Last week, we considered several of the revenue proposals included in the Biden Administration’s 2022 Budget that are probably of interest – or should we say, “of concern”? – to the owners of closely held businesses.[i]

Rate Hikes

The proposed increases in the federal corporate income tax rate – for C corporations[ii] and for S corporations that are subject to the built-in gains tax[iii] – to 28 percent, and in the individual income tax rate for ordinary income to 39.6 percent, were expected, though the phase-in of the corporate rate increase results in an unanticipated retroactive effect.

The corporate tax hike will be enacted, albeit at a rate below that requested by the President,[iv] and hopefully only for taxable years beginning on or after January 1, 2022; the individual rate, coupled with some significant compression of the brackets, will probably end up at the level requested.[v]

The President’s request for an increase in the individual tax rate on long-term capital gains from 20 percent to 39.6 percent was also anticipated, though many were taken aback by its retroactive application to late April 2021.[vi] Although there will be rate increase – hopefully with prospective effect only – it will likely disappoint many in the Democrat-controlled Congress.

Deemed Sale

I imagine that the biggest surprise among the proposed revenue generators, and the measure that will be the most difficult to enact, was the Administration’s request that gifts and testamentary transfers of assets by an individual taxpayer[vii] be treated as a sale of such assets, with the result that the gain deemed to have been recognized from the fictitious sale will be included in the gross income of the taxpayer.

I also suspect that the Administration has not thoroughly considered the range of consequences that may follow a deemed sale.

For example, what if a partnership has a Section 754 election in effect when individual partners start making gifts of partnership interests that trigger the above-referenced gain recognition? The transferee will take the gifted interest with an outside basis adjusted to the fair market value of the interest. Will the partnership be required to adjust the transferee’s share of the inside basis of the partnership’s assets?[i]

What else?

Today we continue our review of the President’s revenue proposals and how they may impact a closely held business; specifically, the proposed change in the tax treatment of a profits interest.

However, this topic also provides a good illustration of the Administration’s efforts to rationalize, or to back into a technical explanation for, a desired change in the tax treatment of an economic arrangement between unrelated parties – one which has been accepted by the IRS – where the only purpose for the change is to stop the flow of any further benefit to those who make use of such an arrangement.

Mind you, I am not singing the blues over the tax treatment of successful finance types. However, I am raising the flag over how arbitrarily the government may act when it uses the tax laws to reduce the economic return of someone whom the government determines has been “too successful” notwithstanding their having succeeded while remaining within the confines of the law.

Profits Interests

Like the preferential rate on long-term capital gains, the profits interest has been squarely in Mr. Biden’s sights since the early days of the presidential campaign. Its association with the world of finance has also made it an easy target for many in Congress,[ix] though its utility is not limited to the Wall Street types, and it is often used by closely held operating businesses to reward key employees.

In general, a profits interest is a partnership interest that is issued to an individual in recognition of the services provided or to be provided by such individual to the issuing partnership. So, “what is the big deal?” you may ask. Good question.

Equity Interest

If I render a service to a closely held business organized as a partnership, the business may compensate me with money or other property, including an interest in the partnership. In general, I would include the amount of money or the fair market value of the partnership intertest in my gross income as ordinary compensation income for tax purposes.[x] My initial basis for the interest would be equal to its fair market value; my holding period would begin with my receipt of the interest.

Unvested Interest

What if the partnership interest issued to me requires that I regularly provide services to the business for at least two years, failing which I must forfeit my interest to the partnership in exchange for little-to-no consideration?[xi] In that case, I would not be treated as a partner for tax purposes[xii] until my interest has vested, after two years. Consistent with this treatment, the fair market value of the interest would not be included in my gross income until it has vested, at which point it would be included at its then, presumably greater, fair market value.[xiii]

Alternatively, if I believe that the business will do well, I may elect to include the fair market value of the interest in my gross income for the taxable year in which it was issued to me, notwithstanding that I may still have to forfeit the interest if I were to terminate my services prematurely.[xiv]

In that case, I would immediately be treated as a partner for tax purposes, and I would have cut off the compensatory element in the interest, meaning that any appreciation in the value of the interest by the end of the second year (the vesting period) would not be includible in my gross income as compensation at that time, and I would have the opportunity to realize capital gain on the subsequent sale of the interest.[xv]


Instead of granting me equity in the partnership, the business may grant me an option to purchase a partnership interest at an exercise price equal to the fair market value of the interest at the date of grant.[xvi] In most cases, I would not exercise the option until I was certain of realizing some economic advantage by doing so – i.e., when the value of the underlying equity interest exceeded the exercise price.[xvii] The excess of the fair market value of the partnership interest at the time of exercise over the exercise price (the bargain element) would be included in my gross income as ordinary compensation income.[xviii] If I immediately sold the interest, I would not realize any additional gain.

What if I exercised the option immediately after its grant? I would not realize any economic benefit; indeed, I may be placing myself into an economically worse position. After all, I would have given up liquid cash for an illiquid asset of equal value (at least at that point in time), and I would have assumed the potential for loss, along with the potential for gain, that are associated with equity ownership in the business and that are the lot of any investor. In other words, I would have received nothing from the partnership in exchange for my service.

