In a quasi-continuation of episode 6 of How Tax Works, host Matt Foreman discusses the most misunderstood and misapplied form of equity grants: Profits Interests.  This episode is for anyone who wants to better understand promotes and springing interests, as well as anyone who wants to grant or receive equity in a way that does not require the immediate payment of taxes. 

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How Tax Works, hosted by FRB Partner Matthew E. Foreman, Esq., LL.M., delves into the intricacies of taxation, breaking down complex concepts for a clearer understanding of how tax laws impact your financial decisions. Through this, listeners are treated to a comprehensive breakdown of entity structures, from the robust shield of C corporations to the flexibility of partnerships and LLCs. Foreman navigates through the maze of tax considerations, shedding light on entity-level taxation, shareholder responsibilities, and nuanced tax strategies. Foreman shares valuable insights and practical advice, emphasizing the need for informed decision-making and consultation with tax professionals. From qualified small business stock to state and local tax considerations, no stone is left unturned in this illuminating exploration of tax law and entity selection.

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Transcript:

**This transcript has been prepared automatically by AI and may contain inaccuracies**

Matthew Foreman [00:00:00]:
Hi and welcome to the seventh episode of How Tax Works. I’m Matt Foreman. In this episode I’ll discuss profits interests which is part of the completion of my two part episode regarding equity compensation. In the last episode which if you didn’t listen to it, probably should do these in order to. I talked about equity comp generally just sort of how the code deals with it. ISOs, NSOs, stock appreciation rights, phantom stock RSUs, RSAs and just sort of general equity grants with some 83B issues. I’m going to talk a little more about 83B in this one but definitely would recommend going back, you know, listening to that one first.

Matthew Foreman [00:00:45]:
I do think it’s important. How Tax Works is meant for informational and entertainment purposes only. This may be attorney advertising and it is not legal advice. Please hire your own attorney. How Tax Works is intended to help listeners navigate the intricacies and complexities of tax law, regulations, case law and guidance to demystify how taxes shape the financial and business choices that we all make. Before I get started, a few administrative things episodes every two weeks. Next I’m probably going to do convertible debt and simple agreement for future equity or safes, but other kind of debt equity hybrid issues going to veer a little bit off just pure tax because I think that stuff’s really important. The tax stuff I think is really nuanced.

Matthew Foreman [00:01:23]:
I think that’s really important. If you have any questions, comments or constructive criticism, email me at my FRB email address which you can find on the Internet. So thank you Al Gore, for that. Digital Assets I organized a panel for a full day event. It is an 80 minutes of the full day. There’s four panels, tax and digital assets as part of a FinTech event on September 16th, the New York City Bar Association. It is 42 West 44th street between 5th and 6th. For those who are wondering, there’s a link on the webpage and there’s an all star panel.

Matthew Foreman [00:01:56]:
Erica Nyenhuis from the Treasury Department, Roger Brown from Chain Analysis at Edward so he’s a partner at White and Case. He’s going to be our moderator. Really excited for it. I think it’s going to be a great, great panel, have some really good topics and really get into some interesting points. So today we’re talking about, you know, a very, very niche issue, but one that I think really, really gets into a lot of places. A lot of people run into this. And I always, you know, I get people like, hey, how do we do this right? Because in the last episode I Told you how everything is taxed upon grant or if it’s not taxed upon grant, how it ends up being taxed. Right.

Matthew Foreman [00:02:30]:
So as a reminder, section 61 and 83, grant of equity, taxable upon receipt based on a fair market value less than the amount you actually pay. And the entire premise of a profits interest is really that this is what’s called structuring, right? A lot of people say, oh, you know, you can do whatever you want and things like that. And yeah, I mean, you can go pretty broad on this. There’s a lot of stuff. And this is one where planning ahead is really important because profits interest, if you wait three years to document, you have an issue because you filed returns that are inconsistent. So the way I think about things is that a profits interest is two economic rights in a partnership. And this is really how I think about economic rights and partnerships generally. There’s rights to current year income and loss and there’s right to equity, which is the value or some amount of money upon liquidation.

