Businesses frequently wish to incentivize and reward key employees with equity ownership. Those businesses operating as pass-through entities will often find a profits interest a convenient and tax favorable way to accomplish this goal. The profits interest can generally be structured to be received by the employee without triggering a current tax liability while still incentivizing the employee with participation in the up-side of an exit.
However, many are unaware that the granting of a profits interest to an employee transforms the employee into a partner for tax purposes. Profits interest holders are partners and the longstanding position of the IRS, as laid out in Revenue Ruling 69-184, is that a partner in a partnership may not also be an employee of that partnership.
What are the consequences of this transformation? Employees are subject to income and FICA tax withholding (and Form W-2 reporting) while partners, on the other hand, receive Form K-1 and pay income and self-employment taxes on a quarterly estimated basis. Further, this transformation may increase new partners’ employment tax burden because employment taxes for employees are borne equally by both the employee and employer, while employment taxes paid under the self-employment system are born 100% by the self-employed (i.e., by the new partner).
Also, only employees are eligible to participate in cafeteria plans, including flexible spending accounts, whereas partners are not.
What are the consequences of treating a partner like an employee anyway? Aside from potential over or under paying of employment taxes or potentially disqualifying a cafeteria plan by virtue of enrolling a non-qualified participant, future grants of profits interests to a partner who is incorrectly being treated as an employee may lose the benefit of the profit interest safe harbor and be taxable to the partner upon receipt.
The increase in self-employment tax burden caused by the issuance of a profits interest can be mitigated through a salary gross-up or may be overshadowed completely by the up-side of being able to participate in an exit. Complications of profits interest related to cafeteria plans and the future grant of more profits interests can be avoided through understanding the employee’s transformation into a partner and treating such individual accordingly.
Planning opportunities may exist for those businesses that wish to grant equity ownership to their key personnel while retaining the employment status of such personal. Such businesses should carefully vet these opportunities with their tax advisors.