There are two basic types of equity interests that exist for partnerships and limited liability companies: capital interest and profits interests. The two are treated differently by the tax code and carry distinct economic rights.
Capital interests are the most basic form of equity in a partnership. According to the IRS, a capital interest “would give the holder a share of the proceeds if the partnership assets were sold at fair market value and then the proceeds were distributed in a complete liquidation of the partnership.” Rev. Proc. 93-27. Capital interests entitle their holder to a share of partnership allocations and, as noted, upon liquidation a capital interest entitles its holder to a share of the distributed assets. So a capital interest is an interest in the past and future of the company.
Profits interests are an interest only in the future of the company. The IRS describes them as “a partnership interest other than a capital interest.” Rev. Proc 93-27. Not very helpful. In general, a profits interest entitles its holder to a share of partnership allocations going forward, but, at the time it is granted, a profits interest does not entitle its holder to any distributions if the company were to immediately liquidate. A profits interest conveys no right to past accumulated capital. In a sense, it’s a like a stock option, in that it is design to capture and allocate only future growth.
In some cases the distinction between capital and profits interests is significant. Assume an investor injects $100,000 into a venture and takes a capital interest, while a manager offers day-to-day services in exchange for a profits interest. The partners agree to equal allocations of income and loss. In the first year, the company earns $10,000 and at the end of the year, the company liquidates. Each of the partners would receive an allocation of $5,000 of profit. The investor would then receive a liquidating distribution of $105,000—the measure of the investor’s adjusted capital interest—and the manager would receive a distribution of $5,000—equal to the manager’s capital account. If the partners had both taken capital interests, they would each get $55,000 on liquidation. The investor would have a $50,000 loss, and would certainly object to that arrangement. And upon receipt of his capital interest, the manager would likely owe tax on the capital shift of $50,000. By giving the manager an interest only in future growth, and not past-contributed capital, the partners were able to avoid an undeserved loss and an unnecessary taxable event.
In other cases, the distinction is less meaningful. In many services businesses, for example, capital accounts are drawn down at the end of each year. In that case, a profits interest would typically be identical or nearly identical to a capital interest, because the business would have very little past-accumulated capital to distribute. Each year, the partners, whether they held a capital interest or a newly issued profits interest, would start the year with their capital accounts at or close to zero.
Because profits interests have no built-in value, but reflect only future growth, the IRS has determined that a grant of a profits interest is not ordinarily a taxable event. This makes profits interests a powerful tool for incentivizing managers and others contributing services to a partnership or LLC with accumulated capital or substantial market value.