Matthew Foreman [00:03:23]:
And if you notice the things I did in episode six, they all either give you some sort of cash bonus or the equity that you receive has a right to both right current year income and loss, dividends, whatever, depending on what kind of company is. And it gives you some sort of proceeds upon liquidation or sale. So there was an issue. If you really talk About Revenue Procedure 9327 a lot, which I recommend people read if you’re interested, want to learn more? It’s only a couple pages, three, four pages. Pretty quick to read, pretty brief, and it’s really direct, but it’s nuanced and it doesn’t say a lot of things. And what it basically dealt with was the first economic right, which is the current year income and loss. And what they said was, and I’m paraphrasing and definitely colloquialisms in here is we are sick and tired of fighting over the valuation of current year income or loss. We’re just, we’re done with it, we don’t want to do it anymore.

Matthew Foreman [00:04:15]:
So it’s worth zero. There are some very specific requirements that deal with it, which I’ll get into in a second. But it’s worth zero. And then RevProc 9327 ends. Okay, it says there are three situations where it’s not a profits interest. You don’t qualify. You cannot sell the profits interest within two years. If you do, it never was a profit’s interest and the value was.

Matthew Foreman [00:04:36]:
I’m not sure. I’ve always largely Wondered what the value would be if you sell it a year and a half later. I suspect they’ll say it was worth the amount you sold it for a year and a half later. I mean, it should have been taxable. It’s ordinary income, so that’s not great. But I don’t know the answer to that. I’m not sure it really matters. Just don’t sell it within two years.

Matthew Foreman [00:04:52]:
You know, again, structuring plan, plan, plan. You can’t do it if the profit from the business is, I use the word regular and consistent. That’s not what they use in Red Rock 93 27. But what they’re looking for and they’re looking to prevent is people who get part of the current year income and loss tax free. When there are, you know, the two examples they give were a high, you know, high quality bonds, high quality net lease, things like that. High grade, I think is the phrase they use. And the premise is, look, if you can say, look, there’s T bills in this or there’s stock and you know, bonds from a publicly traded company that has, you know, a triple A or whatever grade, there’s really no risk. You’re basically just getting part of the cash flow from the bond.

Matthew Foreman [00:05:33]:
That’s not what we’re looking for. We’re looking for an operating business that has material, material, material risks, right? And that’s what they’re looking for. The third one is, of course, if the profit’s interest, you can’t have one in a publicly traded partnership. There’s little wiggles on that, but basically don’t do it. Those are the three things. We grant those and they’re in that way. Then it’s not a profits interest and it’s taxable upon receipt. So the second part is equity value upon liquidation.

Matthew Foreman [00:05:56]:
Equ. And you know, again, this is what you say, if you’re getting 10% of a company that’s worth a hundred dollars, you’re receiving $10 in cash, right? That’s the deal. That’s how it’s viewed from a tax perspective. And there’s not a whole lot to do with it, right? So what do you do? How do you get around it? And we’re going to take a quick momentary break, get some good music in, and we’ll come back in a moment. So the answer for how do you come back? You know, how do you get around this is what’s called the hurdle, okay? And the premise of the hurdle is what it does, and I explain it and I always use layer cake. There’s layer cake and targeted and I think it’s important to understand them both. But basically what you do is you impose a hurdle. So let’s say right now you have a two person partnership, A and B, okay.

Matthew Foreman [00:06:50]:
And they want to admit partner, a new person partner C, okay. The partnership at the time of the Grant is worth $100, right? You get a current year income and loss, 10%, not an issue. Then what you do is you set up the allocations and distributions are going to match really in which the first upon liquidation, right. Upon sale or something close, you know, if you just liquidate the partnership, sell all the assets, move on. Same idea. What you do is the first hundred dollars goes to A and B and it has to exceed that hurdle. Then beyond that $100 that can go to A, B and C and so you can get 10%. I’ll talk about catch a post hurdle in a second, but that’s later.

Matthew Foreman [00:07:30]:
But the premise basically is, look, if you get none of what the business is worth right now, okay, then you’re getting zero, right? REV. PROC. 93, 27 to current income and loss. And then once you have that, the hurdle deals with the fact that making sure that the equity you receive is worth zero. And that’s the whole idea. That’s really what you’re trying to do. I use layer cake as opposed to targeted. You can use targeted.

