Sophisticated private-company management teams are increasingly asking that their equity compensation be structured to minimize ordinary income tax treatment and maximize capital gains treatment. Many private companies are turning to profits interests as a preferred equity compensation vehicle to accomplish these tax goals. This article provides a brief discussion of traditional forms of equity compensation, discusses typical management concerns regarding these traditional forms of equity compensation, and presents the advantages of profits interests over other forms of equity compensation.
Historically, equity compensation has been in the form of stock options, restricted stock, and restricted stock units. The U.S. federal income tax consequences of each of these forms of award are briefly discussed below.
Arguably, stock options have been the most common form of equity compensation. An option is a right to purchase a fixed number of shares of stock at a fixed price for a fixed period of time, but usually only if vesting criteria (such as continued service or specified performance goals) are satisfied. In general, there is no tax on grant or vesting. The option holder recognizes ordinary income on exercise equal to the “spread” (the excess of the fair market value at exercise over the exercise price paid for the shares purchased). Any additional gain or loss on the subsequent sale of the shares is capital gain or loss.
A special form of option, called an incentive stock option, provides for the avoidance of ordinary income tax recognition on exercise. The requirements for the grant of an incentive stock option are set forth in IRC § 422. Such requirements include that (1) the option is granted under a shareholder approved plan that includes the number of shares that can be issued under the options and the employees (or class of employees) eligible to receive options; (2) the option is granted within 10 years from the earlier of (a) the date the plan is adopted (by a company’s board of directors) or (b) the date the plan is approved by shareholders; (3) the option by its terms is not exercisable more than 10 years after the date the option is granted; (4) the option exercise price is no lower than fair market value of the covered shares on the grant date; (5) the option by its terms is not transferable other than by will or the laws of descent and distribution and is exercisable during the lifetime of the option holder only by the option holder; and (6) the option holder, at the time the option is granted, does not own shares possessing more than 10% of the total voting power of all classes of stock of the employing corporation or a parent or subsidiary corporation, provided, however, that incentive stock options still may be granted to such individuals holding more than 10% of total voting power if the exercise price is at least 110% of fair market value of the covered shares on the date of grant and the option by its terms is not exercisable more than five years after the date the option is granted.
The spread on exercise is not taxed as ordinary income, but instead the option holder recognizes the spread as an income adjustment item for alternative minimum tax purposes. So long as the option holder holds the shares acquired on option exercise for the longer of (1) one year from the date of option exercise and (2) two years from the date of option grant, all gain is long-term capital gain. But, if the individual disposes of shares before meeting those holding periods, then a portion of gain, up to the spread at the time the shares were acquired on option exercise, is taxed as ordinary income. Most frequently, individuals do not recognize the tax benefit of incentive stock options because individuals typically do not meet the required holding periods. Most individuals either (1) wait until there is liquidity following an IPO to exercise and then immediately sell shares on exercise or (2) exercise (or have their options cashed-out) in connection with a corporate change in control, such as a sale of the company.
Grants of restricted stock result in the immediate transfer of shares to the recipient, with the shares being subject to forfeiture if specified vesting conditions, such as continued service or performance goals, are not satisfied. The recipient recognizes ordinary income, equal to the excess of fair market value over the purchase price paid, as the shares vest. But a recipient may elect via a filing under IRC § 83(b) (often referred to as a § 83(b) election) to instead be taxed on the value of the shares, in excess of the purchase price paid, at the time of transfer (grant) instead of at vesting. When restricted stock is granted in an early-stage company and the shares have nominal, if any, value, individuals often file a § 83(b) election because the amount of ordinary income to be recognized is low (because the value of the shares is low). Individuals also typically file a § 83(b) election if they are required to pay fair market value to purchase the shares (because if the purchase price equals fair market value, no tax is due). On a sale of the shares, any additional gain (or loss) in excess of the previously taxed value of the shares is capital gain (or loss).
A restricted stock unit is a contractual right to receive a share in the future, if specified vesting criteria, such as continued service or performance goals, are satisfied. Vesting results in employment tax liability (Social Security and Medicare taxes), but the recipient recognizes ordinary income only when unrestricted shares are delivered in settlement of vested units. Settlement can occur on, or shortly after, vesting, or settlement can be further delayed in compliance with deferred compensation tax rules, thereby further delaying ordinary income tax recognition. Following delivery of shares in settlement of vested restricted stock units, any subsequent gain (or loss) on a sale of the shares is capital gain or loss.
From management’s perspective, the three most common concerns with these traditional forms of equity compensation are (1) ordinary income taxation instead of capital gain treatment, (2) the possibility for taxation without matching liquidity, and (3) the proper valuation of the company’s equity. (The latter two points arise only in the context of private companies when there is no available market for the shares underlying the equity awards.)
