Profits interests and tax reform: Three things you should know
Profits interests are a special form of equity compensation issued by limited liability companies (LLCs). What effect does the Tax Cuts and Jobs Act (TCJA) have on profits interests? Here are three things you should know.
1. Safe harbor provisions
We’ll start with the good news. The TCJA left many aspects of profits interests in place. This means safe harbor provisions offering favorable tax treatment are generally unchanged for profits interests issued as equity compensation in LLCs that operate a business. As a result, profits interests are expected to continue as a favored form of equity compensation used to attract, retain, and incent employees in LLCs.
Even better, tax reform introduced a number of components expected to have a favorable effect on business. This could increase future distributions of operating cash flow, help achieve performance vesting targets, and enhance returns. These aspects will work to increase the value of profits interests as a form of equity compensation.
2. Profits interests issued by investment companies
The TCJA did make a significant change to profits interests issued by investment companies. These so-called applicable partnership interests are granted in exchange for the performance of services to a business involved in raising or returning capital, and either investing in or developing investment types of assets. Under the new law, a three-year holding period is required in order for the holder of the interest to receive long-term capital gain treatment.
Under the new law, a three-year holding period is required in order for the holder of the interest to receive long-term capital gain treatment.
Under prior tax law, this holding period was one year. This holding period appears to apply to both the underlying assets of the investment company if those assets are sold, and to the profits interest itself if sold or exchanged by the holder.
However, the new three-year restriction doesn't apply to profits interests issued to management or employees of an operating company in exchange for services provided to that company. These will still be subject to the one-year criteria.
For new entity formations, differences under the revised laws on taxation between C corporations and LLCs suggest the need to appropriately evaluate the short- and long-term implications of entity choice. Profits interests are a form of equity compensation that are unique to LLCs (and partnerships). As a result, consideration of the features and benefits of profits interests versus other forms of equity compensation and incentives used in C corporations may factor into the decisions on corporate structure.
3. Document grant date value
As always, it remains important to establish and document the appropriate grant date fair market value of the business and total equity applicable to the units issued. This sets the required participation threshold for compliance with safe harbor provisions, supports any IRC Section 83(b) elections, and is used in GAAP financial reporting. It’s also important to document this value in grant agreements, communications with the recipient, or other disclosures. These steps help support the success of the program and avoid unpleasant surprises or issues in a payout, audit, or IRS inquiry.
Of course, taxation for profits interests and LLCs will depend on the facts and circumstances, and can be complex. If you have questions, want more information, or need help, please let us know.