Matthew Foreman [00:07:56]:
It’s a similar concept, but for me I was taught how to do profits interest and how to do allocations in Excel. I learned how to do it working for large accounting firms, Big four accounting firms. And what they basically said is, look, if you can just plug the numbers and everything directly into an Excel spreadsheet and it just flushes it out, it’s easy to follow, it’s easy to understand. It’s just math. And that’s how I think about it and that’s how I try to do it. One problem I see every so often is they put the hurdle in the current year, right? So the first hundred dollars of income, you know, for the current year goes to A and B to continue the example and thereafter it goes to, to, you know, the 10% goes to C. That doesn’t work, right? Because the equity in the business. There’s two reasons I think it doesn’t work.

Matthew Foreman [00:08:45]:
One, the equity in the business is really the problem. Refrock9327 totally deals with it and people say, oh no, we don’t get the money and you still get $100 less. And I’m like yeah, but there’s two distinct economic rights and I’ve always found that that is a, I’ll say an extremely non literal read of 9327 and revenue procedures are non binding. Right? So the loper bright doesn’t matter. There was never Chevron deference anyway. What they are is a statement of IRS policy and how they want to deal with it. And the IRS is giving a gift, frankly. REV.

Matthew Foreman [00:09:15]:
PROC. 9327 has no statutory authority whatsoever. It is just saying, look, we’re going to be nice about this. We’re not going to be jerks. This is what we’re going to do. Don’t be aggressive. So it doesn’t work. The second reason I think it doesn’t work is what’s going to happen is current year’s ordinary income, future years pride, capital gains.

Matthew Foreman [00:09:32]:
You’re shifting from ordinary income to capital gains. You’re increasing capital gains at the cost of ordinary income. I’ve always wondered if that has substantial economic effect, let alone the fact that it’s not a profits interest in and of itself. And that’s problematic. Right? People ask me if do I need to do a rev. Do I need to do an A3B election for it? RevProc2001:43 says don’t do an A3B election. A lot of times I do. A lot of times I actually do an A3B election for two reasons.

Matthew Foreman [00:09:58]:
One, sometimes you get profits interest and it vests over a number of years, right? 4% profits interest, 1% per year. I just tell them to do the A3B election because you’re sort of combining two distinct concepts, right? You’re combining the concept of a restricted stock award with a profits interest, right? And by doing that, by combining those two concepts, you want the A3B protection the restricted stock award has and you don’t want to deal, you know, later increases in value. What’s the hurdle going to be? Do have to change the hurdle? How do we do that? The other reason I like the 83B election is because it’s really the only way to give notice to the IRS that you received a profits interest. Right? So sometimes I tell people to do it even though RevProc2001 43 says don’t. I know that I am not in the minority when I say you should do it. So I know that a lot of people do. So that’s really it. The next sort of premise of what I think about and how to deal with it is I call it hurdle part Two, which is a post hurdle catch up.

Matthew Foreman [00:11:00]:
The premise is again, you know, let’s say the hurdles $100 and they sell for 50. 150, okay. So first Hunter goes to A and B and what a lot of people do is they say, well you know, partner C really should get 10% of 150 so they’ll just get the next X dollars 10. I know my math is imprecise, but let’s say next $10. That way they get immediate catch up again, you know, and I said this were red procurement 9327. Is the IRS being nice? It does not discuss catch ups or anything like that. So it’s a technical compliance point. But you know, similar to the market term, bulls and bears make money, pigs get slaughtered.

Matthew Foreman [00:11:37]:
Okay, So I really don’t want you to be in a situation where there’s a wink and a knot. Look, valuations have an art and a science to them and even the best done ones you can attack. And you can say, well, you know, you use the wrong discount here and you didn’t take this into account and maybe this is too big of this and this is that. So I tell people like, you know, don’t push it too far on this. What I like to do is called the double hurdle catch up. So if the hurdle is 100 over the next 200, what happens is after the $300 sale, so it’s a significant amount of time, significant additional purchase price. So there’s a lot of time between, you know, generally speaking, unless the business really hockey sticks. Right.

