Practical Considerations for Issuing Profits Interests, Part 2

Practical Considerations forIssuing Profits Interests, Part 2By Afshin Beyzaee

Table of Contents

III. Structuring Profits Interests . . . . . . . . . . 1277A. Structuring Techniques . . . . . . . . . . . . 1277B. Timing Considerations . . . . . . . . . . . . . 1281C. Drafting Approaches . . . . . . . . . . . . . . 1282D. Issuing Unvested Profits Interests . . . . . 1284E. Tax Allocations . . . . . . . . . . . . . . . . . . 1286

F. Boilerplate Profits Interests Provisions . . 1288IV. Practical Considerations . . . . . . . . . . . . . 1289

A. Tax Reporting . . . . . . . . . . . . . . . . . . 1289B. Self-Employment Taxes . . . . . . . . . . . . 1289C. Type of Partnership Interest . . . . . . . . . 1290D. Profits Interests’ Voting Rights . . . . . . . 1290E. Tax Distributions . . . . . . . . . . . . . . . . . 1291F. Multiplicity of Partners . . . . . . . . . . . . 1291G. Drag-Along Provisions . . . . . . . . . . . . 1292H. Tag-Along Provisions . . . . . . . . . . . . . 1294I. Valuation of Partnership and Assets . . . . 1294J. Revaluation of Partnership Assets . . . . . 1295K. Top-Up Profits Interests . . . . . . . . . . . . 1296L. Grants Not From Partnership . . . . . . . . 1296M. Disqualification Issues for

Partnership . . . . . . . . . . . . . . . . . . . . 1297N. Proposed Carried Interest Legislation . . 1297

V. Probably-Not-Final Thoughts . . . . . . . . . 1297

III. Structuring Profits Interests

There are almost infinite possibilities for structur-ing variations on the profits interests, giving prac-titioners and business owners great flexibility inachieving their desired outcomes. This section willprovide some examples of how profits interests arestructured, followed by drafting techniques forimplementing those structures.

A. Structuring Techniques

There are many ways to economically structureprofits interests. This section will examine severalapproaches that can be used, but they are by nomeans exhaustive — creative taxpayers and practi-tioners can certainly develop others.

1. Fixed profit share. The most common form ofprofits interest is probably one in which the holderis entitled to share in a fixed percentage of any gainsor profits above the value of the partnership at thetime the interest is granted, or some higher speci-fied threshold. For example, if the partnership isworth $1 million when the profits interest isgranted, the holder might be entitled to 5 percent ofall gains and profits exceeding $1 million. Alterna-tively, the holder might be entitled to 5 percent of allgains and profits exceeding $1.5 million or 5 percentof all gains and profits after the existing partnershave received the $1 million plus a preferred returnthereon.

Afshin Beyzaee

Afshin Beyzaee is a part-ner in the Los Angeles officeof Liner LLP, where heheads the firm’s tax practice.The author would like tothank Hatef Behnia and J.Nicholson Thomas for theirinvaluable comments andsuggestions.

In this report, Beyzaeediscusses how profits inter-

ests can provide an equity incentive to peopleproviding services to a partnership. The tax treat-ment to the recipient is favorable, and there arealmost endless possibilities in terms of how theyare structured. But their use raises a host of issues,in both implementation and administration, thatpractitioners should be attuned to. And althoughprofits interests have been sanctioned by the IRS forsome time, many unanswered questions about theirtreatment remain.

This report is being published in two parts. Thefirst part, published June 9, discussed the currentstate of the law governing profits interests. Thissecond part includes practical guidance for estab-lishing these arrangements.

The information contained herein is of a generalnature and is based on authorities that are subject tochange. Its applicability to specific situationsshould be determined through consultation withyour tax adviser. This report represents the views ofthe author only and does not necessarily representthe views or professional advice of Liner LLP.

Copyright 2014 Afshin Beyzaee.All rights reserved.

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This structure would clearly satisfy the safe har-bor requirement that the profits interest have a zeroliquidation value. The one caveat, however, is thatthe parties must be confident that the specifiedvalue for allowing the profits interest holder toparticipate is not below the current liquidationvalue of the partnership.117

2. Catch-up right. A problem with the kind ofprofits interest described above is that a serviceprovider that is promised a fixed percentage of theentire partnership for its services is really not get-ting a share of the existing value of the partnership.Although it does not exactly accomplish this goal,there is a second approach that attempts to approxi-mate that result while still qualifying as a profitsinterest: Allocate the first gains and profits of thepartnership only to the profits interest holder untilthe holder is economically pari passu with the otherpartners and only thereafter sharing gains andprofits pro rata.

Example 13: Partnership AB is worth $1 millionwhen a service provider, C, is granted a profitsinterest. The parties want to give C a one-thirdinterest in the partnership. This catch-up approachwould allocate the first $500,000 of gains and profitsand one-third of all subsequent gains and profits toC.118 Table 1 shows what C would receive in ahypothetical liquidation of the partnership in thisexample at various liquidation values:

A prime example of this approach is in connec-tion with the management fee waiver techniqueused in many private equity funds. There, the

partnership interest received by the waiver partnertypically entitles the holder to this kind of catch-upallocation until the amount of the management fee‘‘waived’’ is reached and then a pro rata share offuture gains and profits of the fund is distributed.119

This approach can itself take many differentforms. For example, the catch-up need not start atthe value of the partnership at the time of the grant;instead, it can apply starting at a higher threshold(perhaps $1.2 million in Example 13). Likewise, thecatch-up does not need to provide the same per-centage of the existing value as the future sharingpercentage. So the holder might get only a 5 percentcatch-up on existing capital, together with a 10percent share of future profits, or a 10 percentcatch-up with a 5 percent share of future profits.

As with the first approach, this structure wouldclearly satisfy the safe harbor requirement of havinga zero liquidation value. But here again, even moreso than in the first approach, the parties should becareful not to underestimate the existing value ofthe partnership. Because of the ‘‘juiced’’ catch-uprights of the profits interest, the holder of the profitsinterest would likely be taxed immediately to thefull extent of any understatement of value becauseall that value would accrue to the interest. InExample 13, if the value of the partnership werereally $1.2 million but the parties treated it as only$1 million, the profits interest would have a liqui-dation value of $200,000 upon grant, which amountwould likely be fully taxable to C at the time ofgrant.3. Gross allocations. A more exotic technique is tostart with one of the first two approaches but add a‘‘gross’’ twist. Tax items arising after the date ofgrant (not including built-in gains and losses) areallocated on a gross basis (that is, allocations ofgross items of profits and losses, rather than netprofits or losses) among the partners, with grossprofits being allocated to the profits interest holderand gross losses allocated to the other partners untiltheir respective capital accounts match up with thedesired economics. The holder of the profits interestwill at no time be entitled to share in any value inexcess of its capital account.

Example 14: Partnership AB has a liquidationvalue of $1 million, consisting entirely of cash,when a profits interest is granted to a serviceprovider, C. The business goal is that C share in 10percent of all value of the partnership, so this grossallocation approach is used. In the first year after

117See Section IV.I for a discussion of valuation issues.118The amount of the initial catch-up allocation can be

calculated using the following formula, where x is the percent-age of the partnership to be given to the profits interest holder:

Catch-Up Amount = (1 - )x

Value of Partnership at Grant

The profits interest holder’s share of liquidation proceedscan be represented by the following Excel formula:

= min max l - i x l( )(0, ( )), ( * )

wherex = the profits interest holder’s sharel = the liquidation value of the partnership at liquidationi = the liquidation value of the partnership at the time of thegrant of the profits interest.

119For a more detailed analysis of the management feewaiver approach, see Afshin Beyzaee, ‘‘Current Tax StructuringTechniques for Private Equity Funds,’’ 20 J. Tax’n & Reg. of Fin.Inst. 16, 18-20 (May/June 2007).

Table 1 — Example 13AB Liquidation

ValueC’s Share of

ProceedsC’s Percentage

of Value$500,000 $0 0%

$1,000,000 $0 0%$1,200,000 $200,000 16.67%$1,500,000 $500,000 33.33%$3,000,000 $1,000,000 33.33%

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grant, the partnership has no net profits or netlosses (that is, it breaks even for tax purposes),consisting of $100,000 of gross profits and $100,000of gross losses. The partnership allocates $100,000 ofgross profits to C, bringing its capital account up to$100,000, and $100,000 of gross losses to the otherpartners, bringing their aggregate capital accountsdown to $900,000. When the partnership later liq-uidates at a liquidation value of $1 million, Creceives $100,000 and the other partners receive$900,000. Table 2, above, shows other outcomesbased on different amounts of gross profits andlosses of the partnership.

As Example 14 illustrates, there are situations inwhich even if the partnership has an overall netloss, the profits interest holder will receive a full 10percent of the liquidation proceeds.

Because the safe harbor looks to whether theprofits interest shares in any proceeds on a hypo-thetical liquidation generally tested at the time ofreceipt, this type of profits interest should againqualify for the safe harbor. That said, the reliance ongross allocations rather than a form of net alloca-tions significantly increases the likelihood that theholder will share in distributions from the partner-ship. This alone should not be a problem. But if thepartnership has any gross items of income that aresubstantially certain and predictable, this approachmay result in the interest failing the requirementthat it not relate to a substantially certain andpredictable stream of income.120

When implementing this approach, the partner-ship should take care at the time of grant to identifyexisting built-in gains and not allocate those to theprofits interest recipient.121 This will prevent theinterest from sharing in the liquidation value of thepartnership in violation of the safe harbor rules. Asdiscussed below, taxpayers can consider a non-safe-harbor profits interest that permits a sharing ofthose built-in gains, but that feature raises addi-tional risks.122

One other thing to be careful about is howleveraged distributions are addressed. Because sim-ply incurring debt does not add to the partners’capital accounts, if holders of profits interests arenot permitted to share in distributions that exceedtheir capital accounts, they would likely be unableto participate in some or all of any leverageddistributions. As mentioned above, it is unclearwhether permitting them to share in those distribu-tions would spoil the profits interest treatment.123

But if profits interest holders are to participate inthose leveraged distributions, a special dispensa-tion from this rule should be included to permitthat.4. Capped participation. In some cases, the partieswant the service provider to share in some of thegrowth of the partnership but not above a specificpoint. In that situation, they might cap the partici-pation of the profits interest.

Example 15: Partnership AB is worth $1 millionwhen a service provider, C, is granted a profitsinterest. Under this capped participation approach,C could be given 10 percent of only the first $2million of the partnership’s gains and profits.

Some might argue that this kind of profits inter-est is not a true partnership interest. But the fact thatits participation is limited should not alone convertan otherwise real partnership interest into someother kind of arrangement.124 If preferred stockwith merely a preference on liquidation can berespected as equity, there is no reason a profitsinterest whose participation is capped would notbe.125 Moreover, the interest will still have featuresdiscussed above that would support treatment of itsholder as a partner.126

That said, once the profits interest has receivedthe full amount of its participation, it would likelybe viewed as though that partnership interest ter-minated for tax purposes, because the holder would

120See Section II.E.1 (Part 1 of report).121One way to accomplish this is to revalue partnership

assets in connection with the grant. See Section IV.K.122See Section III.A.6.