As described above, a significant portion of the value delivered by traditional equity awards is recognized as ordinary income. Current U.S. federal ordinary income tax rates are as high as 39.6%, significantly higher than the long-term capital gain tax rate, which is currently capped at 20% for the highest tax bracket. The authors have yet to come across a management team that prefers to pay ordinary income tax over capital gain tax.
Given that there is no readily available market for private-company equity, there is a significant potential for a mismatch of taxation and liquidity on traditional awards. Absent a § 83(b) election, restricted stock offers no ability to control the timing of taxation. Although an option holder controls when to exercise, and therefore the timing of taxation, if an option otherwise would expire (for instance, on a termination of employment), an individual may choose to exercise rather than forfeit the option, even though exercise will trigger taxation. For restricted stock units, applicable tax law often limits the events that can trigger settlement, generally requiring that the vested units be settled on vesting, on termination, on a change in control, or on a fixed date (that is, January 1, 2020), with the decision about the settlement trigger made when the units are granted. The settlement date or event may occur before there is liquidity, creating tax without a corresponding ability to receive cash, or, alternatively, settlement may be well after there is liquidity, also frustrating the management team that does not receive a payout at the same time as shareholders.
Management’s third significant concern with traditional equity awards relates to company valuation. Valuation questions arise in a number of different situations. To avoid adverse taxation under deferred compensation tax rules, stock options must be granted with an exercise price no less than fair market value of the covered shares on the date of grant. To comply with applicable tax guidance, many companies seek an independent appraisal, often annually, for purposes of establishing option exercise prices. The appraisal process takes management’s attention away from business development, and the cost of the appraisal adds additional costs to the equity compensation program. A board of directors also must determine current value whenever an event occurs that potentially triggers ordinary income tax recognition of an equity award: when restricted stock is granted (so that an individual knows the value for purposes of determining a § 83(b) election), when restricted stock vests (if no § 83(b) election was filed), when stock options are exercised, and when restricted stock units are settled. Determining how to allocate value between various classes of stock, such as between preferred stock and common stock, is not a trivial matter.
To address the perceived, if not actual, shortcomings of options, restricted stock, and restricted stock units, sophisticated management teams are increasingly requesting profits interests. Profits interests are a form of partnership equity compensation that provide for a right to benefit from future appreciation in the value of the partnership after the date of grant. Specifically, per a 1993 IRS ruling, assuming the profits interest does not relate to a substantially certain and predictable stream of income from partnership assets and is not disposed of within two years of grant, “if a person receives a profits interest for the provision of services to or for the benefit of a partnership in a partner capacity or in anticipation of being a partner, the IRS will not treat the receipt of such an interest as a taxable event to the partner or the partnership.” See Rev. Proc. 93-27. For purposes of this ruling, a profits interest is “a partnership interest other than a capital interest,” and a capital interest is an “interest that would give the holder a share of the proceeds if the partnership’s assets were sold at fair market value and then the proceeds were distributed in complete liquidation of the partnership.” Said differently, a profits interest is a partnership interest in which the recipient is not entitled to any distribution if the partnership were to liquidate and distribute all of the proceeds of its assets on the date of grant. Court decisions provide for support of profits interests treatment beyond that provided by the IRS ruling (see, e.g., Campbell v. Commissioner, 943 F.2d 815 (8th Cir. 1991)), but most practitioners structure profits interests to comply with the ruling for certainty.
The most common implementation of profits interests is to provide that the holder is entitled to partnership distributions only after amounts equal to a “distribution threshold” have been distributed in respect of other partnership interests. Because a partnership interest is a profits interest only if the individual would not be entitled to a distribution if the partnership were to immediately liquidate (on the date of grant of the interest), the distribution threshold must be set at no less than the partnership’s fair market value on the date of grant. In other words, if the partnership has a fair market value of $100 million on the date the award is granted, then at least $100 million must be distributed in respect of other partnership interests before the new interest, intended to be a profits interest, is entitled to a distribution. As a result, the profits interest holder effectively is entitled to a payment only from future appreciation in the value of the partnership.
Alternatively, a profits interest can be structured to provide for earlier distributions, but only to the extent of actual “profits.” On the final liquidating distribution, however, that would occur at the winding up of the partnership (for example, in connection with a sale of the business), the profits interest holder may be entitled to a payment only to the extent of an increase in the value of the business measured from the date the profits interest was granted.