Matthew Foreman [00:12:17]:
The basic premise is that instead of doing it so again, first hundred goes 50, 50 to A and B, the next 200 is done in a way so that partner C gets a total of 30. Right. So after a total of 300 that has 30, which is 10% and the remaining 270 just gets split up. Right. 135. 135. So at the end, if I did that math right, I think think I did. Nope, I didn’t do it.

Matthew Foreman [00:12:45]:
Right, right. So it’s 30 and then it’s hearing the fact I can’t do math on the fly. Then you’re doing right, 30 and then 85. 85. There we go. Thank you. I did not edit that on purpose so you could hear my brain creak. So at the end of what happens right at the end of 300 you have, you know, 10% to see and then 45.

Matthew Foreman [00:13:06]:
45. And that’s the idea, that’s the premise. And then after that it just goes 45, 45, 10 total. Right. So you’re there, but it takes a while to get there. And by doing that, I think that’s more easily defendable. It’s not as much of a question of, wow, you were a little aggressive on the hurdle. Maybe you were, maybe you weren’t, but I think that that’s really helpful.

Matthew Foreman [00:13:26]:
So I think that’s the idea. People always ask me, do I need evaluation? I say, yes. Can you do it yourself? Absolutely. Make it contemporaneous, make it real, have an explanation. I strongly recommend getting a professional to do it because that’s a really, really, really easy way to tell the IRS to go away or a state revenue agency that’s looking into this. Right. Same idea. And that’s it.

Matthew Foreman [00:13:46]:
You know, some people get a couple. You know, for a hurdle, you want to go low. I’ve seen a lot of people who do this as part of gifting, as part of estate planning. You know, children get profits, interests who are involved in the business. And so for estate planning, you want the hurdle to be low because you want the value to be low. But, you know, for other purposes. Right. If there’s a sale or you’re considering other things or someone’s buying into the business, do it at a time where you’re not just looking for a low valuation.

Matthew Foreman [00:14:10]:
Right. That’s the idea. And so now, going to take another quick momentary break and I’ll be back in a moment. Hope you enjoyed the music again. Welcome back, everyone. Hope you enjoyed it. So, you know, people always ask me, well, okay, look like, can we do this with an S Corp? No. Any sort of profits, interest is pretty overtly a second class of stock.

Matthew Foreman [00:14:38]:
Right. Just does something totally different economically. So S Corps can’t do it. Where you can do it is you do the F reorg S Corp. The historic people still own the S Corp. The operating code of the LLC generally is a partnership. Partnership can do it. And that’s what you’re going to have to do there.

Matthew Foreman [00:14:53]:
You can do a really similar concept in a C Corp, where you just have another class of stock where the dividends or proceeds from a sale would just have the hurdle. I’ve done it a few times in a C Corp. It’s a little more clunky. And if you take on investment in the future, they always want to know what happened here. Right. What’s going on. So I think that’s really important to be able to explain it and think through why you did it and how you did it. I always point back you know, as we’re sort of starting to wrap up a little bit here, but the profits interests really focus on economics rights.

Matthew Foreman [00:15:20]:
Generally speaking, profits interests have no voting rights. And the reason for that is twofold. One, a lot of times you’re giving people a small amount of the business. You don’t really want to deal with them, you don’t want them to vote. If they want to vote, they’re either paying tax on the way in or they’re going to buy in and that’s it. The second reason is voting rights can have value. You know, anyone who’s ever looked at an S Corp and done estate planning, a lot of times what people do is voting and non voting shares, which you can do with an S Corp. Obviously if you listen to episode one, I talked about that, and what you do is by having it be non voting, that guarantees it’s just not going to have value for the voting.

Matthew Foreman [00:15:52]:
But if you put voting in it, that may have value. You have to think through that. You have to evaluate that and that’s really important. And now as really my final point, I’m going to talk about a type of profits interest that’s actually pretty common and done kind of differently in what’s called promote, commonly referred to as a promote. I call it a springing interest, Some people call it a contingent interest, whole lot of different names for it. One of the big ideas is, and this is very common in real estate development is there’s an LLC or just general partnership, some sort of entity that’s taxed as a business, that’s taxed as a partnership. And what you do is the people who do the work. These 64 things have to happen.

