Man looking at a decision cross road

Partnership equity compensation for employees? Use this decision tree to help you with the issues.

Thought Leadership on Tax Planning presented by Thomas & Libowitz.

In a prior article, we described the choices and issues for corporate equity compensation given to employees. Suppose the employer is a partnership or an LLC. The issues are different, and the decision matrix, as well as the explanation which follows, describes the choices.

 

Employment tree

Unlike corporate employers, partnership employers generally do not grant options because options do not work efficiently with profits interests. Additionally, incentive stock options are unavailable to partnerships. So, the first issue in the partnership context is whether the employee will be granted a capital interest or a profits interest in the partnership.

A capital interest is an interest that would give the employee a share of the proceeds if the partnership’s assets were sold at fair market value and the proceeds were then distributed in a complete liquidation of the partnership. This determination is generally made at the time the capital interest is awarded to the employee.

A profits interest, on the other hand, is any interest other than a capital interest. Said a different way, a profits interest entitles the holder to a share of partnership income and of future appreciation in value of the partnership’s assets, but no share of current proceeds if assets were sold at fair market value on the date the interest was awarded and the partnership was liquidated.

Capital Interests. The grant of a capital interest is treated as compensatory to the recipient in an amount equal to the fair market value of the capital interest at the time the interest vests. Therefore, if the interest vests immediately, the recipient will recognize compensation income immediately. If the interest vests over time, the recipient will recognize income as the interest vests, at the current fair market value of the interest each time it vests, absent a Section 83(b) election. As discussed in the prior article regarding corporate compensation, a Section 83(b) election permits the recipient to accelerate the vesting, for tax purposes, to the date on which the interest was granted so that future increases in value are not taxed to the recipient each time the interest vests.

Assuming a capital interest is granted and it either vests immediately or vests over time, the remaining issue becomes how to determine fair market value for purposes of determining the income recognized by employee and the deduction to which the employer partnership is entitled. In determining fair market value, two choices are available:

  • fair market value can be determined using valuation discounts for lack of marketability and minority interests, or
  • based upon proposed regulations issued by the Internal Revenue Service, fair market value can be determined by making a “safe-harbor election” to have all compensatory partnership interests valued using a liquidation value approach in which the value of the interest is the amount the recipient would receive on the date the interest is awarded if the partnership’s assets were sold at fair market value and the proceeds were distributed in a complete liquidation of the partnership.

Profits Interests. For a profits interest which either vests immediately, or vests over time and for which a Section 83(b) election is made by the recipient to treat the interest as vesting as of the date of award, the liquidation value safe-harbor election would result in a zero value of the interest for tax purposes. The liquidation value election would be beneficial for the recipient because the recipient would recognize no income. Conversely, the liquidation value approach would not be beneficial to an employee who was awarded a capital interest, because the liquidation value approach would presumably prohibit the use of minority interest and lack of marketability discounts.

Where a profits interest subject to vesting is awarded and no Section 83(b) election is made, the treatment to the employee is problematic. Unless the partnership is revalued under the liquidation approach at each time the interest vests, it is arguable that the profits interest could transform into a capital interest over time and result in the recognition of income to employee in future years as vesting occurs.

Based upon the above matrix and tax rules, the conclusions would seem to be:

  1. If a capital interest is awarded, regardless of whether it vests immediately or over time, the safe-harbor election to use the liquidation method should not be made so that minority interest and lack of marketability discounts can be used in determining fair market value. Whether or not an employee makes a Section 83(b) election is up to the employee.
  2. If a profits interest is awarded, the liquidation value safe-harbor election should always be made, and if the interest does not vest immediately, the employee should always make a Section 83(b) election. The combination of these two elections will assure the employee that no income is recognized as a result of the award of a profits interest.

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