123See Section II.F.4 (Part 1 of report).124See Section II.E.5.e (Part 1 of report).125See TAM 200116002 (preferred stock with no dividend

rights and preference on liquidation respected as stock).126See Section II.E.5.e (Part 1 of report).

Table 2 — Example 14

Net Profit (Loss)

Gross Profit toProfits Interest

PartnerGross Losses toOther Partners

LiquidationProceeds

Profits InterestProceeds

Percentage ofProceeds

($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%



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no longer have any economic rights in the partner-ship. So, parties that are concerned about the effectof such an interest disappearing should ensure thatthey limit distributions to avoid the participationbeing satisfied or that the holder otherwise has apartnership interest that will not terminate.5. Liquidity event participation. As mentionedabove, one of the problems with granting a profitsinterest is that the holders will generally be allo-cated a share of a partnership’s current income,which, for an operating business, is normally ordi-nary income.127 However, many people ask why theprofits interest holder can’t have capital gain treat-ment. One way to largely achieve that result is topermit the profits interest to participate only inspecified liquidity events.

This approach gives profits interests only a rightto gains and losses on specific events that resultprincipally in capital gain income. Those eventsmight include the sale of particular capital assets ora sale of all or a division of the partnership busi-ness.128

Example 16: Partnership AB is worth $1 millionwhen a service provider, C, is granted a profitsinterest. The profits interest entitles C to 10 percentof any gains realized by AB upon a sale of thepartnership business. If the partnership business islater sold for $1.2 million, C will receive a distribu-tion of $20,000 (20 percent of $200,000).

In this example, C would not participate in theoperating income of the partnership, so it would bereasonable not to allocate any of that ordinaryincome to C. A better approach would be to allocateto C only its share of the gain on the sale of thepartnership business, which would likely be prin-cipally capital gain.129

A few things to keep in mind: First, as with thegross allocations approach, the parties should re-value the assets or otherwise ensure that the profitsinterest holder does not share in existing built-ingain in the business unless the parties knowinglytake on the risks described below in Section III.A.6.Second, the parties should be sensitive to the riskthat if they too closely link the distribution rights tospecific assets, the interest will be treated as aninterest in those assets rather than a partnership

interest.130 Third, the parties should consider in-cluding a provision in the partnership agreementthat would allocate sales proceeds on a sale of theequity of the partnership to avoid a discount on therelative value of the profits interests because ofthese limitations.6. Share of built-in gain. Yet another approachbuilds on the gross allocations approach by lookingnot just to future gains and profits but also toexisting built-in gains and profits to build theprofits interest holder’s capital account.131

Example 17: Partnership AB has a liquidationvalue of $1 million, consisting of property worth $1million with a tax basis of $700,000 and no debt. Thebusiness wants C to share in 10 percent of all valueof the partnership, so the share of built-in gainapproach is used. The profits interest is given theright to share in any gains or profits of the partner-ship, including the $300,000 of built-in gain. If theproperty were sold for $800,000, C could still re-ceive $80,000, because $100,000 of gain would berecognized by the partnership. Along with that, Cwould be allocated $80,000 of the partnership gainrecognized on the sale of the property.

Obviously, a profits interest granted under thisapproach would not qualify for safe harbor treat-ment because if there were an immediate hypotheti-cal liquidation, the holder of the profits interestwould receive a distribution. Instead, this approachis based on a rather aggressive reading of the law.The theory is that because the value to the recipientis still based on recognizing a gain on property heldby the partnership, that value is still speculative.And because the profits interest holder is allocateda corresponding portion of the taxable income, theholder is in no different tax position than if it weregranted an identical interest when the value of theproperty equaled its book value. Indeed, if theprofits interest holder were taxed on the receipt ofthe interest and still allocated a share of the income,the holder would effectively be double-taxed onthat income and left only with excess outside basisthat it could not use until it disposes of the profitsinterest.132

The IRS would almost certainly challenge thegrant of this kind of interest being treated asnontaxable. In GCM 36346, the IRS Office of ChiefCounsel considered a revenue ruling that would

127For partnerships that have principally investment assetsheld for appreciation (rather than current income), such asprivate equity funds, this is not as much of a concern, becausethe partnership’s income will be primarily capital gain.

128Subject to the discussion in Section II.F.4 (Part 1 of report),the profits interest may also be able to participate in somerefinancing proceeds.

129The gain attributable to ‘‘hot assets’’ that would be treatedas ordinary income under section 751.

130See supra text accompanying note 93 (Part 1 of report).131To accomplish this, the partnership should not revalue its

assets when the profits interest is granted. See Section IV.K.132And if there is a loss on that later disposition, the taxpayer

may never recoup that second tax on the income because it isseverely limited in its ability to (or, for individuals, unable to)carry back that loss or use it to offset other kinds of income (inthe case of a capital loss).



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have treated built-in gain as part of the ‘‘capital’’ ofa partnership that would be taxable to the extent aservice provider received a partnership interest thatwould participate in that built-in gain. As supportfor that conclusion, the revenue ruling pointed tolegislative history for a bill that was never passed.The revenue ruling was never approved or issued,but was ‘‘deferred pending further discussion of thealternative positions available to the Service inresolving the issue involved.’’133 Moreover, itsanalysis was not included in either of the revenueprocedures when they were eventually released.Nevertheless, it suggests that the IRS is inclined totreat interests granted under the share of built-ingain approach as capital interests rather than prof-its.

Thus, while this approach has some appeal, itwill likely face significant scrutiny, and it is veryuncertain whether courts would agree with it.Other factors may heighten the risks, such as situ-ations in which the asset with built-in gain is veryliquid (such as marketable securities) or otherwiseeasily valued, or the asset is being held out for saleor marketed at the time of the grant of the profitsinterest or is disposed of shortly after the profitsinterest is granted. Accordingly, any practitioner ortaxpayer contemplating this structure should treadlightly and carefully consider the risks beforeadopting it.7. Deficit restoration obligation. Although I havenot seen an example of this out in the wild, anotherpossible way of permitting a profits interest holderto share in distributions from the time of grant is tosubject any pre-profit distributions to a deficit res-toration obligation. The idea here is that by impos-ing a deficit restoration obligation, the result of anyimmediate distributions is still that the profits in-terest holder would not receive any net proceeds ona hypothetical liquidation.

This approach would not be particularly appeal-ing to a profits interest holder in the ordinarycourse, however, because the holder would initiallyhave no basis in the interest. Even though thedistribution would be subject to a deficit restorationobligation, the holder would be taxed on the distri-bution if it were a distribution of cash.134 In the longrun, the holder would receive an offsetting loss onthe disposition of the interest, but that is likely to beof little comfort to the holder.

Still, there may be some situations in which thisapproach would have appeal. One might be whenthere will be distributions of property. The holder ofthe profits interest would receive a carryover basis

in the distributed property, limited by the holder’soutside basis (presumably of $0), rather than recog-nize gain.135

Likewise, this approach might be appealing ifpartnership liabilities are allocated to the partner.As discussed above in Section II.F.3 (Part 1 ofreport), the holder’s share of the liabilities shouldcreate basis, which could shelter some of the distri-butions.

Example 18: The facts are the same as in Example12, but the partnership has a provision that wouldrequire C to restore any negative capital account tothe partnership on a liquidation of the partnership.

In this example, presumably the profits interestholder could receive up to $30,000 of distributionson a tax-free basis while potentially still qualifyingfor safe harbor treatment.

Unfortunately, there is no guidance on this typeof approach to profits interests. Neither the revenueprocedures nor the proposed compensatory inter-ests regulations provide any guidance on howdeficit restoration obligations are treated when de-termining the liquidation values of partnershipinterests. Moreover, this is not an approach that iscommonly used in the market (if ever). Therefore,practitioners and taxpayers should again take carewhen adopting it.

B. Timing ConsiderationsThe foregoing discussion of structuring tech-

niques addressed how the overall economics of thepartnership are to be shared. But it does not specifi-cally address the issue of timing. For many, thequestion of when a partner will share in distribu-tions is at least as important as the question of theamount of distributions.

Some tend to think about profits interests ashaving a ‘‘last-out’’ right to economics of the part-nership. In other words, they think the other part-ners must get the full liquidation value distributedto them before the profits interest holder can share.But this is not the case. As long as there are profits,the profits interest holders can share in currentdistributions and still fall within the safe harbor.

Example 19: Partnership AB is worth $1 millionwhen a service provider, C, is granted a profitsinterest. Partnership AB has $100,000 of net profitsin year 1. There is no reason why C cannot get up to$100,000 of distributions in year 1.

Provided the right to distributions depends onthe partnership having profits, the interest does notviolate the prohibition on receiving any proceeds ona hypothetical liquidation at the time of grant. This

133GCM 36346.134Section 731(a). 135Sections 731, 732.



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is useful for partnerships that want to begin sharingdistributions with profits interest holders rightaway.

Oddly, perhaps, it appears that there is not evena requirement that the partnership have net taxablegain or profits to allow a holder of a profits interestto share in distributions and still qualify for the safeharbor. For example, in capital-intensive partner-ships, such as real estate partnerships, depreciationor amortization deductions may exceed any taxablereceipts. The partnership may have a positive cashflow, even with no net taxable income. Alterna-tively, the partnership may hold an asset with abuilt-in loss when the profits interest is granted. Thevalue of the property may later increase to equal itstax basis before being sold. In either case, the holderof the profits interest may well have had no share inthe liquidation value of the partnership when it wasgranted, but the value of the partnership propertyhas now increased to the point at which the holderwould share in a liquidation of the partnership.136

There is no apparent reason why allowing theholder of the profits interest to share this wayshould take it out of the safe harbor treatment.

C. Drafting ApproachesJust as there are a variety of ways to structure

profits interests, there are several drafting ap-proaches. This section will summarize three catego-ries of drafting techniques. The first category relieson the specific distribution waterfall(s) in the part-nership agreement to establish the profits interest(the waterfall-driven approach). The second cat-egory relies on assigning each profits interest adistribution threshold to qualify it as a profitsinterest (the distribution threshold approach). Thethird category relies on general language in theagreement limiting distributions to profits interestsas a way to qualify it as a profits interest (the safeharbor limiter approach).

This discussion is far from exhaustive. Many ofthe structures described above require careful draft-ing that is beyond the scope of this report. My hopeis, however, that these examples will help novices togain a footing, as it were, in the land of profitsinterests.1. Waterfall-driven approach. The waterfall-drivenapproach involves drafting the basic distribution, orwaterfall, provisions of the partnership agreementin a way that results in specified interests beingprofits interests. For example, the waterfall mightprovide that distributions be made only to the

existing partners until a specific amount equal to orgreater than the liquidation value is distributed,followed by distributions to all partners:

Distributions shall be made in the following orderand priority:

a. first, to all Preferred Partners,137 pro ratain proportion to the Percentage Interests138 ofeach partner at such time, until one milliondollars ($1,000,000)139 has been distributedpursuant to this subparagraph, andb. thereafter, to all partners, pro rata inproportion to the Percentage Interest of eachpartner at such time.

