Tax Consequences of Granting Partnership Interests

Many early-stage technology clients begin as LLCs and offer incentive membership units to those involved in Company growth. In many instances, these units are scheduled to accrue, or “vest,” a certain percentage interest in the LLC over a period of time.

LLC members, along with the businesses themselves, should be aware of the tax consequences of such arrangements. According to Section 83 of the Internal Revenue Code, property transferred to a recipient in exchange for the performance of services is taxable to the recipient when the recipient’s rights in that property become vested. The taxable amount equals the fair value of the vested interest, less any amounts paid in exchange for it. Grants of capital interests in an LLC (capital interests are defined as those interests that would give a partner a share of liquidation proceeds) to a partner in exchange for the performance of services are an example of a transaction that would fall under Section 83.

Therefore, it is critical that the terms and conditions of these transactions be clearly documented in an LLC’s articles of organization and capitalization table. Specifically, there should be a written record of the following for each applicable arrangement:

  • Recipient name
  • Number of units granted
  • Vesting period
  • Fair value per unit at the date of grant and at each vesting date

In the case of an early-stage LLC that has yet to raise substantial outside investment, one might expect that the fair value per unit is close to zero, and/or is expected to grow significantly over time. In these situations, it is advantageous for the recipient to make what is called an “83(b) election” upon receipt of the grant. This election allows the recipient to recognize taxable income on the entire award in the year of the grant, rather than in future years when the grant becomes vested and is worth more. Businesses should make each recipient aware of the 83(b) election immediately upon the date of the grant, as the election must be made within 30 days of this date.

The amount of taxable income recognized by the recipient, with or without the 83(b) election, may be recognized as a tax deduction by the business in the year in which the respective income is recognized.

Considering the above, there is a more tax-friendly alternative to granting a capital interest in exchange for services. This alternative is called a “profits interest.” The difference between a profits interest and a traditional capital interest is that a profits interest gives the recipient the right to share only in the future profits and appreciation of the Company after the date of the award, and not in any of the previously existing capital prior to the award. According to the terms of Revenue Procedure 2001-43 and 93-27, profits interests are not taxable to the recipient upon grant OR upon vesting, provided that:

  • The related services were provided in a partner capacity or in anticipation of being a partner
  • It does not relate to a substantially certain and predictable stream of income from partnership assets, such as income from high-quality debt securities or net leases
  • The recipient does not dispose of the profits interest within two years of receipt
  • The profits interest is not a limited partnership interest in a publicly traded partnership