There are two types of interest that can be received when providing services to a partnership – capital interests and profits interests. Partnership interest is considered a percentage of ownership in the partnership that is held by an individual or entity. You will learn about what profits interests are and how vested and unvested profits interests are taxed in this blog. This can help you determine what type of partnership interest would be the most appropriate for you to receive.
What are Profits Interests?
Profits interests provide the person who receives them a right to a percentage of future profits. Profits interests pertain to interest in the future profits and appreciation of the partnership only meaning that the recipient is not entitled to any current capital in the partnership. The owner of profits interests does not have an immediate capital account at the time when partnership interest is granted. The only way for capital to accumulate is if there are future profits to share in.
Are Vested Profits Interests Taxed?
Profits interests are vested and unrestricted if the interest can be transferrable free of a substantial risk of forfeiture or if it is not subject to a substantial risk of forfeiture. If a person anticipates becoming a partner and they receive profits interests for services provided to or for the benefit of the partnership, the receipt of interest is not considered a taxable event. Because of this, the person will not recognize income when granted the interest.
There are three exceptions that would cause vested profits interests to be taxed:
- The vested profits interests will provide a substantially certain and predictable stream of income from partnership assets (for example, income from high-quality debt securities or a high-quality net lease);
- The partner disposes of the vested profits interests within two years of receiving them; or
- The profits interests are a limited partnership interest in a “publicly traded partnership” as defined by the Internal Revenue Code.
Are Unvested Profits Interests Taxed?
The tax treatment of an employee or service provider who received substantially unvested profits interests was unclear until 2001. The IRS issued rulings to provide clarity on this issue. These rulings stated that the person who receives substantially unvested profits interests granted by the partnership will be treated as receiving the interest on the grant date. This causes the receipt of unvested profits interests to be taxed.
The receipt of unvested profits interest are taxed if these three requirements are met:
- The partnership and person granted interest treat that person as a partner starting on the date the unvested profits interests are granted;
- The person being granted profits interests accounts for the distributive share of partnership income, gain, loss, deduction, and credit associated with it when calculating their income tax liability for the entire time the service provider has the interest; and
- There is no compensation deduction taken by the partnership or any partner in connection with the grant of the unvested profits interests.
Additionally, the ruling requires the allocation to the person granted unvested partnership interest to receive allocations of partnership gains and losses from the date of grant. It also requires consistent tax treatment by all parties throughout the ownership of the interest.
The Impact of Section 1061 Rules?
Generally, before the new tax law took effect, if a partner held a partnership interest for more than one year and then sold it for a gain, it would have been subject to long-term capital gain treatment. After the new tax law took effect, the required holding period for certain types of profits interests in partnerships, known as “applicable partnership interests” (API), have been increased to three years to qualify for long-term capital gains rates. API is defined as a partnership interest held by, or transferred to, a taxpayer, directly or indirectly, in connection with the performance of substantial services by the taxpayer, or by any other related person, in any “applicable trade or business.” More specifically, a profits interest is an API if the partnership’s purpose is to raise or return capital by investing in or disposing of:
- Securities such as corporate stock, a note/bond/debenture, currency, a partnership interest in a widely held or publicly traded partnership or trust;
- Cash or cash equivalents;
- Options or derivative contracts; or
- Rental or investment real estate.
If you have any questions on how vested and unvested profits interests are taxed or which type of partnership interest is best for your tax situation, please contact your Untracht Early advisor.