Or, if at the time the profits interest is granted,the aggregate capital contributions of the otherpartners equals or exceeds the liquidation value ofthe partnership and no distributions have beenmade to the partners, the waterfall might providethat distributions first return capital and then beshared pro rata:


a. first, to all partners, pro rata in proportionto the Unreturned Capital140 of each partnerat such time, until the Unreturned Capital ofall partners is reduced to zero ($0), and

b. thereafter, to all partners, pro rata inproportion to the Percentage Interest of eachpartner at such time.

If the partnership has more than one waterfall —such as one waterfall for current distributions andanother for liquidating distributions — then, at aminimum, the waterfall for liquidating distribu-tions should be drafted in accordance with one ofthe foregoing. Whether all of the waterfalls need tosatisfy these tests will depend on how the partiescome out on the no liquidation value test.141

This approach is the simplest to draft, but it doesnot easily adapt to changing circumstances. Thefirst example would not take into account futurecapital contributions by the partners. If the liquida-tion value of the partnership increases after the first

136These situations would likely result in unintuitive taxallocations (or lack thereof), outside basis that does not matchcapital accounts, taxable distributions, or combinations of these.

137‘‘Preferred Partners’’ would be defined to include allpartners other than the profits interest holders.

138‘‘Percentage Interest’’ would be defined to represent thepercentage of the residual gains and profits that each partner isentitled to.

139The amount used here (less any previous distributions)must be equal to or higher than the liquidation value of thepartnership when the profits interests are granted.

140‘‘Unreturned Capital’’ would be defined as the aggregatenet capital contributions made by a partner, less the amount ofany distributions made to the partner under clause (a).

141See Section II.E.1 (Part 1 of report).



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profits interest is granted, neither example couldaccommodate the granting of later profits interests.As a result, new situations like those would requireamendments to the partnership agreement. More-over, several of the structuring techniques dis-cussed above would be difficult or impossible toimplement by simply using this approach.2. Distribution threshold approach. Under thedistribution threshold approach, the primary water-fall is essentially left untouched. Instead, the realaction comes from the use of a ‘‘distribution thresh-old’’ to prevent holders of profits interests fromsharing in the existing value of the partnership.

With this approach, each profits interest that isissued is assigned a distribution threshold. Thedistribution threshold must be an amount at orabove the liquidation value of the partnership at thetime the profits interest is granted.142 A provision isthen included in the partnership agreement thatprevents any distributions from being made inrespect of the profits interest before aggregate dis-tributions equal to the distribution threshold havebeen made to all other partners:

Notwithstanding [the normal distribution and liq-uidation provisions], no distributions shall be madein respect of any partnership interest with a Dis-tribution Threshold (‘‘Profits Interest’’) unless anduntil aggregate distributions previously or concur-rently made in respect of all other partnershipinterests since the date of issuance of such ProfitsInterest equal or exceed the Distribution Thresholdof such Profits Interest at such time.

Alternatively, the partnership agreement cantreat those interests as not outstanding for thepurposes of the distributions until the distributionsthreshold has been met:

Solely for the purposes of making distributionspursuant to [the normal distribution and liquida-tion provisions], any partnership interest with aDistribution Threshold (‘‘Profits Interest’’) shall betreated as not outstanding unless and until aggre-gate distributions previously or concurrently madein respect of all other partnership interests since thedate of issuance of such Profits Interest equal orexceed the Distribution Threshold of such ProfitsInterest at such time.

When the partnership agreement designatespartnership interests as units, the agreement caninstead use a concept of an eligible unit in thedistributions. That concept can then be included in

any step of a waterfall in which the profits interestis to participate once the distribution threshold ismet:

‘‘Eligible Unit’’ means at any time (i) each out-standing Common Unit143 and (ii) each outstand-ing Profits Unit with respect to which an amountequal to its Distribution Threshold has been dis-tributed to the partners (other than in respect ofsuch Profits Unit144) subsequent to the issuance ofsuch Profits Unit pursuant to the provisions of thisagreement.

* * *

Distributions shall be made to all partners, pro ratain proportion to the number of Eligible Units heldby each at such time.

OR


a. first, to the partners holding CommonUnits, pro rata in proportion to the Unre-turned Capital in respect of the CommonUnits held by each partner at such time, untilthe Unreturned Capital in respect of eachCommon Unit is reduced to zero ($0), and

b. thereafter, to all partners, pro rata inproportion to the number of Eligible Unitsheld by each at such time.

Another important aspect of this approach is toaccount for capital contributions made after thedate the profits interest is granted. If there is noth-ing that adjusts the rights of the holders of profitsinterests, this can result in a capital shift to theprofits interest holder. Given that a profits interest,by definition, is given in connection with the per-formance of services, any capital shift to the holderof the interest is likely to result in ordinary incomefor the holder.145 To avoid a capital shift, the distri-bution threshold for some profits interests mayneed to be adjusted at the time of the contribution:

Unless otherwise determined by the general part-ner, the Distribution Threshold applicable to each[Profits Interest/Unit] shall be adjusted upward bythe amount of any capital contributions made to thepartnership at the time such capital contributionsare made.

142The distribution threshold would typically be specified inany documentation, such as a grant agreement, whereby theprofits interest is issued.

143Common units would be held by the non-profits-interestpartners.

144This parenthetical is included to account for tax distribu-tions made regarding a profits interest, as discussed in SectionIV.E.

145See reg. section 1.721-1(b)(1).



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There will be situations in which a capital con-tribution will not on its own result in a capital shiftto the holder of the profits interest.146 But moreoften it will result in a capital shift absent anadjustment in the distribution threshold.147 Accord-ingly, it is wise to make the default adjustment asconservative as possible and let the general partner(or other decision maker or makers) make a differ-ent adjustment if appropriate.

This approach has many advantages: It is anunobtrusive way to insert a profits interest me-chanic into an existing agreement or form of agree-ment. It allows for easily granting future profitsinterests without further amendments to the agree-ment. Business people and profits interest recipientshave little difficulty understanding how the me-chanic works. And from an operational perspective,it is not difficult to account for the economics ofeach profits interest if the partnership’s financialrecords are otherwise in good order.3. Safe harbor limiter approach. The safe harborlimiter approach operates again not by adjustingthe normal waterfalls of the partnership but byproviding an override mechanism to establish theprofits interest status. The override is simply arequirement that distributions for a profits interestbe limited to the extent necessary for the interest toqualify for the safe harbor treatment:

It is the intention of the partners that distributionsunder this agreement with respect to [ProfitsInterests/Units] be limited to the extent necessaryso that each [Profits Interest/Unit] constitutes a‘‘profits interest’’ for federal income tax purposesunder Rev. Proc. 93-27, Rev. Proc. 2001-43, andany final Treasury regulations concerning the U.S.federal income tax consequences of the grant andforfeiture of compensatory partnership interests,and, in effect, will only be entitled to distributionsunder [the normal distribution and liquidationprovisions] to the extent of the income, gains, orprofits generated by the partnership’s assets andactivities, or the subsequent (or, to the extentconsistent with the intent expressed above, prior)appreciation in the assets of the partnership afterthe grant of the [Profits Interests/Units]. In fur-therance of the foregoing, the [general partner]shall, if necessary (as determined in its sole good-

faith discretion), limit distributions in respect ofany [Profits Interests/Units] under [the normaldistribution and liquidation provisions] so thatsuch distributions, in the aggregate, do not exceedthe amount necessary to preserve such character-ization (as determined by the [general partner] inits sole good faith discretion). If the distributions inrespect of the [Profits Interests/Units] are reducedpursuant to the preceding sentence, an amountequal to such excess distributions shall be treatedinstead as apportioned to the other partners under[the normal distribution and liquidation provi-sions], and the [general partner] shall make appro-priate adjustments (as determined by the [generalpartner] in its sole good faith discretion) to futuredistributions, if any, to the partners receiving suchexcess distributions so that the amount distributedin respect of such [Profits Interests/Units] (subjectto and consistent with the principles of this para-graph) equal the amount that would have beendistributed in respect of such [Profits Interests/Units] but for this paragraph.The effect of this language is to make a profits

interest as close as possible, economically, to anyother partnership interest. So it is an ideal way toimplement the catch-up form of a profits interestand to allow current distributions to holders ofprofits interests. Moreover, it automatically ac-counts for any capital contributions made to thepartnership after the grant of a profits interest.

That said, this approach is more difficult toadminister than the previous approaches. It re-quires someone to make a legal determination ofwhether a profits interest can participate in thedistribution and, if so, how much. As a result, thepartnership will typically need to look to its taxadvisers for assistance before making any distribu-tions. Also, given the areas of ambiguity surround-ing profits interests, it may be unclear how muchdistributions must be limited. Therefore, it is impor-tant to have clear language that establishes howthat determination is to be made to avoid disputesover the amounts of the distributions. In the textabove, for example, that determination is to bemade by the general partner in its sole good-faithdiscretion.

D. Issuing Unvested Profits InterestsThe parties will also typically want to impose

vesting restrictions on profits interests that aregranted in anticipation of future services. Again,there is no single way to treat unvested profitsinterests. Here I will go over three different ways totreat distributions for unvested profits interest: cur-rent sharing of distributions, withholding of distri-butions until vesting, and no sharing ofdistributions before vesting. These types of provi-sions can generally be used in conjunction with any

146This might happen, for example, when the distributionthreshold for a profits interest is higher than the liquidationvalue of the partnership immediately after the capital contribu-tion.

147This might happen, for example, when the distributionthreshold is exactly equal to the liquidation value of thepartnership immediately before the capital contribution and thepartner making the capital contribution is not entitled to apriority return of capital in the distribution waterfall.



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of the drafting approaches described above in Sec-tion III.C. Special considerations for profit and lossallocations for these interests will be addressedbelow in Section III.E.3.1. Current sharing of distributions. First, the part-nership agreement can provide that for the pur-poses of distributions, an unvested profits interestwill be treated the same as if it were vested. In termsof drafting, these economics are the easiest to cap-ture, because the agreement makes no distinctionbetween vested and unvested profits interests.2. Withholding of distributions until vesting. Sec-ond, the partnership can provide that unvestedprofits interests will not currently share in distribu-tions but will receive a distribution of their shares ofthose distributions immediately upon vesting. Aswith the current sharing of distributions, the agree-ment generally will not distinguish between vestedand unvested profits interests for the purposes ofdistributions. However, another provision will re-quire that distributions for an unvested profitsinterest be held back until the profits interest vests:

Notwithstanding [the normal distribution and liq-uidation provisions], no amounts shall be distrib-uted in respect of any unvested [Profits Interests/Units]. Instead, the portion of any distribution thatwould be made in respect of unvested [ProfitsInterests/Units] in the absence of this paragraph(the ‘‘Unvested Amount’’) shall be set aside in asegregated account of the partnership. The Un-vested Amount shall be held in such account untilthe earlier of the vesting, forfeiture, or repurchaseby the Company of such unvested Incentive Units.To the extent such unvested [Profits Interests/Units] become vested, the partnership shallpromptly distribute such Unvested Amount to theowner of the vesting [Profits Interest/Units] upon(and to the extent of) such vesting. Upon a forfei-ture or repurchase of any such unvested [ProfitsInterest/Unit], the Unvested Amount in respect ofsuch forfeited or repurchased unvested [ProfitsInterest/Unit] shall be removed from the segregatedaccount and added to the general funds of thepartnership. Upon the liquidation of the partner-ship, the Unvested Amount remaining in the seg-regated account shall be removed from thesegregated account and added to the general fundsof the partnership to be apportioned in accordancewith [the liquidation provision].This language contemplates putting the withheld

amounts in a segregated account. This is not neces-sary, but it may be a way of providing reassuranceto profits interest holders that the funds will actu-ally get paid to them if the profits interest vests.

