SPECIAL REPORT (C) Tax Analysts 2014. All rights reserved. does not claim copyright in any public domain or third party content. tax notes™ Practical Considerations for F. Boilerplate Profits Interests Provisions . 1288 Issuing Profits Interests, Part 2 IV. Practical Considerations ............. 1289 A. Tax Reporting .................. 1289 By Afshin Beyzaee B. Self-Employment Taxes ............ 1289 C. Type of Partnership Interest ......... 1290 D. Profits Interests’ Voting Rights ....... 1290 Afshin Beyzaee is a part- E. Tax Distributions .................1291 ner in the Los Angeles office F. Multiplicity of Partners ............ 1291 of Liner LLP, where he heads the firm’s tax practice. G. Drag-Along Provisions ............ 1292 The author would like to H. Tag-Along Provisions ............. 1294 thank Hatef Behnia and J. I. Valuation of Partnership and Assets ....1294 Nicholson Thomas for their J. Revaluation of Partnership Assets ..... 1295 invaluable comments and K. Top-Up Profits Interests ............ 1296 suggestions. L. Grants Not From Partnership ........ 1296 In this report, Beyzaee M. Disqualification Issues for Afshin Beyzaee discusses how profits inter- Partnership .................... 1297 ests can provide an equity incentive to people N. Proposed Carried Interest Legislation . 1297 providing services to a partnership. The tax treat- V. Probably-Not-Final Thoughts ......... 1297 ment to the recipient is favorable, and there are almost endless possibilities in terms of how they III. Structuring Profits Interests are structured. But their use raises a host of issues, in both implementation and administration, that practitioners should be attuned to. And although There are almost infinite possibilities for structur- profits interests have been sanctioned by the IRS for ing variations on the profits interests, giving prac- some time, many unanswered questions about their titioners and business owners great flexibility in treatment remain. achieving their desired outcomes. This section will provide some examples of how profits interests are This report is being published in two parts. The structured, followed by drafting techniques for first part, published June 9, discussed the current state of the law governing profits interests. This implementing those structures. second part includes practical guidance for estab- A. Structuring Techniques lishing these arrangements. There are many ways to economically structure The information contained herein is of a general profits interests. This section will examine several nature and is based on authorities that are subject to approaches that can be used, but they are by no change. Its applicability to specific situations should be determined through consultation with means exhaustive — creative taxpayers and practi- your tax adviser. This report represents the views of tioners can certainly develop others. the author only and does not necessarily represent the views or professional advice of Liner LLP. 1. Fixed profit share. The most common form of profits interest is probably one in which the holder Copyright 2014 Afshin Beyzaee. is entitled to share in a fixed percentage of any gains All rights reserved. or profits above the value of the partnership at the time the interest is granted, or some higher speci- Table of Contents fied threshold. For example, if the partnership is worth $1 million when the profits interest is III. Structuring Profits Interests .......... 1277 granted, the holder might be entitled to 5 percent of A. Structuring Techniques ............ 1277 all gains and profits exceeding $1 million. Alterna- B. Timing Considerations ............. 1281 tively, the holder might be entitled to 5 percent of all C. Drafting Approaches .............. 1282 gains and profits exceeding $1.5 million or 5 percent D. Issuing Unvested Profits Interests .....1284 of all gains and profits after the existing partners E. Tax Allocations .................. 1286 have received the $1 million plus a preferred return thereon. TAX NOTES, June 16, 2014 1277 COMMENTARY / SPECIAL REPORT This structure would clearly satisfy the safe har- partnership interest received by the waiver partner bor requirement that the profits interest have a zero typically entitles the holder to this kind of catch-up (C) Tax Analysts 2014. All rights reserved. does not claim copyright in any public domain or third party content. liquidation value. The one caveat, however, is that allocation until the amount of the management fee the parties must be confident that the specified ‘‘waived’’ is reached and then a pro rata share of value for allowing the profits interest holder to future gains and profits of the fund is distributed.119 participate is not below the current liquidation This approach can itself take many different value of the partnership.117 forms. For example, the catch-up need not start at 2. Catch-up right. A problem with the kind of the value of the partnership at the time of the grant; profits interest described above is that a service instead, it can apply starting at a