Matthew Foreman [00:16:30]:
The investors get their money back first and then they get 10%. Right? And if they don’t meet all these requirements, they get zero. That’s a profits interest. That’s all it is, right? It may spring because you have to do certain things in addition to getting your money back. It may be contingent in that different things have to happen, same idea, but there’s almost always a hurdle. Also I’ve seen it and this is sort of mirroring the concept of, of a profits interest, but it’s a little different. Some people will buy an interest that it can vary. What you can do is draft an interest that say, let’s say you’re buying an interest, it gets absolutely nothing.

Matthew Foreman [00:17:05]:
Okay, and you bought it for $100. I’m making up a number. But if you meet these 16 requirements, the amount it gets upon liquidation increases, increases, increases Increases. And that’s the idea, right? That’s the idea of a promote is really like, look, I’ll pay you and I’ll pay you for services. Oh, I’ll pay is the wrong word. Probably compensate you for services, right. But what I’m compensating you with at the time you receive it is worth zero, right? Same idea as a profits interest. That’s how promotes work.

Matthew Foreman [00:17:33]:
However, when you do it, when you receive it, towards zero. But it could be something in the future. And that’s the idea, you know, and that’s really what you’re going for with promotes super, super, super common in the real estate. I see them in other contexts you really have to watch out for to make sure it’s not worth more than they’re paying at the time. There’s other issues with it and it has to change by a mechanism within the equity, within how the LLC’s operating agreement, bylaw, shareholder agreement, what have you, how it operates. You can’t agree to a new thing and change out. Right. There’s a case that deals with, you know, swapping different assets.

Matthew Foreman [00:18:07]:
If you change what the asset is, the type of equity change, debt change, you know, material terms that can actually trigger income by changing material terms of equity and debt. So I think it’s really important to really think through that and make sure that’s done correctly. Again, you know, and I said this before, you know, and I probably say this every episode is get someone who does this, right? I, I know I do. I do a lot of profits interest work becomes something I, I just, I don’t say stumbled into, but I’ve been doing it for, you know, five, six years now. Fair, good clip number of times a year. And I think it’s really important to get someone who really knows it, has done it, can talk you through the risks and can explain it to the recipient, right? Because people think, oh, I’m getting 10% of the company, great. And you’re saying, well, you’re getting 10% kind of. Right.

Matthew Foreman [00:18:47]:
And so you get this thing where, you know, you look on the K1, right? Profits interest, 10% loss interest, 10% capital interest, various. Right. What does that mean? And you have to explain what it is. And I often when I do operating agreements, I put in examples of how it works. And when I grant it and I talk to the employee and I explain how it works, I work through it with them and I say, look like it’s worth a hundred dollars Today, if in 10 years it’s worth 300, these are how the numbers work out. This is what it is and this is capital gains. Above that, a hundred above the hurdle. It’s going to be much better for you that way.

Matthew Foreman [00:19:18]:
And they tend to like it. People tend to be adverse, right? They don’t want taxes or adverse taxes. But there’s a level of this is really not that risky. It’s very common. It’s a way that, you know, people incentivize, especially if you’re buying, you know, people come in by a company, they want to incentivize key employees, profits, interest are a great way to do it. Especially if you have an LLC taxed as a partnership in the new entity. So that’s a really good way to do it. So really think that’s a way to do it.

Matthew Foreman [00:19:43]:
But again, you know, and I go back to this, you know, there are two economic rights in a partnership. There’s current year income and loss and there’s the value upon liquidation. And they’re separate, they’re distinct. And you really need to treat them differently because RevProc 9327 only deals with current year income and loss. And you have to use the hurdle to, to deal with the fact that you have a value upon liquidation to mitigate that tax. It’s not completely ameliorate it. So that was the seventh episode of How Tax works. I hope you learned something today.

Matthew Foreman [00:20:11]:
I’ll be back in two weeks with the eighth episode of Discuss probably convertible debt and safes. I need to totally figure that out. So no warranties expressed or otherwise. But I think that’s what I’m going to do. It should be a good one and try to prevent the two parters that are a little more clunky to do. And now for the best song of all time. Thank you for listening. Have a good day.