Assuming a partnership interest qualifies as a profits interest, and certain other conditions are met, then neither the grant itself nor vesting results in taxation. See Rev. Proc. 2001-43. Instead, the recipient is taxed on his or her allocation of partnership income based on the nature of the underlying income. For example, if the underlying income is capital gain, then the recipient will recognize capital gain. If the underlying income is a qualified dividend, then the recipient will recognize a qualified dividend. (The authors note that the income is recognized when allocated to the partner by the partnership, even if there is no payment or distribution out of the partnership.) The type of income recognized “passes through” the partnership. If the partnership sells a capital asset it has held for more than 12 months, any partner allocated income as a result of such sale recognizes long-term capital gain, even if the partner has held the partnership interest for 12 months or less. See Rev. Rul. 68-79. If a profits interest is sold or otherwise disposed of, the sale is treated as a sale of a capital asset, and therefore any gain (or loss) is taxed as capital gain (or loss). Although a § 83(b) election is not required for the beneficial tax treatment described in Rev. Proc. 2001-43, recipients of profits interests will often file an election as a protective measure in the event it is later determined that the profits interests did not satisfy the requirements of Rev. Proc. 93-27 (in which case the vesting may be a taxable event).
It is important to note that, under current IRS guidance, profits interests granted in connection with the performance of services generally are treated as not providing deferred compensation. See IRS Notice 2005-1, Q&A-7. The deferred compensation tax rules impose significant limitations on the timing and form of payment of deferred compensation (these rules often apply to settlement of restricted stock units) and limit modifications to deferred compensation. Avoiding these tax rules is generally viewed as another positive attribute of profits interests, as it removes one potential complication from compensation planning.
Because of the pass-through taxation feature of partnerships, general structuring is important to maximize beneficial tax treatment. A common structure is to establish a partnership parent holding company with an operating company subsidiary. In this structure, the only asset of the partnership is the operating company subsidiary. Profits are held in the operating company, avoiding tax to the holders of partnership equity interests until amounts are transferred to the partnership from the operating company subsidiary, usually in the form of a dividend. On payment of the dividend from the operating company subsidiary to the partnership parent, the dividend income is allocated to partners. Assuming the dividend meets the criteria for a qualified dividend, noncorporate holders of partnership equity, including profits interests, recognize income, but receive preferential qualified dividend treatment, when they are allocated their portion of the dividend received by the partnership. See IRC §§ 1(h)(11) and 702(a)(5). This permits the dividends to be taxed to the partners at long-term capital gain rates instead of at ordinary income rates. To be a qualified dividend, the operating company must be a U.S. corporation or a qualified foreign corporation, the partnership/subsidiary structure generally must have been in place for at least 60 days, and the dividends must not be a “capital gains distribution.” (If the dividends are capital gains distributions, then, instead of qualified dividend treatment, income allocation would be taxed as long-term capital gain, regardless of the actual holding period of the profits interest.)
If the operating company is sold in an asset sale, the holders of profits interests likely will recognize capital gain when proceeds from the sale are allocated to the partners. If partnership interests, including profits interests, are purchased by a third party, the holders of profits interests will recognize capital gain in accordance with the general tax rules that apply to the sale of a capital asset (except as provided in IRC § 751).
Because there is no tax on grant or vesting, and because there is no equivalent of an option exercise with profits interests, taxation with no liquidity as a general issue does not apply. Instead, the partnership equivalent is taxation without a distribution. Because of the pass-through taxation feature of partnerships provided by Part I of Subchapter K of the Code (IRC §§ 701 through 709), if there is no corresponding distribution when income is allocated to partners, the partners will recognize income without receiving any associated cash payment that they can use to cover the related taxes.
Three common methods avoid income allocation without a distribution for profits interest holders. The first is to address income allocation through general structuring. If the partnership is a holding company, with an operating company subsidiary, so long as income remains in the operating company subsidiary, there is no income to allocate at the partnership level. In most cases, the controlling partners will not cause income to be moved (via dividend) from the subsidiary to the partnership without a corresponding distribution from the partnership to the partners because, in the absence of a distribution, the controlling partners will recognize income without receiving a payment.
A second method to address the same issue is to provide for tax distributions in the partnership agreement. The partnership agreement is the basic governance document of the partnership, setting forth the obligations and benefits that flow from holding various partnership interests. The partnership agreement might provide that to the extent partners are allocated income, those partners also will receive a distribution to cover applicable taxes. Often the distribution is at a fixed rate, such as 40% of the income allocated.
The third method is to delay income allocation until a liquidity event. Specifically, the partnership agreement might provide that no holder of profits interests is allocated income until a liquidating distribution. In other words, no payment is provided in respect of a profits interests until the partnership, or its assets, is sold.
