Locke Lord QuickStudy: Be Careful in Granting Profits Interests to Your Key Employees; New IRS Regulations Suggest the IRS is Keen on Form K-1 Filing

Locke Lord LLP
May 12, 2016

On May 5, 2016, the Department of Treasury and the Internal Revenue Service published final and temporary regulations amending Treasury Regulations §301.7701-2 under Section 7701 of the Internal Revenue Code of 1986, as amended (the New Regulations) clarifying the tax treatment of partners in a partnership that owns a disregarded entity.   

The New Regulations highlight the surprising complexities and, in some instances, the troubling impracticalities of incentivizing key employees with equity grants in a “pass-through” entity. 

The New Regulations clarify that self-employment taxes do apply to partners of a partnership that owns a disregarded entity in which the same partners are “employees”. Accordingly, such partners are ineligible for coverage as W-2 employees under certain benefit plans. While that clarification is noteworthy, what is more interesting is that Treasury and the Internal Revenue Service actually issued a clarifying regulation on this topic. This suggests additional governmental scrutiny is now focused on what some had believed to be a technical requirement the violation of which would be, for the most part, tax neutral to the IRS.   

Since “pass-through” entities such as limited liability companies are not bound by the inflexible requirements of a corporation, portfolio companies owned by growth and private equity funds as well as other privately owned operating businesses have tended to favor the ability to grant “profits interests” to their management teams. Profits interests are a special type of equity interest sanctioned by IRS administrative convention that can return capital gains to service providers and which can be issued with no income tax recognition on grant or vesting.   

The New Regulations are particularly important in light of the relatively widespread use of “profits interests” because one of the material drawbacks to their use is that under current IRS guidance (based on IRS Revenue Ruling 1969-184), the grant of a profits interest to a W-2 employee of a pass-through entity necessarily converts that W-2 employee into a K-1 partner. For the service provider, this conversion results in self-employment taxes, ineligibility for certain benefit plans, and K-1 reporting with estimated tax obligations.   

While many taxpayers have embarked on complex structuring efforts to avoid this K-1 status in connection with the grant of profits interests such as the creation of a wholly owned C-Corp. management company, or the establishment of an S-Corp management company to hold the profits interests, or even “chipping off” a small interest to a third party in the pass-through entity to avoid disregarded entity treatment, some taxpayers have relied on an interpretation of the current tax law to continue W-2 status, or on the more general principle that so long as employment taxes were being paid, there was really no harm and that the IRS should be indifferent.

The New Regulations clearly quash the notion that the IRS is indifferent and owners, employers and management teams should take note that the IRS’s long slumber on this topic is apparently over, as evidenced by the IRS’ surprising but purposeful reference to the 1969 Revenue Ruling, which is the founding authority for the position that a profits interest held by an employee converts the employee from W-2 status to K-1 status.   

That said, the IRS did offer hope by soliciting comments on how to apply the principles of Revenue Ruling 69-184 to tiered partnerships and the circumstances in which it may be appropriate to permit partners to also be employees (i.e., in the context of small ownership interests) or, in other words, to be treated as both a K-1 partner and a W-2 employee. 

To allow time for taxpayers to make necessary payroll and benefits adjustments, the New Regulations will be effective as of the later of August 1, 2016 or the first day of the benefit plan year that begins after May 4, 2019 for an affected plan (e.g., a section 125 cafeteria plan, qualified plan, or health plan) if the plan includes participants whose employment status is affected by the regulations.   

Please contact your Locke Lord relationship attorney about the need, if any, to restructure current arrangements and benefit plans.