Note, however, that while the withheld amountsare placed in a segregated account, they are not setaside in an escrow or otherwise removed from the

assets of the partnership and protected from theclaims of its general creditors. This is to avoidconstructive receipt of the distribution by the profitsinterest holder. If the amounts are put beyond thereach of the partnership’s general creditors, theywould almost certainly be treated as received by theprofits interest holder.148 Likewise, giving theholder the right to separately direct and control theinvestment of that amount could be treated as adistribution of those amounts to the holder.149 Butsimply holding the funds in segregated accountshould not trigger a deemed distribution. To givethe profits interest holders more reassurance, prac-titioners might also consider the use of a rabbi-trust-like arrangement.150

Whether the constructive receipt of the distribu-tion would even be a problem will likely dependprimarily on the way profits and losses are allo-cated for the unvested profits interest. For example,if the profits interest holder would otherwise not beallocated income for that withheld amount, a con-structive distribution to the holder would likelyresult in a taxable distribution in excess of theholder’s basis. However, if the profits interestholder would be allocated a corresponding amountof income, the holder would likely obtain sufficientbasis to prevent a constructive receipt from beingtaxable. The related issues, which again are beyondthe scope of this discussion, are the consequences tothe holder of the loss of the constructively receivedamount if the profits interest is forfeited beforevesting, and the consequences to the partnershipwhen that amount reverts to the partnership.3. No distributions before vesting. A third alterna-tive is to simply not share any distributions with aprofits interest holder before the profits interestvests. This approach can be reflected in a partner-ship agreement much in the same way a distribu-tion threshold mechanic is included:

Notwithstanding [the normal distribution and liq-uidation provisions], no distributions shall be madein respect of any unvested [Profits Interest/Unit].

ORSolely for the purposes of making distributionspursuant to [the normal distribution and liquida-tion provisions], any unvested [Profits Interest/Unit] shall be treated as not outstanding unlessand until it is vested.

OR

‘‘Eligible Unit’’ means (i) each outstanding Com-mon Unit and (ii) each outstanding vested Profits

148Reg. section 1.83-3(e).149See Rev. Rul. 55-39, 1955-1 C.B. 403.150See, e.g., LTR 8113107, LTR 8329070.



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Unit with respect to which an amount equal to itsDistribution Threshold has been distributed to thepartners (other than in respect of such Profits Unit)subsequent to the issuance of such Profits Unitpursuant to the provisions of this agreement.151

Further, there should be clear language indicat-ing that the profits interest is not entitled to anykind of catch-up for the amounts being withheldfrom it:

Any amounts that would be distributed in respectof any unvested [Profits Interest/Unit] but that arenot distributed in respect of such [Profits Interest/Unit] solely by reason of such [Profits Interest/Unit] being unvested shall be treated as havingbeen distributed to such [Profits Interest/Unit] forthe purposes of determining the amount of anysubsequent distributions to be made to such [Prof-its Interest/Unit] pursuant to [the normal distri-bution and liquidation provisions].

E. Tax AllocationsAfter the parties have decided how the profits

interests should work from a business perspective,the tax practitioner is left to prepare tax allocationsthat will correspond to the economic rights. Asdiscussed above, the economic rights of a profitsinterest holder can be quite complex. So the specificallocation approach will depend on the combina-tion of economic rights associated with the profitsinterests. At a very high level, the two main alloca-tion methods are a ‘‘layer cake’’ and a ‘‘target’’(sometimes called a ‘‘forced’’) method of allocatingtax items. Depending on the structure of the profitsinterest and the drafting approach used, onemethod may have advantages over the other. Ineither case, however, practitioners should be carefulof the complications that arise from the introductionof unvested profits interests.1. Layer cake allocations. The tried-and-true prac-tice of specifically describing the amount and orderof allocations of the profits and losses (or specificitems of profits and losses) of a partnership — ofteninformally referred to as ‘‘layer cake allocations’’ —remains an option when dealing with profits inter-ests.

This method is an obvious choice when imple-menting a capital-account-driven drafting approachfor the profits interest because it is the allocationsthat will determine the economic rights of theprofits interest holder. Likewise, it is generally easyto use when a partnership is relying on thewaterfall-driven drafting approach for establishingthe profits interest status of the interest, because it is

unlikely that the allocations would have to be anydifferent than they would have been if there wereno profits interests.

In a distribution threshold approach, the layercake method starts requiring some adjustment. Oneway to accommodate that approach in this kind ofallocation method is to reference the distributionthreshold much in the same way as with the distri-bution and liquidation provisions:

Notwithstanding the [other profit allocation provi-sions], no net profits shall be allocated in respect ofany [Profits Interest/Unit] unless and until theaggregate capital accounts attributable to all otherpartnership interests equals the excess, if any, of (i)the Distribution Threshold of the [Profits Interest/Unit] over (ii) the aggregate distributions made bythe partnership between the time of issuance of the[Profits Interest/Unit] and the end of the taxableperiod with respect to which the allocation is beingmade.If the loss allocations have the typical language

reversing overall net profits and reducing capitalaccounts to zero before otherwise sharing losses, itis unlikely that any special loss provision will beneeded to accommodate a profits interest.

However, this allocation method would be diffi-cult to use with the safe harbor limiter approach fordrafting distributions. As discussed above, withthat drafting approach, the economics are typicallyunclear when the interest is granted because theyrely on determinations that are to be made in thefuture.152 The pre-baked nature of the layer cakemethod would generally not allow for that kind ofuncertainty.2. Target allocations. The target allocation method(or forced allocation method) is rapidly gainingpopularity as an alternative to layer cake alloca-tions, particularly in partnerships with complicatedeconomic arrangements. The principle in thismethod is that tax items be allocated to make thecapital accounts of the partners match, as much aspossible, some specified capital account targets.Normally, the target capital account of each partnerwill be the amount the partner would receive on ahypothetical liquidation of the partnership basedon the current book values (subject to some adjust-ments) as of the end of the applicable tax period.153

While there are several issues to consider ingeneral when adopting this approach to allocations,it is often easier to draft these allocation provisions

151Note the added qualifier ‘‘vested’’ to the term ‘‘ProfitsUnit.’’

152See Section III.C.3.153See Robert L. Whitmire et al., Structuring & Drafting

Partnership Agreements: Including LLC Agreements, para. 5.05[2](2003, with updates through May 2014) (discussion of ‘‘forcedallocation technique’’).



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than layer cake allocations for many types of profitsinterests.154 Indeed, there is typically nothingunique about profits interests that would requireany different drafting than in any other partnershipagreement using this approach.

The place where this approach may require spe-cial care is if the gross allocation or share of built-ingain profits interest techniques are used. In thosecases, the distribution rights of the holder aredriven by the allocations. Thus, using a targetcapital account determined on the basis of a hypo-thetical liquidation in accordance with the normaldistribution provisions would likely be circular (theallocations would be based on the hypotheticalliquidation, which would be based on the alloca-tions, which would be based on the hypotheticalliquidation). An alternative target could be used,but the drafter must ensure that the target used willyield a result consistent with the economics soughtby the parties.3. Allocations to unvested profits interests. Asdiscussed above, it is far from clear how an un-vested profits interest must share in partnershipallocations.155 How you ultimately resolve the is-sues described above will dictate the appropriatedrafting approach. Because there are many ways toresolve them, I will not cover all the draftingpermutations. But we will look at a few key thingsto focus on when drafting.

a. Layer cake allocations for unvested profitsinterests. Let’s start with layer cake allocations. Ifyour conclusion is that any unvested profits interestshould be allocated tax items as if it were fullyvested, the basic allocations should be drafted nodifferently. The difficulty, as discussed above, iswhat happens if there are distributions while un-vested interests that do not share in the distribu-tions are outstanding or if the interests are forfeitedbefore vesting. One possibility is to give a decisionmaker the ability to make appropriate adjustmentsto address any issues:

It is the intention of the partners and the partner-ship that the foregoing allocations be consistentwith the requirements of the Internal Revenue Codeand Treasury regulations (the ‘‘Tax Law’’). In theevent that the general partner determines that as aresult of distributions made by the partnershipwhile any [Profits Interest/Unit] is unvested or theforfeiture of any [Profits Interest/Unit] prior to itsvesting, it is prudent to modify or make adjust-ments to the allocations or the capital accounts ofthe partners so as to comply with the Tax Law, thegeneral partner may make (or cause the partnership

to make) such modifications or adjustments (orboth), provided, however, any such modification oradjustment that has a material adverse effect uponany partner’s economic entitlement under thisagreement must first be approved in writing bysuch partner.156

Obviously, this only kicks the can down the roadand does not present a rule to use. But it allows theactual facts to arise before making any decisionabout the appropriate way to adjust for the discrep-ancies. If the parties want something more concrete,there is, unfortunately, no standard way of address-ing the issue.157 So a drafter must determine theparties’ desires (which will probably be difficult)and draft language specific to that intent.

If you conclude that profits interests should startsharing in allocations only after they have vested orto the extent of distributions, the adjustment shouldbe made at the time of vesting rather than the timeof forfeiture. One possibility is to prevent the inter-ests from receiving any allocations before vestingbut give them special catch-up allocations on vest-ing to account for any mismatches:

Notwithstanding [the normal allocations provi-sions], no allocations of net profits or net losses (orgross items thereof) shall be allocated with respectto any unvested [Profits Interests/Units] for anytaxable period prior to that in which they vest,except to the extent of any distributions made inrespect of such [Profits Interests/Units]. Subject to[the regulatory allocations], beginning with thetaxable period in which any [Profit Interests/Unit]vests, net profits and net losses [(or gross itemsthereof)]158 shall be allocated first to the partnerholding such [Profits Interest/Unit] in an amountsufficient to make the capital account balance of thepartner holding such [Profits Interest/Unit] equalto the balance it would have had if the [ProfitsInterests/Units] had never been unvested prior tomaking any allocations under [the normal alloca-tions provisions].

154Id.155See Section II.E.5.a (Part 1 of report).

156The final proviso may, of course, be omitted. An alterna-tive that may also be used is ‘‘provided, however, any suchmodification or adjustment that materially and disproportion-ately affects any partner must first be approved by suchpartner.’’