Although profits interests do not eliminate valuation questions, the related issues are greatly simplified when profits interests are the sole form of equity compensation. First, in general, the only point in time in which a valuation is relevant is at the time of grant. To ensure that the interests are characterized as “profits interests,” as defined in Rev. Proc. 93-27, the value of the partnership must be determined at grant so that the profits interest can be structured to provide no payment if the partnership were immediately liquidated, with the value of assets distributed in respect of partner interests. There are no subsequent valuation events with respect to profits interests. Second, the valuation method is much simpler. When determining the value of a partnership for purposes of profits interests, a simple liquidation analysis is appropriate. The valuation must answer the question—if the partnership were liquidated today (on the date of grant of the profits interest), what is the value of its assets? This type of analysis is usually simpler than the valuation analysis that is used to support option grants.
One additional benefit of profits interests, or any other partnership equity compensation, is the significant flexibility in designing how income will ultimately be allocated in respect of all of the various partnership interests, referred to as the “waterfall.” For example, the profits interest holders could be allocated a greater percentage of income as the value of the partnership increases or if specified performance objectives are satisfied, all while maintaining preferential tax treatment. The only limitation is that the holder of a profits interest not be entitled to a payment if the partnership were liquidated on the date the interest is granted.
A particularly interesting income allocation provision is a “catch-up” provision. A catch-up provision typically provides that the holder of a profits interest is allocated the first dollars of income, after income allocations equal to the distribution threshold, until the holder has received allocations so that he or she is “caught-up” on his or her proportionate interest. In other words, if a profits interest is granted with a distribution threshold of $95 million and the holder is entitled to 5% of the interest of the partnership, a catch-up feature would provide that after $95 million is allocated in respect of other interests, the next $5 million is allocated in respect of the profits interest, and thereafter the profits interest holder is entitled to 5% of all distributions. This effectively mirrors a generic capital interest over 5% of the value of the enterprise, such as restricted stock, while still maintaining the tax benefits of profits interests (so long as the partnership appreciates in value to the extent sufficient to pay the full catch-up). Alternatively, a more generic profits interest, providing for allocations only after prior distributions of at least a specified distribution threshold, mirrors the general economics of an option (ignoring tax consequences) with an exercise price equal to the distribution threshold but expressed on a per share basis.
Often overlooked are “unrecognized” profits interests. These are profits interests that look like another form of equity compensation but are characterized as profits interests by operation of U.S. tax law. This most commonly occurs when a non-U.S. corporation is established, such as a Cayman company, with a preferred and common class of shares, and such corporation is eligible to elect, and does so timely elect, to be taxed as a U.S. partnership (that is, such corporation is not a per se association described in Treas. Reg. § 301.7701-2(b)(8)). If shares in such a company of the common class of stock are granted as an award of restricted stock, when the fair market value of the corporation equals the preferred liquidation preference, the grant of restricted stock is actually a profits interest, as defined in Rev. Proc. 93-27. By way of example, assume a Cayman corporation with a preferred class and common class of ordinary shares. Furthermore, assume the preferred class has a liquidation preference of $100 million (meaning, in general, that if the company were liquidated, $100 million would be paid to the preferred shareholders before any amounts were paid to the common shareholders). If common ordinary shares are granted when fair market value of the company is $100 million or less, those shares, which appear to be an award of restricted stock, are actually profits interests. The corporation has elected to be taxed as a partnership for U.S. tax purposes, and if the partnership were liquidated on the date of grant of the ordinary shares, no amounts would be paid in respect of those shares (because of the $100 million liquidation preference in favor of the preferred shares). Thus, the requirements of profits interests have been satisfied, and neither the grant of the profits interests nor the vesting of such profits interests should be taxable to the parties, assuming that either (1) the conditions provided by Rev. Proc. 2001-43 are satisfied or (2) the recipient of such profits interest files a § 83(b) election immediately after the receipt of the common ordinary shares.
As is explained above, profits interests have many advantages over options, restricted stock, and restricted stock units. Hedge funds, in particular, have been active in granting profits interests to provide beneficial tax treatment to employees. This has not escaped the attention of Congress, and Congress frequently debates whether the continued preferential tax treatment of profits interest is appropriate. Various proposals in recent years (as recently as 2014) would tax all or a portion of income received through carried interests (a form of profits interests commonly used by hedge funds) as ordinary income. For example, see section 3621 of the draft of the Tax Reform Act of 2014 released by U.S. Rep. David Camp (R-Mich.), chair of the House Ways and Means Committee, on February 26, 2014. As of the date of this article, however, profits interests holders still enjoy beneficial tax treatment. So long as this continues, the authors expect the use of profits interests in lieu of traditional forms of equity awards to continue to increase.
