Capital and Profits Interest – What is The Difference?

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Capital and profits interest—what are they and when are you taxed on it? The answer is generally the same with any other lawyer answer . . . it depends.

First thing to look for is whether the company is taxed as a corporation or a partnership. The treatment on capital or profits interests granted from these entities is different. And For purposes of this discussion, we are going to focus on the interests granted by partnerships. Ownership in partnerships are either capital interests or profits interests. Depending on the interest granted to you dictates how you’re taxed.

What Interest Is Capital and What Interest is Profit

Generally, a capital interest is an interest that gives the holder a share of the proceeds of the partnership’s assets if they were liquidated and distributed. That’s a pretty tight definition. Well, what about profits interest? Well, this is a more vague—profits interests is defined as partnership interests other than a capital interest.

To put simply, if the interest granted allows you to participate in the proceeds upon the liquidation of the company, that’s a capital interest. Anything else is a profits interest. If its not clear what interest you have, consult a tax advisor determine the status of your interest.

Taxing the Grant of Capital and Profits Interest

Interests Granted in Exchange for Contribution—Generally Not Taxable

As a general rule, if you provide capital in exchange for the interest, then you are not taxed on the receipt of such interest. The Internal Revenue Service (“IRS”) looks at this transaction as receiving an ownership interest in the company in exchange for an investment. That type of transaction is not a taxable event under the IRC.

Interests Granted in Exchange for Services—Taxable, but Depends on Vesting

Capital Interests

Okay, so how does it work if you’re granted an capital interest in exchange for services? Generally, if the interest you receive is substantially vested, then you are immediately taxable on its receipt. Something is substantially vested if it is freely transferrable by you. Essentially, if you’re granted the interest and don’t have to do any further work for those interests to vest, they are substantially vested and are immediately taxable on receipt.

So how are capital interest that are not substantially vested taxed? The short answer is that you’re not taxed on those capital interests until the restriction on those interests are lifted. So, if you’re granted capital interests in your company but you still have to work for the company for a set period of time until you are entitled to them, then you’re not taxed on the immediate receipt of those interest but rather when you meet your employer’s requirements.

Profits Interest

Profits interests are taxed differently than capital interests. Under current law, the grant of a vested profits interest is a taxable event if a IRS safe harbor provided is met. Under Rev. Proc. 93-27, if a person receives a profits interests for services, the interest is not a taxable upon it’s grant.

However, there are three exceptions to this general rule. Under the same Rev. Proc., a vested profits interest is immediately taxable if—

  1. The profits interest relates to a substantially certain and predictable stream of income from partnership assets, such as income from high-quality debt securities or a high-quality net lease;
  2. Within two (2) years of receipt, the partner disposes of the profits interest; or
  3. The profits interest is a limited partnership interest in a “publicly traded partnership” within the meaning of IRC 7704(b).

If the safe harbor isn’t met or any three of the exceptions are met, the interest is taxable. However, if the safe harbor is met, then the interest is taxable.

What about those profits interest that aren’t substantially vested? Well until 2001, this question was unclear. In 2001, the IRS issued Rev. Proc. 2001-43 which was designed to provide guidance on this topic. Under this guidance, even if an unvested profits interest is granted, the individual will be treated as receiving the interest on the date of its grant and subject to tax if—

(a) both the partnership and the service provider treat the service provider as a partner from the date the profits interest is granted;
(b) the service provider takes into account the distributive share of partnership income, gain, loss, deduction and credit associated with that interest in computing the service provider’s income tax liability for the entire period during which the service provider has the interest;
(c) no compensation deduction is taken by the partnership or any partner in connection with the grant of the profits interest; and
(d) all of the requirements of Rev. Proc. 93-27 are satisfied.

Thus, the grant of an unvested profits interest is not taxable until the individual receiving the grant meets the requirements set for the interest to vest. This is the case unless the company and the individual meet the four requirements set out above.

An Alternative—An Section IRC 83(b) Election

So what if you believe your unvested interest is going to grow quite a bit by the time its vested? Wouldn’t you want to pay tax on the interest’s then low value and avoid paying tax on the higher value when the interest becomes vested? Most people say yes to this question.

Well, the IRC provides for an election that allows taxpayers to be immediately subject to tax on the grant of an capital or profits interest. To properly elect this treatment on the receipt of an unvested interest, the individual will have to file an 83(b) election no later than 30 days after the receipt of the interest.

While some people want to avoid paying tax on the value of the interests granted to them in exchange for their services until as late as possible there are others out there who recognize the benefit of this election if they believe that their interest will be worth a whole lot more by the time it vests.

Have questions how this topic applies to you and your situation? Contact Alton.

Want to see what the IRS has to say about this topic and tax partnerships in general? See IRS Publication 541.