157Indeed, most agreements tend to disregard the issueentirely.

158Allowing gross allocations will likely benefit the partnersother than the holder of the vesting profits interest in that itcould give them allocations of losses even when the partnershiphas a net profit. However, the parties should keep in mind thatif the tax distribution provision would allow for a distribution tothe holder of the vesting profits interest, a gross allocationprovision may require the partnership to make a distributionthat it otherwise would not be required to make (or require it tomake a larger distribution).



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b. Target allocations for unvested profits inter-ests. With target allocations, there is less concernabout dealing with adjustments depending onwhether the profits interest vests. For the most part,the target allocation method will resolve discrepan-cies automatically.159 The primary question is howthe target should be adjusted, if at all, to take intoaccount the unvested profits interest.

If an unvested profits interest is treated as vestedfor the purposes of allocations, some language tothat effect should be included:

Notwithstanding any other provision of this agree-ment, outstanding unvested [Profits Interests/Units] shall be treated as vested [Profits Interests/Units] for purposes of allocating profits and lossespursuant to [the allocations provisions] (includingfor the purposes of determining amounts distribut-able to the partners in the case of any hypotheticaldistribution or liquidation).

But if you want to make allocations for anunvested profits interest only to the extent of anydistributions made for the profits interest beforevesting, then, generally, no changes to the targetallocation provisions will be necessary.

F. Boilerplate Profits Interests ProvisionsBefore we put aside the discussion of drafting, I

want to identify a couple of boilerplate provisionsthat should usually be in a partnership agreementthat includes profits interests. The first is a provi-sion outlining the intended treatment of the profitsinterest. The second is designed to allow the part-nership agreement to satisfy a safe harbor in theproposed compensatory interests regulations.1. Profits interest treatment. As mentioned above,many partnership agreements that include profitsinterests will forbid the partnership or its partnersfrom taking specific actions that are inconsistentwith the treatment of those interests as profitsinterests. For a partnership agreement with profitsinterests that are intended to constitute safe harborprofits interests, there might be language like thefollowing:

Absent a contrary determination by a court or by[the general partner] following the date hereofbased on a change in law governing the taxation ofany interest in the partnership issued in connectionwith the performance of services for or for the

benefit of the partnership or any of its subsidiaries,(A) the partnership and each partner shall treateach [Profits Interest/Unit] as a ‘‘profits interest’’within the meaning of Rev. Proc. 93-27, 1993-2C.B. 343, as clarified by Rev. Proc. 2001-43,2001-34 IRB 191; (B) the partnership and eachpartner shall treat each partner as the owner of its[Profits Interests/Units] (whether vested or un-vested) from the date such [Profits Interests/Units]are granted until such [Profits Interests/Units] areforfeited or otherwise disposed of; (C) each holder ofa [Profits Interest/Unit] agrees to take into accountsuch distributive share of the partnership’s income,gain, deduction and loss in computing its U.S.federal income tax liability for the entire periodduring which it holds such [Profits Interests/Units]; (D) the partnership and each partner agreenot to claim a deduction (as wages, compensationor otherwise) for any value attributable to any[Profits Interest/Unit] either upon grant or vestingof the [Profits Interest/Unit] and (E) the holder of a[Profits Interest/Unit] agrees not to transfer orotherwise dispose of that [Profits Interest/Unit]within two (2) years of date such [Profits Interest/Unit] is granted.

If the profits interests are not intended to consti-tute safe harbor profits interests, the languagemight read something like this instead:

Absent a contrary determination by a court or by[the general partner] following the date hereofbased on a change in law governing the taxation ofany interest in the partnership issued in connectionwith the performance of services for or for thebenefit of the partnership or any of its subsidiaries,(A) the partnership and each partner shall treateach [Profits Interest/Unit] as being without anyliquidation value or fair market value and therebynot taxable to the recipient of the [Profits Interest/Unit] in accordance with Kenroy Inc. v. Commis-sioner, T.C. Memo. 1984-232, and Campbell v.Commissioner, 943 F.2d 815 (8th Cir. 1991); (B)the partnership and each partner shall treat eachpartner as the owner of its [Profits Interests/Units](whether vested or unvested) from the date such[Profits Interests/Units] are granted until such[Profits Interests/Units] are forfeited or otherwisedisposed of; (C) each holder of a [Profits Interest/Unit] agrees to take into account such distributiveshare of the partnership’s income, gain, deductionand loss in computing its U.S. federal income taxliability for the entire period during which it holdssuch [Profits Interests/Units]; (D) the partnershipand each partner agree not to claim a deduction (aswages, compensation, or otherwise) for any valueattributable to any [Profits Interest/Unit] eitherupon grant or vesting of the [Profits Interest/Unit];and (E) the holder of a [Profits Interest/Unit]

159The principal exception is the question of what happens tothe capital account attributable to a profits interest held by aperson that does not otherwise have a partnership interest thatreceives allocations of profits but forfeits the interest before itvests. However, as discussed above in Section II.E.5.a (Part 1 ofreport), there appears to be no way to resolve this throughallocations anyway.



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agrees not to transfer or otherwise dispose of that[Profits Interest/Unit] within two (2) years of datesuch [Profits Interest/Unit] is granted.160

One thing to note is that these provisions containlanguage regarding the holding period of the prof-its interest. Normally, partnership agreements heav-ily restrict the ability to transfer profits interests. Asa result, if those transfer restrictions would sub-sume the holding period clause, that clause can beomitted.

This type of provision is by no means requiredfor an interest to qualify as a profits interest. How-ever, it would give a recipient and the other part-ners more assurance that they will all treat the grantof the interest consistently and will not take anyaction that would likely disqualify an interest fromthat treatment.

2. Proposed compensatory interests regulations.The proposed compensatory interests regulations,as discussed above, include a safe harbor election totreat a compensatory partnership interest as havinga FMV equal to its liquidation value. To qualify forthat election, the partners must agree to specificitems. Accordingly, partnership agreements thatgrant compensatory partnership interests (includ-ing profits interests) generally include languagethat would allow the partnership to qualify to makethat election:

[The general partner] may cause the partnership tomake the safe harbor election provided for by theproposed revenue procedure included in Notice2005-43, or any similar election provided in a finalrevenue procedure or other official guidance relat-ing to the compensatory transfer of partnershipinterests (a ‘‘Safe Harbor Election’’). Each partneragrees to comply with all requirements of theproposed revenue procedure included in Notice2005-43, or any similar final revenue procedure orother guidance relating to the compensatory trans-fer of partnership interests, if a Safe Harbor Elec-tion is made. The partners also hereby authorize[the general partner] to make any required changesto the maintenance of the partners’ capital accountsand the allocations of items of income, gain, deduc-tion, and loss as may be required in any finalregulations issued in connection with such pro-posed revenue procedure or any other guidancepertaining to the compensatory transfer of partner-ship interests.

Again, this language is not required to qualifypartnership interests as profits interests, but it givesthe general partner (or other decision maker ormakers) the ability to take advantage of the safeharbor election (if the proposed compensatory in-terests regulations are finalized) without the need toamend the partnership agreement.

IV. Practical ConsiderationsIn this section, I will discuss several other prac-

tical issues that the parties should consider whendeciding whether to use profits interests and howthey should be structured.

A. Tax ReportingSomething that may not be immediately appar-

ent to business people when they are consideringthe use of profits interests is some of the taxreporting it entails. As a partner, the holder of aprofits interest will receive a Schedule K-1 from thepartnership each year.161 When there are manyholders of profits interests, this means that thepartnership will be required to issue many moreSchedules K-1 than it would if those holders simplyparticipated in a bonus plan.

The corollary, of course, is that as partners, theholders will not receive a Form W-2 for any com-pensation paid to them for services performed forthe partnership.162 Rather, that compensation willbe reflected as a guaranteed payment on the recipi-ent’s Schedule K-1.163

This will likely puzzle many of the holders if theyhave not been prepared in advance for this kind ofreporting. Likewise, if they have not been warned,the holders may not understand that they may notreceive the Schedule K-1 until much later than theywould ordinarily receive a Form W-2, which maydelay their ability to file their own tax returns.

Accordingly, it is important that everyone in-volved be aware of this alternative reporting upfront.

B. Self-Employment TaxesJust as holders of profits interests will receive

Schedules K-1 instead of Forms W-2, because theyare partners, their compensation for services will besubject to self-employment taxes rather than payrolltaxes.164 As a result, the partnership will not with-hold or pay payroll taxes (Social Security, Medicare,and unemployment taxes) on the compensationpaid to the holders. Instead, the compensationwould constitute guaranteed payments, and the

160Because the non-safe-harbor profits interest does not havea strict holding period requirement, the two-year restriction inclause (E) can probably be lowered somewhat while still pre-serving the profits interest status of the interest.

161Reg. section 1.6031(b)-1T.162See section 6051.1632013 Instructions for Form 1065, line 10.164Rev. Rul. 69-184, 1969-1 C.B. 256; cf. ILM 200215053.



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holder would be required to pay self-employmenttaxes on that compensation.165

As a result of shifting the payroll taxes to self-employment taxes, if the holder’s compensationdoes not change after the receipt of the profitsinterest, the holder’s after-tax income will be lowerthan before the receipt of the interest. But by thesame token, the partnership will no longer berequired to pay the employer share of any payrolltaxes, so the partnership will have a lower out-of-pocket cost for that level of compensation. Accord-ingly, to reduce this hardship on the recipient of theinterest, the partnership can consider paying therecipient the amount it saves on the employer shareof those payroll taxes as additional compensation.

Further, if the profits interests are general partnerinterests, the holder’s distributive share of anyincome arising from a trade or business carried onby the partnership will also be subject to self-employment taxes.166 If the profits interests arelimited partner interests or membership interests ina limited liability company, the law is muddy, butthere is a good chance the IRS will argue that theholder has the same result as if the interest were ageneral partner interest, particularly if the holder isa full-time service provider.167 That said, this rulegenerally does not apply to income that is in thenature of investment income or capital gain, so forinvestment partnerships, this is likely to be less of aconcern.168

For most recipients of profits interests, theseconsequences will be very surprising, especially forindividuals who have only ever had salary income.And there are real economic burdens for the hold-ers. So it is critical to make them aware of theseissues when they receive the interests, ideally in awritten summary provided when the interest isgranted.

C. Type of Partnership InterestThese days, it is usually an LLC that is issuing a

profits interest, so there is no question aboutwhether the recipient has limited liability — it does.For a general partnership, there is similarly nothingthat can be done to avoid the recipient of a profitsinterest being a general partner, because all partnersof a general partnership are general partners.169

But for limited partnerships, there is a choice:The profits interest can be a limited partner interestor a general partner interest. The standard practiceis to make profits interests in these situations lim-ited partner interests. However, the parties shouldbe aware that even if the interests are denominatedas limited partner interests, the holders may insome cases have liability for the partnership’s obli-gations if they participate in the control of thebusiness.170

If a service provider is receiving a profits interestfrom a true partnership, it is worth consideringsetting up a wholly owned LLC to hold the interest.Even when the interest is a limited partner interest,this may give the holder more assurance that it isnot subject to the liabilities of the partnership,especially if the holder has significant managementauthority over the partnership.

