capital interest. Although the election may result in the immediate recognition of some compensation in the event the interest is treated as a capital interest, the resulting liability is likely to be much less than it would have been had the compensation element been deferred until vesting.
Notwithstanding the risks associated with profits interests, they remain a valuable tool for rewarding and incentivizing key employees. With the proper guidance and drafting, there is no reason why the issuance of a profits interest should not be considered a viable option.