A common way to reward and incentivize key employees in a partnership is to issue them a profits interest. If properly structured, the profits interest is not taxable as income to the employee upon issuance and provides the opportunity for potential capital gains treatment in the event of a future sale. Based on my experiences, however, principals often struggle with the decision to put another seat at the table; to give a mic to another voice; and in some instances, to share the smallest element of control of the business. Additionally, putting aside the issue of control, a profits interest is not a viable option for S corporations, which must be wary of creating a second class of stock, nor businesses where there are numerous key employees as it is simply not practical to make them all partners. It is further worth noting that the IRS is posturing to limit the types of arrangements where service providers are compensated through a profits interest. Specifically, on July 22, 2015, the Department of the Treasury and the IRS issued proposed regulations under I.R.C. §707(a)(2)(A) to treat the grant of certain profits interests as a disguised payment for services.
For these reasons and more, alternative compensation agreements can and should be considered. Virtually every benefit of an owner can be synthesized and written into an agreement. Whether in the form of phantom units or appreciation rights (to name a couple), these agreements allow owner/principals to provide compensation linked to equity value without the transfer of an ownership interest. Stated simply, these agreements are designed to reward key employees for acting like an owner without actually being one. By separating the “real” owners from the “synthetic” ones, there are the added benefits of limiting access to certain key business and financial information, as well as reducing obstacles for amending governance documents such as bylaws and partnership agreements. The latter point takes on increasing significance, as many partnerships will soon be required to amend their partnership agreements to reflect new IRS audit procedures that allow the IRS to collect taxes directly from a partnership at the entity level.
The takeaway here: there is more than one way to skin a cat. If you would like to discuss ways to help your clients compensate and retain key employees, or if you have any questions about the new IRS audit rules for partnerships, please do not hesitate to contact Anthony Daddino at (214)749-2464.