D. Profits Interests’ Voting RightsWhether the profits interest is in a true partner-

ship or an LLC, there is a question about the votingrights of the profits interests. Subject to some statu-tory constraints on disenfranchising members orpartners, the parties are generally entitled understate law to specify in the governing agreementwhether particular partners, such as profits interestholders, are entitled to vote.171

From a tax perspective, the voting rights have alimited effect on the analysis of the interest’s status.As observed above, the right to vote is one of thefactors considered in the status of a holder of aprofits interest as a partner for tax purposes.172

Many profits interests are given few, if any, votingrights. This is largely because the principal inves-tors do not want to have to deal with the hassle ofrounding up votes from diverse, potentially unso-phisticated parties. That said, if the parties areconcerned that the holders of the interests theydesign are not partners, they should consider givingthem voting rights.

165Reg. section 1.1402(a)-1(b).166Section 1402(a).167See William S. McKee et al., Federal Taxation of Partnerships

and Partners, para. 9.02[5][b] (2007, with updates through May2014) and compare section 1402(a)(13) (‘‘there shall be excludedthe distributive share of any item of income or loss of a limitedpartner, as such, other than guaranteed payments . . . for . . . ser-vices’’) with prop. reg. section 1.1402-2(h) (a person is not alimited partner if the person has authority to contract on behalfof the entity or participates in its trade or business for more than500 hours during the entity’s tax year); Renkemeyer, Campbell &Weaver LLP v. Commissioner, 136 T.C. 137 (2011) (holding thatattorney partners of a limited liability partnership were liablefor self-employment taxes on their distributive shares from thepartnership).

168See section 1402(a)(2) (excluding from self-employmentincome dividends and interest not related to a trade or busi-ness), and section 1402(a)(3) (excluding from self-employmentincome gain or loss from the sale or exchange of a capital asset).

169See, e.g., 6 Del. Code section 16-306, Cal. Corp. Codesection 16306.

170See, e.g., 6 Del. Code section 17-303, Cal. Corp. Code.section 15903.03.

171See, e.g., 6 Del. Code section 18-302, Cal. Corp. Codesection 17704.07.

172See Section II.E.5.e (Part 1 of report).



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E. Tax DistributionsBecause it is the owners, not the partnership, that

are taxed on a partnership’s income, it is commonfor partnership agreements to provide for tax dis-tributions to the partners to cover those tax liabili-ties. Typically, the parties view the tax distributionas being the equivalent of the business actuallypaying the tax liability directly if it had been acorporation.

When profits interests are issued, the question oftax distributions is often particularly sensitive forthe recipients of the interests. The recipients ordi-narily consist of individuals who lack the resourcesto pay substantial tax liabilities without distribu-tions from the partnership. And in a structure inwhich the other partners receive return-of-capital orsimilar distributions before the profits interest hold-ers participate, the profits interest holders couldhave taxable income for a long time before theyreceive distributions in the ordinary course.

As a result, it is typical for partnership agree-ments to include holders of profits interests in anytax distributions. There are, however, a few specialconsiderations that arise in connection with profitsinterests.

First, the parties need to decide the amount of thetax distributions. Typically, the partnership agree-ment will provide for an amount equal to theproduct of the income allocated to the partner andan assumed tax rate. The assumed tax rate isnormally the highest applicable combined federaland state income tax rate for an individual residentin the state with the highest tax rate that any partneris a resident of. For profits interest holders, how-ever, the income allocated to them might also besubject to self-employment tax.173 So the partiesshould consider whether the assumed rate shouldinclude self-employment taxes.

Relatedly, the parties typically do not want thetax distributions to include tax liabilities for anysalary or other fixed compensation paid to serviceproviders that happen to also own profits interests.While typical tax distribution provisions can usu-ally be read to apply only to allocations of netprofits, it would be a good idea to make it clear thatthe tax distributions do not include tax liabilitiesarising from guaranteed payments.

Second, the parties should consider whetherholders of unvested profits interests should get taxdistributions and whether there should be a claw-back of those distributions if the profits interests areforfeited before vesting. Regarding the former, theholders have the same concerns as holders of vestedprofits interests about phantom income. From the

other partners’ perspective, the tax distributions tothe holders of unvested profits interests shouldgenerally not be particularly problematic, becausethe tax distributions would correspond to taxableincome that is allocated away from those partnersto the holder of the unvested profits interests.Moreover, tax distributions typically are set up to beadvances of other distributions to the partners. Sothe fact that the tax distributions are going to theholders of unvested profits interests may be viewedby the other partners as a good thing because thoseamounts do not reduce any of their future preferreddistributions or reduce their preferred return accru-als. If the parties take this route, the drafter shouldensure there is a carveout for tax distributionswithin any language that would prevent holders ofunvested profits interests from sharing in distribu-tions.

The potential problem for the other partners is inconnection with any forfeiture of an unvested prof-its interest. If, as discussed above, the forfeitureresults in a taxable capital shift to the other part-ners, they may be upset that the tax distributionsessentially attributable to that capital shift weredistributed to the holder of the interest before theforfeiture.174 It may be particularly frustrating if theprofits interest holder is at the same time allowed aloss for the forfeiture.175 Here is where it may beuseful to have a provision requiring the holder topromptly return the tax distributions to the partner-ship if the interest is forfeited. Naturally, this maybe a difficult right to enforce if the holder lacks theresources to repay that amount. The holder is alsolikely to chafe at this unless the clawback is limitedto any tax benefit the holder receives in connectionwith the forfeiture. So it is reasonable not to de-mand this, but it is worth considering.

F. Multiplicity of PartnersBefore adopting a plan to issue profits interests,

the parties should also consider the increased num-ber of partners that the partnership will have.

For state law purposes, each holder of a profitsinterest will usually be a partner or member of thepartnership or LLC, respectively.176 Under state law,they could be entitled to specified information from

173See Section IV.B.

174See Section II.E.5.a (Part 1 of report).175Id.176Technically, because a partnership interest does not have

to be a legal ownership interest in an entity, neither does aprofits interest. See, e.g., Wheeler v. Commissioner, T.C. Memo.1978-208; ILM 200215053. But not making the holder a legalowner will increase the risk that the holder is not considered apartner (and the interest not a profits interest) if other factorsalso do not support the holder’s status as a partner. See SectionII.E.6 (Part 1 of report).



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the partnership,177 the benefit of fiduciary duties,178

or other state law privileges or rights that theywould lack if they were simply service providers tothe partnership.

As owners, the partnership would also need thecooperation of profit interest holders in selling orpledging all the equity of the partnership. Drag-along provisions and obligations to pledge interestscould be included in the governing documents totry to avoid problems in these areas. But if thepartners still do not cooperate, the partnershipcould incur significant expenses trying to enforcethese provisions. A more robust solution might beto also have the business and its assets and opera-tions held in a wholly owned, disregarded subsid-iary of the partnership. This would permit all theequity of the business to be sold or pledged by theparent partnership without rounding up all thepartners to participate.179

Another concern with many owners is the in-creased risk that the partners take positions on taxreturns that are inconsistent with the partnership’sreturns. Again, the governing documents can re-quire partners to file their returns consistently withthe tax return of the partnership, but as with sellingand pledging interests, these may be difficult cov-enants to enforce. Indeed, because partners aresubject to overriding legal obligations to file taxreturns in good faith, there may be situations inwhich courts find this kind of provision unenforce-able.180

Finally, the multiplicity of partners increases therisk that the partnership inadvertently becomes apublicly traded partnership. In most cases, partner-ships use the 100-partner safe harbor for avoidingbeing treated as a publicly traded partnership.181

This safe harbor does not include any carveoutsfrom the 100-partner limit for profits interests. So ifthe partnership issues a large number of profitsinterests, it will need to look to another safe harboror other basis to avoid becoming a publicly tradedpartnership.

G. Drag-Along ProvisionsAs discussed in the previous section, it is usually

important for the investor partners to be able toforce holders of profits interests to sell their inter-ests at the same time the investor partners sell theirinterests. This means that most agreements includea drag-along that permits a group of partnersdesiring to sell at least some threshold portion ofthe partnership interests (usually somewhere be-tween a majority of and all of the partnershipinterests) to require the other partners (includingholders of profits interests) to sell their interests onthe same terms as the selling partners.

The tricky part is that when you say the holdersof profits interests will be required to sell theirinterests ‘‘on the same terms,’’ you probably mean‘‘on the same terms, subject to accounting for thediffering economic interests of the partnership in-terests.’’ When allocating the aggregate consider-ation, the parties do not want the considerationallocated to a profits interest to be the same as whatis allocated to interests that also have a right tocapital.

This is a concern any time a partnership hasinterests that do not all have the same economicrights. But normally, if there are differences, it is justamong various classes or series of interests — it isunusual for there to be economic differences withina class or series. Often, however, profits interests aregrouped together as a single class or series butdifferent profits interests within that class havedifferent distribution thresholds or other economicrights based on differing issue dates or vesting.Thus, allocating the purchase price becomes morecomplicated with profits interests.

Although it does not have to be done this way,probably the most appropriate way to allocate thepurchase consideration is based on the interests’respective liquidation values as inferred from theconsideration being paid:

‘‘Drag-Along Consideration’’ means with respectto each partnership interest a value equal to the

177See, e.g., Cal. Corp. Code section 15903.04 (Californialimited partnerships), Cal. Corp. Code section 17704.10 (Califor-nia LLCs), Del. Code section 17-305 (Delaware limited partner-ships), Del. Code section 18-305 (Delaware LLCs).

178See, e.g., Cal. Corp. Code section 15904.08 (Californialimited partnerships), Cal. Corp. Code section 17704.09 (Califor-nia LLCs).

179For a sale, the proceeds could then be distributed by theparent partnership in complete liquidation. Practitioners shouldremember, however, that a sale of the wholly owned, disre-garded subsidiary followed by a complete liquidation is notalways a perfect substitute for a sale of the partnership interestsby the partners. For example, if there is a difference between thepartners’ holding periods in their partnership interests and thepartnership’s holding period in its asset, the form woulddetermine whether the partners have long-term or short-termcapital gain. But practitioners should consider the application ofthe ‘‘sale of a going business’’ doctrine and related case law.Barran v. Commissioner, 334 F.2d 58 (5th Cir. 1964) (holding thatin substance, the sale of assets of the partnership was a sale ofpartnership interests). For further discussion of this issue, seeMcKee et al., supra note 167, at para. 16.03 (Transfers ofPartnership Interests: Transfers of Partnership Assets Com-pared).

180See Metz v. Medford Fur Foods Inc., 90 N.W.2d 106 (Wis.1958) (hold harmless clause found unenforceable when theunderlying act was criminal). 181See reg. section 1.7704-1(h)(1).



