Editor: Mark Heroux, J.D.
This may be a good time to revisit the use of unvested partnership interests as compensation because these situations can come up and the applicable authority is perhaps not widely known. The author recently reviewed two matters of this kind. The present discussion focuses on a company's hiring of a new CEO, where the consultations with the tax adviser about the executive's compensation package addressed a number of issues concerning the use of an unvested capital interest in a limited liability company (LLC) taxed as a partnership.
Much has been written and discussed over the years about profit interests (as opposed to capital interests) issued for services, including those that are unvested. Still governed by the combination of Rev. Proc. 93-27 and Rev. Proc. 2001-43, the tax-free nature of these types of compensatory ownership interests keeps them a favorite of tax planners, employees, and employers alike. However, profit interests have limitations, most notably involving economic risk in the event the value of the subject entity does not rise to ultimately provide the desired level of economic value. The discussion here focuses on the use of unvested capital interests as compensation.
The CEO and the unvested interest
Consider the following scenario:Acme LLC, a closely held manufacturing company, is in search of a new CEO to replace the retiring longtime leader of the business. The existing CEO has led the company through more than two decades of second-generation family ownership. With that generation now aging into their 60s and 70s and there being little direct family involvement in the operations, the owners are looking for an executive who will be able to jump-start growth in some new opportunities and help develop and execute an exit strategy for family ownership.
KJ has been identified as a very strong candidate to be the new CEO, and she has accepted the job, subject to negotiating a full compensation package. Among other things, KJ insists on obtaining a 5% ownership interest in the outstanding common unit ownership of the LLC. A recent appraisal of the LLC places the value of the common shares at $30 million. The LLC's tax adviser suggested considering the use of a profit interest with a "catch-up" capital transaction profit allocation feature as a more tax-advantaged strategy.
With the events of 2020 creating an entirely new landscape in many aspects of business, KJ is unwilling to take the economic risk associated with a catch-up allocation structure. The ownership group is willing to agree to this dilution of their existing ownership but requires that the ownership interest remain unvested until the earlier of five years or a sale of a controlling interest in the company, which is acceptable toKJ.
As the tax adviser for the company, you are tasked with outlining for the parties the income tax issues related to the issuance of this type of unvested interest. You have advised many times on matters involving unvested profit interests covered by the revenue procedures noted above but have never dealt with a compensatory capital interest. Although there continues to be a lack of compensatory partnership interest guidance in the form of regulations, with proposed regulations having been issued in 2005 and remaining unmoved since that time, fortunately, there is a valuable Tax Court case that provides some rather comprehensive guidance related to unvested capital interests.
The case of Crescent Holdings, LLC, 141 T.C. 477 (2013), involved several tax issues surrounding a 2% nonvested partnership capital interest issued as part of a comprehensive compensation package for a newly hired CEO of a large real estate holding company. In this case, the CEO chose not to make an election under Sec. 83(b) with respect to the nonvested capital interest. Although the value of the interest was not discussed at any length in the case, it can be discerned from the facts provided that such an interest would have been valued at several million dollars at the time it was issued. Following a significant leveraged reorganization, the company ultimately went bankrupt prior to the vesting of the subject interest, and, in fact, the CEO left the company and abandoned all rights to any ownership. This was a fortuitous move on his part.
The pertinent holdings of the Tax Court in Crescent Holdings include the following:
- The court found the 2% interest in this case to be a capital interest and therefore not subject to Rev. Proc. 93-27 or Rev. Proc. 2001-43 guidance.
- As a capital interest that constitutes property received in exchange for services, Sec. 83 does apply. As such, the nonvested interest would also be subject to the election opportunity under Sec. 83(b).
- In what the court termed an issue of first impression, it held that under Regs. Sec. 1.83-1(a)(1), the undistributed partnership income allocations attributable to the nonvested 2% partnership capital interest are allocable to the transferor of the interest, i.e., the partnership and, as such, allocable to the remaining partners.
Points of negotiation
Not discussed in this case are the important economic and tax considerations that need to be taken into account in the course of dealing with nonvested capital interests and whether an election under Sec. 83(b) will be made. The most notable of these considerations is what happens if an election is made and the interest fails to vest or is forfeited.
Returning now to our discussion of the client and its prospective CEO, certain questions need to be addressed: What will be the impact to KJ if she makes an election under Sec. 83(b)? What if the interest fails to vest? The key here lies directly in Sec. 83(b) itself, which states that following an election, "if such property is subsequently forfeited, no deduction shall be allowed in respect of such forfeiture."
Unlike an unvested profit interest in which the (liquidation) value at the time of issuance is zero, thus making an 83(b) election a mere formality, a nonvested capital interest requires some substantive consideration. In the case involving prospective CEO KJ, the liquidation value of the 5% interest would be $1.5 million. Would minority interest and/or lack-of-marketability discounts be available? If so, the Sec. 83(b) fair market value might be in the range of $900,000, making the potential tax hit $360,000 at a 40% effective rate (for illustration purposes).
The next point of potential negotiation will be for the parties to determine, in the event an 83(b) election is made, whether KJ will be reimbursed for the tax outlay. Negotiations on this point go both ways, and in Crescent Holdings the CEO was not entitled to receive a reimbursement for any taxes paid with respect to the interest received. On the other hand, in the present situation, if KJ makes an election and recognizes $900,000 of taxable income, the current owners of the LLC will receive an offsetting $900,000 compensation deduction, thus reducing their current collective tax liability by that same $360,000, assuming similar effective rates for illustration purposes. In other words, a point of negotiation here is that the $360,000 to be distributed for taxes by the LLC either will be to the existing owners in the absence of a Sec. 83(b) election or could be diverted to KJ in the event she makes an election.
If agreement can be reached on neutralizing the upfront tax hit on the election regarding the unvested capital interest, it clearly makes the situation significantly more palatable to KJ. The end result of such an agreement is that if the interest fails to vest, the loss of the ability to claim a deduction might not be as economically difficult for KJ to swallow. On the flip side — because there is always a flip side — it is now the remaining owners who might very well receive an offsetting income allocation or recognition event with the shifting of capital back in their direction upon the failure to vest. This is another reason the typical capital interest scenario does not provide reimbursement for taxes to be paid when making an election or upon vesting of the interest.
The uncertainties created throughout 2020 have profoundly affected everything from where people live to how they work. It is quite likely your practice will face many new scenarios. Practitioners should keep in mind Crescent Holdings, a well-written opinion worthy of a careful read.
Mark Heroux, J.D., is a tax principal in the Tax Advocacy and Controversy Services practice at Baker Tilly US, LLP in Chicago.
For additional information about these items, contact Mr. Heroux at 312-729-8005 or email@example.com.
Unless otherwise noted, contributors are members of or associated with Baker Tilly US, LLP.