higher threshold provider that is promised a fixed percentage of the (perhaps $1.2 million in Example 13). Likewise, the entire partnership for its services is really not get- catch-up does not need to provide the same per- ting a share of the existing value of the partnership. centage of the existing value as the future sharing Although it does not exactly accomplish this goal, percentage. So the holder might get only a 5 percent there is a second approach that attempts to approxi- catch-up on existing capital, together with a 10 mate that result while still qualifying as a profits percent share of future profits, or a 10 percent interest: Allocate the first gains and profits of the catch-up with a 5 percent share of future profits. partnership only to the profits interest holder until As with the first approach, this structure would the holder is economically pari passu with the other clearly satisfy the safe harbor requirement of having partners and only thereafter sharing gains and a zero liquidation value. But here again, even more profits pro rata. so than in the first approach, the parties should be Example 13: Partnership AB is worth $1 million careful not to underestimate the existing value of when a service provider, C, is granted a profits the partnership. Because of the ‘‘juiced’’ catch-up interest. The parties want to give C a one-third rights of the profits interest, the holder of the profits interest in the partnership. This catch-up approach interest would likely be taxed immediately to the would allocate the first $500,000 of gains and profits full extent of any understatement of value because and one-third of all subsequent gains and profits to all that value would accrue to the interest. In C.118 Table 1 shows what C would receive in a Example 13, if the value of the partnership were hypothetical liquidation of the partnership in this really $1.2 million but the parties treated it as only example at various liquidation values: $1 million, the profits interest would have a liqui- dation value of $200,000 upon grant, which amount Table 1 — Example 13 would likely be fully taxable to C at the time of AB Liquidation C’s Share of C’s Percentage grant. Value Proceeds of Value 3. Gross allocations. A more exotic technique is to $500,000 $0 0% start with one of the first two approaches but add a $1,000,000 $0 0% ‘‘gross’’ twist. Tax items arising after the date of $1,200,000 $200,000 16.67% grant (not including built-in gains and losses) are $1,500,000 $500,000 33.33% allocated on a gross basis (that is, allocations of $3,000,000 $1,000,000 33.33% gross items of profits and losses, rather than net profits or losses) among the partners, with gross A prime example of this approach is in connec- profits being allocated to the profits interest holder tion with the management fee waiver technique and gross losses allocated to the other partners until used in many private equity funds. There, the their respective capital accounts match up with the desired economics. The holder of the profits interest will at no time be entitled to share in any value in 117See Section IV.I for a discussion of valuation issues. excess of its capital account. 118The amount of the initial catch-up allocation can be Example 14: Partnership AB has a liquidation calculated using the following formula, where x is the percent- value of $1 million, consisting entirely of cash, age of the partnership to be given to the profits interest holder: Value of Partnership at Grant when a profits interest is granted to a service provider, C. The business goal is that C share in 10 Catch-Up Amount = (1 -x ) percent of all value of the partnership, so this gross The profits interest holder’s share of liquidation proceeds allocation approach is used. In the first year after can be represented by the following Excel formula: = min() max(0, ( l - i )), ( x * l ) where x = the profits interest holder’s share 119For a more detailed analysis of the management fee l = the liquidation value of the partnership at liquidation waiver approach, see Afshin Beyzaee, ‘‘Current Tax Structuring i = the liquidation value of the partnership at the time of the Techniques for Private Equity Funds,’’ 20 J. Tax’n & Reg. of Fin. grant of the profits interest. Inst. 16, 18-20 (May/June 2007). 1278 TAX NOTES, June 16, 2014 COMMENTARY / SPECIAL REPORT Table 2 — Example 14 (C) Tax Analysts 2014. All rights reserved. does not claim copyright in any public domain or third party content. Gross Profit to Profits Interest Gross Losses to Liquidation Profits Interest Percentage of Net Profit (Loss) Partner Other Partners Proceeds Proceeds Proceeds ($10,000) $50,000 ($60,000) $990,000 $50,000 5.05% ($10,000) $99,000 ($109,000) $990,000 $99,000 10.00% $0 $50,000 ($50,000) $1,000,000 $50,000 5.00% $10,000 $30,000 ($20,000) $1,010,000 $30,000 2.97% $10,000 $101,000 ($91,000) $1,010,000 $101,000 10.00% grant, the partnership has no net profits or net One other thing to be careful about is how losses (that is, it breaks even for tax purposes), leveraged distributions are addressed.