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amount that would be distributed in respect of suchpartnership interest if an amount equal to the valueof one hundred percent (100 percent) of the equityof the partnership implied by the consideration tobe paid by the proposed purchaser were distributedto the partners in accordance with [the normaldistribution or liquidation provisions] at suchtime.182

If desired, the parties can elaborate on how todetermine the value of the partnership’s equity. Forexample, you can say that it assumes that thepurchase price does or does not reflect premiums ordiscounts for control or marketability or require thepartnership to retain an appraisal firm to make thedetermination. If the drag-along right arises only ona sale of 100 percent of the company, this willunlikely be a concern, but if the drag-along istriggered at a lower threshold, there may be somedisagreement on what value is ‘‘implied.’’

Another issue to consider is that in any case, thiswould result in no consideration being allocated toa profits interest that would not be entitled to anyamount on a hypothetical distribution. Given thatthe applicable threshold for participation has notbeen met, it would be reasonable to provide thatthose profits interests do not participate in the saleproceeds and are (1) automatically dragged along,(2) automatically canceled, or (3) simply remainoutstanding. If one of the first two alternatives isused, and there is a concern that the result is unfairor that there is inadequate consideration to bindthose holders in the transaction, the parties canconsider assigning a minimum amount to be allo-cated to those profits interests in the transaction.183

Choosing the alternative (3), however, will meanthat the dragging partners cannot sell 100 percent ofthe partnership’s equity to a buyer using the drag-along rights.

Related to the purchase price allocation is thedetermination of how much of each holder’s profitsinterests are ‘‘dragged’’ if less than all of the part-nership is sold. Again, there is no right answer, buta reasonable approach would be to make the allo-cation based on relative liquidation values:

‘‘Dragged Interests’’ means with respect to eachpartner, a portion of that partner’s partnershipinterests with an aggregate Liquidation Value equal

to (i) the aggregate Liquidation Value of all of thepartnership interests held by such partner at suchtime, multiplied by (ii) (A) the value of the aggre-gate consideration to be paid in connection with theproposed transaction, divided by (B) the aggregateLiquidation Value of all outstanding partnershipinterests at such time. In the event such partner haspartnership interests with differing economics, theDragged Interests shall be a proportionate amountof each of such partner’s partnership interests,determined based on their respective LiquidationValues.

‘‘Liquidation Value’’ means in connection with aproposed transaction and with respect to any eachpartnership interest a value equal to the amountthat would be distributed in respect of such part-nership interest if an amount equal to the value ofone hundred percent (100 percent) of the equity ofthe partnership implied by the consideration to bepaid by the proposed purchaser in the proposedtransaction were distributed to the partners inaccordance with [the normal distribution or liqui-dation provisions] at such time.

That language does not clearly delineate whathappens with any profits interest that has a liqui-dation value of zero. So again, the parties shouldspecify what happens to them.

A concern in the drag-along context that isunique to holders of profits interests is the riskassociated with the two-year requirement for safeharbor treatment. If the drag-along is exercisedbefore the holder has held the profits interest fortwo years, the interest will no longer qualify for thesafe harbor. As seen above, the holder may still beable to rely on case law to avoid having the grant betaxable, but this does create added risk.184 Whilethis is a legitimate concern for the holder, it isnormally not something the holder will receiveprotection from, as the investor partners do notwant their ability to sell the business hindered. If arecipient of a profits interest has the leverage toextract a guarantee that there will not be a drag-along right exercised within two years of grant, itwould still be wise for the partnership to memori-alize that in a side letter of some kind rather than inthe partnership agreement to avoid it applying toall other holders of profits interests.185

182Whether the distribution waterfall or liquidation waterfallis used is purely a business decision.

183That an interest would receive a minimum amount ofconsideration on that drag-along transaction generally shouldnot jeopardize the safe harbor status of the interest (since it stilldoes not guarantee any amount on a hypothetical liquidation ofthe partnership), unless the interest were granted in contempla-tion of such a transaction.

184See Section II.F.1 (Part 1 of report).185If the partnership is continually granting profits interests

(at least once every two years), this kind of provision in thepartnership agreement would effectively remove the ability tosell 100 percent of the partnership using the drag-along right. Sothe parties should be very careful about putting such a provi-sion in the partnership agreement.



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H. Tag-Along ProvisionsAlthough drag-along provisions typically apply

to profits interests, holders of profits interest usu-ally do not receive the benefit of tag-along provi-sions. But if the parties wish to give them theserights, some of the same concerns as in drag-alongprovisions apply. The consideration must be prop-erly allocated, and there should be a mechanism fordetermining the portion of the holder’s interest thatcan participate in the sale. Provisions similar tothose set forth in the previous section can be usedfor these purposes. There are, however, a couple ofmeaningful differences that arise with tag-alongs.

The first distinction is the application of thetwo-year rule. Here the holder is the one that wouldbe deciding to sell the interest. So a provisionpreventing participation in the sale within twoyears is necessary only if the partnership believes itis important to satisfy the safe harbor requirements.

Secondly, and probably more importantly, if aholder of profits interests exercises a tag-alongright, the purchaser is getting a different set ofrights and economics than if the holder had notparticipated. As we have seen in various placesalready, profits interests rarely are given the samekind of voting or other rights as other partnershipinterests. This means that if a purchaser were look-ing to purchase 75 percent of the voting rights of thepartnership, the participation of holders of anynonvoting profits interests would reduce the votingpower the purchaser ends up with. Likewise, as aholder of profits interests, the purchaser may finditself subject to drag-along obligations that non-profits-interests may not be.

On the flip side, however, the participation of aprofits interest will ordinarily increase the purchas-er’s share of later profits. This is because any profitsinterests will normally have much less capital valueassociated with a given percentage of future profitsthan the other interests have. For every dollar spentfor a profits interest, the purchaser will get a largershare of profits. A purchaser expecting to purchase50 percent of the value of the company may end upwith 60 percent of the profits.

Example 20: Partnership AB has 4,000 commonunits, each with a liquidation value of $10, and1,000 profits interest units, each with a liquidationvalue of $1. Each unit (common or profits) isentitled to 0.02 percent of the profits of the partner-ship. AB has tag-along provisions similar to thesample drag-along provisions in Section IV.G. Apurchaser offers to purchase 2,500 common units,constituting 50 percent of the profits, for $25,000,and all the holders of the profits interests try to tagalong. Each class of interests will effectively beentitled to sell around 61 percent ($25,000/$41,000)of its units. So the common unit holders will sell

about 2,439 common units for $24,390, and theprofits interest unit holders will sell about 610profits interest units for $610. This would give thepurchaser 3,049 units, constituting about 61 percentof the profits of AB.

The purchaser may be happy with this, but theother partners may think the purchaser is gettingtoo good of a deal.

Because the decision to pull the profits interestsinto the transaction is in the hands of the sellingpartners in the drag-along situation, these concernsare not really an issue there. But to prevent theseresults in the tag-along situation, the partnershipagreement could cause any profits interests to au-tomatically convert into ‘‘normal’’ interests on thebasis of liquidation values.

Example 21: The facts are the same as in Example20, but the 610 purchased profits interests automati-cally convert into 61 common units, thereby givingthe purchaser 50 percent of the value of AB and 50percent of the profits of AB.

Or the agreement could require the profits inter-est holders to sell the interests to the selling partnersand allow them to decide whether the profits inter-ests or the selling partners’ existing interests aresold to the purchaser.186

I. Valuation of Partnership and AssetsIt must be readily apparent by now that valua-

tions play an important role in the granting ofprofits interests. Even for an issuance of the mostbasic profits interest, the parties must determine thevalue of the partnership. Depending on the type ofprofits interest granted, individual assets of thepartnership may also need to be valued.187 Andunless the profits interest is issued near the time ofan event that clearly establishes the value of thepartnership (such as the issuance of new equity forcapital or the sale of equity between unrelatedparties), it is often difficult to establish that value.What are the parties to do? Does this mean the

186This mechanism could create tax hazards or opportunities.Because partners generally are treated as having a unified basisin their partnership interest (see Rev. Rul. 84-53, 1984-1 C.B. 159)and a divided (weighted average) holding period (see reg.section 1.1223-3(b)), a purchase and resale of partnership inter-ests could leave the selling partners with a net taxable gain orloss if the form of those transactions is respected. And if asection 754 election is in place (or will be made for that tax year),the partnership’s basis in partnership property could differ as aresult of two transfers instead of one. Of course, the twotransfers could be joined together under the step transactiondoctrine and treated simply as a sale of the interests from theprofit interest holders to the ultimate purchaser.

187For example, a valuation of individual assets might benecessary if the profits interest permits the holder to participatein the gross increase in the value of partnership assets or specificassets.



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partnership or the recipient must obtain a third-party appraisal each time a profits interest isgranted?

Fortunately, a third-party appraisal is not re-quired. Indeed, there is no requirement at all thatanyone do anything at the time of the grant toestablish the value. If the interest had a zero liqui-dation value at grant, it would satisfy that require-ment, even if it were by accident — there is nointent requirement. That said, if the IRS challengesthe treatment of the interest as a profits interest onthe basis that the interest had a positive liquidationvalue, it becomes a battle over the support eachparty has for its valuation.

In a dispute, an independent appraisal obtainedat the time of the grant of the interest, while notrequired, would obviously carry significant weightin that analysis.188 But given the costs associatedwith getting that appraisal, this will likely be im-practical except in unusual situations. So what arethe alternatives?

A good approach would be for the partnership tomake a good-faith estimate of the value at the timeof the grant and prepare a contemporaneous inter-nal memorandum with the analysis and support forthe estimate. The more rigorous the analysis anddocumentation, the more weight it will carry in achallenge. It is up to the parties to balance theresources dedicated to such an analysis with therisk of the value being challenged. If the parties donothing, they will be in the unenviable position ofrelying on an after-the-fact appraisal or analysis,which would likely carry much less weight.

J. Revaluation of Partnership AssetsMost partnership agreements permit, but do not

necessarily require, the partnership to revalue itsassets for book purposes at the times permittedunder reg. section 1.704-1(b)(2)(iv)(f)(5). One timerevaluation is permitted under that regulation is ‘‘inconnection with the grant of an interest in thepartnership (other than a de minimis interest) . . . asconsideration for the provision of services to or forthe benefit of the partnership.’’ Clearly, the grant ofany profits interest that is not de mimimis forservices for a partnership would satisfy this andpermit a revaluation.189 But is that a good idea?

As with most things, it depends. Revaluing theassets of the partnership should bring the partners’capital accounts in line with their economic rights to

the partnership assets at that time. This will gener-ally make future allocations more intuitive andprobably more closely align them with the econom-ics from a timing perspective. And it will link anyexisting built-in gain or loss and the associated taxconsequences with the existing partners.190

Example 22: Assume A and B are each 50 percentpartners in partnership AB. Each has a capitalaccount of $10, the partnership’s assets have a bookvalue of $20, and the partnership agreement pro-vides for target allocations. When it is worth $100,AB issues a profits interest to C giving C 10 percentof all distributions after the first $100 of distribu-tions. AB revalues its assets, giving each of A and Ba new capital account of $50.

