Hiring and keeping talent at the executive level is one of the more challenging issues facing companies in the middle market space. A common solution is to provide the executive or key person with equity compensation. Where the company is, however, a partnership for tax purposes, a unique and challenging set of rules comes into play. Should a potential exit be contemplated, the tax exposure related to a foot-fault on following these rules can be very substantial, and, unfortunately, is a common issue in working through a transaction.
The common scenario is that the executive receives a “profits interest” or an “unvested interest” that only vests on a change-in-control event. For example, new CEO joins Company ABC, and as part of the CEO’s compensation package, receives a 2% profits interest in the company, which is subject to forfeiture should the CEO leave the Company before a change-in-control, defined as a sale of either 80% of the company’s assets or equity. Alternatively, high performing Employee receives an equity interest where, upon a change-in-control event, the equity interest fully vests. Should the employee leave before the sale, the interest is forfeited.
In both scenarios, failure to address the tax issues at the time of the grant can result in substantial tax exposure on a sale of the company. The IRS has issued several rulings that provide guidance on how to protect the company and the employee in these scenarios.
There are a few basic requirements to avoid current taxation at the time of the grant:
- The grant must be of a profits interest, resulting in the individual becoming a partner (or receiving a greater interest as a partner), in exchange for services to the partnership;
- The profits interest is not related to a substantially certain predictable stream of income (e.g., from high quality debt instruments, etc.);
- The profits interest must not be disposed of within two years; and
- The partnership is not a “publicly traded partnership.”
If the above are met, in preparing for a transaction, confirmation of the following will typically confirm that any payments to the executive as a result of a transaction would not be treated as compensation:
- Did the individual file a Section 83(b) election with the IRS? (While technically this is protective, there are scenarios where failure to file the election can result in detrimental consequences);
- Did the Company treat the individual as a partner after receipt of the interest? That is, did they receive a K-1 as a partner?
- Did the company take a compensation deduction with regards to the grant of the interest?
Insight Tax Advisors is a specialized M&A tax advisor. Should you be engaged in a transaction and need assistance in addressing issues related to the above or any other transaction related tax issue, please reach out to info@insighttaxadvisors.com.