In Example 22, if AB has $100 of subsequent netincome, that income would be allocated $45-$45-$10among A, B, and C, respectively. If AB thereaftersold all its assets and liquidated, the tax gain arisingfrom the existing $80 of built-in gain would beallocated $40 to A and $40 to B to match theamounts allocated to each on the revaluation event.

What if the assets are not revalued? First, anybuilt-in gain or loss will not be tied to the existingpartners under reverse 704(c) principles. This is animportant result if the parties are trying to use anapproach in which they let the profits interestholder share in existing built-in gain.191 It is hard tojustify allowing the holder of the profits interest toparticipate in any of the built-in gain if it is beingallocated for tax purposes to the other partnersbecause of a revaluation.

Second, the existing partners’ capital accountswill unlikely be matched up with their economicrights. In most cases, this would have the effect ofallocating a larger share of current income (forbuilt-in gain) or current loss (for built-in loss) to theexisting partners.

Example 23: Assume the same facts as in Ex-ample 22, except that the assets are not revaluedupon the grant of the profits interest to C.

Here, if AB has $100 of subsequent net incomebefore liquidating, that income will be allocatedamong A, B, and C on a $49-$49-$2 basis.192 Then, ifAB sells its assets and liquidates, the $80 book andtax gain would be allocated among A, B, and C on

188See, e.g., Pittsburgh Plate Glass Co. v. Commissioner, T.C.Memo. 1965-159.

189Cf. LTR 200329001 (taxpayer represents that the partner-ship will revalue its assets and adjust its existing partners’capital accounts); REG-139796-02, 68 F.R. 39498, 39499 (July 3,2003).

190See reg. section 1.704-3(a)(6)(i).191See Section III.A.6.192After the $100 of income is earned, the partnership will

have an aggregate book value of $120 (the existing $20 plus the$100 of income). On a liquidation basis, this would be distrib-uted $59 to each of A and B (50 percent of the initial $100, plus45 percent of the subsequent $20) and $2 to C. To bring theexisting $10-$10-$0 capital accounts of A, B, and C, respectively,up to these hypothetical liquidation amounts, the income wouldbe allocated $49-$49-$2.



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a $36-$36-$8 basis. As you can see, this will, in theaggregate, give the partners the same overall $85-$85-$10 allocations, but A and B will have a largershare of the current income. If the built-in gain werecapital gain and the current income were tax-exempt income, A and B might prefer this result.However, if the built-in gain were capital gain andthe current income were ordinary income, A and Bmay dislike this result.

That said, even when the current income issubject to tax at a higher rate than the built-in gainis expected to have, there may be reasons theexisting partners want to avoid a revaluation. Theparties may want to reduce the taxable incomeallocated to the holders of profits interests in theearly years. This could reduce the self-employmenttax exposure in the early years (if the other partnersare not actively involved in the business) and avoidtax distributions to the holders of profits inter-ests.193 If any of the profits interests are unvested,this might also avoid some of the difficulties arisingwith an unvested interest that is forfeited while ithas a capital account.194

K. Top-Up Profits InterestsSometimes in business, as in life, things do not go

as well as planned. If a partnership’s prospectsdeteriorate after the grant of a profits interest, then,as with options, the holder may find itself so far outof the money that the incentive associated with theprofits interest is not meaningful. Sometimes apartnership in this situation will look for a way toreestablish that incentive.

An intuitive response might be to cancel theoriginal profits interest and grant a new profitsinterest with a lower participation threshold. Butthe form of this transaction raises some concerns ifit is done within two years of the grant of theoriginal profits interest. Remember that the two-year test does not on its face provide much guid-ance about what constitutes a disposition of theinterest.195 The IRS might argue that the cancella-tion of the original interest is a disposition thatdisqualifies the original grant from the safe harbortreatment. Moreover, the holder would now likelyalso be treated as having a profits interest entirelysubject to a new two-year holding period for thesafe harbor treatment, not to mention a new holdingperiod for determining long-term capital gain treat-ment.

What if, instead, the original profits interest issimply amended to provide for a lower participa-

tion threshold? Unlike the cancellation and reissu-ance, this is not in form a disposition of the originalprofits interest. Nevertheless, the IRS might arguethat it is an exchange that similarly disqualifies theoriginal grant. Or the IRS might argue that theamendment is a taxable event because it is not inform a grant of a profits interest.

In substance, both of those approaches are sim-ply an attempt to grant the holder a new top-upprofits interest that allows it to participate in profitsfrom the new, lower participation threshold up tothe original, higher participation threshold.196 Theholder will, of course, have a split holding periodfor the holder’s partnership interest, but it wouldnot jeopardize the original grant.197

Given that the cancellation/reissuance andamendment routes would yield the same substan-tive result as just granting a top-up profits interest,there really should be no difference in the taxtreatment. That said, occasionally the form of atransaction matters, and taxpayers are typicallyheld to the form they select.198 So unless there is animportant nontax reason to use another form, theparties should probably stick to granting a top-upprofits interest to accomplish this goal.

L. Grants Not From PartnershipThere is no requirement that the grant of the

profits interest come from the partnership itself.Instead, the profits interest can come from an exist-ing partner in the partnership.

Example 24: Partnership AB consists of partnersA and B, each of whom has a 50 percent interest inall capital, distributions, and allocations of thepartnership. For services performed for the partner-ship by C, A assigns to C a portion of its partnershipinterest representing 10 percent of the partnership’sgains and profits.

The interest granted to C can qualify as a safeharbor profits interest if all the other requirementsare satisfied, since the revenue procedures nowhererequire that the interest be transferred or granted bythe partnership or any other particular person.

The partner assigning the interest should firstensure that there are no transfer restrictions in theagreement that would prevent the assignment. If itis permitted, the assignor should then address the

193See Section IV.E.194See Section II.E.5.a (Part 1 of report).195See Section II.F.1 (Part 1 of report).

196This could be accomplished using the capped participa-tion approach discussed above in Section III.A.4.

197See Section III.A.4.198See, e.g., United States v. Morris & Essex R. Co., 135 F.2d 711,

713 (2d Cir. 1943) (‘‘It is true that the Treasury may take ataxpayer at his word, so to say; when that serves its purpose, itmay treat his corporation as a different person from himself; butthat is a rule which works only in the Treasury’s own favor; itcannot be used to deplete the revenue’’), citing Higgins v. Smith,308 U.S. 473 (1940).



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fact that it probably has no easily separable interestrepresenting these rights that it can simply assign tothe service provider. One approach would be toamend the partnership agreement to accommodatethe interest being assigned.

If the other partners are not interested in amend-ing the partnership agreement — a likely situation— the assignor can consider remaining the recordholder of the interest and contractually assigning abeneficial interest in the assignor’s partnership in-terest to the service provider. Then the assignor canpass through the appropriate distributions to theservice provider and pass through tax allocations inaccordance with the nominee reporting rules.199

M. Disqualification Issues for PartnershipIn thinking about many of these risks regarding

the qualification of partnership interests as profitsinterests, there is a tendency to view them asconcerns for the recipient but not the partnership orexisting partners. That is a mistake. There aremeaningful consequences to the partnership and, asa result, the other partners.

It is true that if the partnership interest turns outnot to be a profits interest, the partnership may beentitled to a deduction for the value of the interestgranted.200 However, it may also be liable for failingto withhold income taxes for the grant and failing towithhold and pay payroll taxes for the grant.201

Moreover, the deduction, which flows through tothe partners, will not offset these withholding taxliabilities, which will fall on the partnership itself.202

As a result, the partners may end up with adeduction that they cannot use, while the partner-ship will have real cash liabilities for the withhold-ing taxes and any penalties and interest.

Accordingly, the partnership and the existingpartners should not assume that the question ofwhether an interest qualifies as a profits interest isnot relevant to them.

N. Proposed Carried Interest Legislation

Over the past decade, the taxation of ‘‘carriedinterests’’ has received significant scrutiny fromlawmakers. Several proposals for changing thetaxation of carried interest have been made by thepresident and Congress.203 Those proposals havetaken various forms, but generally they wouldapply to profits interests granted in connection withthe performance of services when the profits inter-est received is in a partnership whose assets primar-ily consist of investment assets. They are, in effect,primarily targeting interests granted in private eq-uity funds, hedge funds, and real estate funds(sometimes called investment services partnershipinterests). Under the proposals, capital gain allo-cated to the holder of a profits interest or capitalgain realized by the holder on the sale of the interestwould generally be converted into ordinary in-come. It is difficult to predict whether this conceptwill be adopted or what form it would take if it isadopted, but the possibility of the change in law issomething that people dealing with profits interestsshould keep in mind. And although profits interestsin partnerships that operate an active trade orbusiness would generally be unaffected by theseproposals, practitioners should still continue tomonitor proposed legislation in the area in case thatchanges.

V. Probably-Not-Final Thoughts

As this report illustrates, profits interests can be agreat way to provide an equity incentive to peopleproviding services to a partnership. The tax treat-ment to the recipient is very favorable, and there arealmost endless possibilities in terms of how they arestructured. But their use raises a host of issues bothin implementation and administration that practi-tioners should be attuned to. And unfortunately,while they have been sanctioned by the IRS forsome time, there remain many unanswered ques-tions about their treatment.

199Reg. section 1.6031(c)-1T.200Section 83(h).201See section 3102 (requirement to withhold employee share

of payroll taxes), section 3111 (requirement to pay employershare of payroll taxes), and section 3402 (requirement to with-hold income tax). While not entirely clear, the principles of Rev.Rul. 69-184 (which states that a partner is not an employee foremployment tax purposes) likely would not apply if the recipi-ent were not a partner before the receipt of the partnershipinterest. But see reg. section 1.721-1(b) (‘‘To the extent that any ofthe partners gives up any part of his right to be repaidcontributions (as distinguished from a share in partnership profits) infavor of another partner as compensation for services . . . it is aguaranteed payment for services under section 707(c)’’) (empha-sis added).

202Reg. sections 31.3401(d)-1(c), 31.3403-1, 31.3102-1,31.3111-4.

203See, e.g., Tax Reform Act of 2014 (as proposed by HouseWays and Means Committee Chair Dave Camp, R-Mich.),section 3621; H.R. 4213 (111th Cong.), section 601; H.R. 1935(111th Cong.); H.R. 2834 (110th Cong.); Office of Managementand Budget, ‘‘Fiscal Year 2015 Budget of the U.S. Government’’(Mar. 4, 2014); OMB, ‘‘Fiscal Year 2014 Budget of the U.S.Government’’ (Apr. 10, 2013); OMB, ‘‘Fiscal Year 2013 Budget ofthe U.S. Government’’ (Feb. 13, 2012); OMB, ‘‘Fiscal Year 2012Budget of the U.S. Government’’ (Feb. 14, 2011); OMB, ‘‘FiscalYear 2011 Budget of the U.S. Government’’ (Feb. 1, 2010); OMB,‘‘Fiscal Year 2010 Budget of the U.S. Government’’ (Feb. 26,2009).



(C) Tax A




Documents

Practical Considerations for Issuing Profits Interests, Part 2