Of course, if I were confident in the prospects of the business, I may exercise the option right away,[xix] and thereby avoid any ordinary compensation income.

Profits Interest

Each of the foregoing compensatory arrangements satisfies a particular business purpose of the partnership and/or of the service provider. But what if the service provider wants neither to make a capital contribution to the partnership,[xx] nor to incur an income tax liability[xxi] in connection with the receipt of the partnership interest?

Enter the profits interest.[xxii] In exchange for my service, the partnership grants me an equity interest in its business.[xxiii] I make no capital contribution to acquire this interest, and I have no right to share in any portion of the partnership’s current value, which necessarily belongs to the existing partners.[xxiv]

Rather, my interest entitles me to a share of the appreciation in the partnership’s value occurring after I have become a partner. It also entitles me to a share of profits generated by the partnership after my admission as a partner.


Thus, if the partnership were liquidated immediately after the grant of my equity intertest, I would not be entitled to any distribution from the partnership in respect of my interest.[xxv] If the partnership were liquidated at some later time, I would not be entitled to a distribution until an amount equal to the fair market value of the partnership as of the date of my admission was first distributed to the pre-existing partners.

However, does that mean my interest has no value at the time of grant? It is true the interest has no immediate liquidation value, but that does not necessarily indicate it has no value whatsoever, unless such value is too speculative to determine. Query how often that is the case.

What if the profits interest relates to a substantially certain and predictable stream of income from partnership assets, such as income from a high-quality net lease?[xxvii] What if I was able to sell the interest to an unrelated person within a relatively short period after its grant?

In the absence of a predictable income stream or other realization event, the IRS was – quite generously though, I think, incorrectly – willing to accept that the typical profits interest had no value at the time it was issued to the service provider. However, I ask you, who would accept such an arrangement as compensation? That is, unless they were already adequately compensated for their services, and the equity was thrown in as something extra that may or may not pan out.

Partnership Profits

Of course, if the partnership had profits, some portion thereof may be allocated to the holder of the profits interest; for example, the holder’s share of ordinary business income. In accordance with the tax rules applicable to partnerships, the character of the income in the hands of the partnership will carry out to its partners as though they themselves had realized the income directly from the source from which it was realized by the partnership.[xxix]

Partnership Gains

Similarly, if the partnership realizes long-term capital gain from the disposition of an asset, and part of that gain is allocated to the holder of the profits interest, then the holder will report their share of the capital gain as such on their own tax return. The fact that they received their interest in exchange for services, or that they held their interest for not more than one year by the time of the asset’s disposition,[xxx] is irrelevant.

Capital Accounts

The immediately preceding paragraph assumes the partnership’s business or assets appreciated in value after the issuance of the profits interest. To ensure that the profits interest shares only in such appreciation – and not in the unrealized gain of the partnership’s assets at the time of issuance of the profits interest – the partnership must establish the date-of-issuance value of, and thus the unrealized gain inherent in, its assets at that time.

Then, in accordance with IRS regulations, the capital accounts of the pre-existing partners must be adjusted to reflect the manner in which this unrealized gain (that has not been reflected in the capital accounts of these partners previously) would be allocated among the pre-existing partners if there were a taxable disposition of such assets for fair market value on that date.[xxxi]

In determining such fair market value as of the date of issuance, the partnership should consider future events – including agreements for the sale of assets to a strategic acquirer – that were reasonably foreseeable at that time.

Sale of Interest

Gain recognized on the sale of a partnership interest is generally treated as gain from the sale of a capital asset.[xxxii] If the selling partner has held the interest for more than one year, the gain will be taxed as long-term capital gain, except to the extent it is attributable to any “hot assets” of the partnership.[xxxiii]

If a profits interest is sold within a relatively short period following its issuance, the amount realized on the sale should be indicative of the fair market value of the interest on the date of issuance – and of the compensation value of the interest – notwithstanding its liquidation value.

TCJA 2017 Amendment

In 2017, the Republican-led Congress enacted the Tax Cuts and Jobs Act,[xxxiv] which added Section 1061 to the Code. With respect to certain profits interests, this provision extended to three years the long-term holding period requirement for capital gains resulting from the disposition of partnership property and from the sale of a partnership interest.[xxxv]

The Administration’s Proposal

According to the Administration, an extended holding period does not address what the Administration identifies as the fundamental nature and problem of the profits interest; specifically, that the income allocable to such interests is received in connection with the performance of services.

Thus, the Administration proposes that the holding period rule of Section 1061 of the Code be repealed for taxpayers with taxable income of over $400,000.[xxxvi]


The Administration also concludes that a service provider’s share of a partnership’s income or gain attributable to the service provider’s profits interest should be taxed as ordinary income – i.e., compensation – and should be subject to employment tax, because such income is derived from the performance of services.

Interestingly, the proposal says nothing about when this ordinary income treatment would terminate; rather, it seems to imply that the interest (as well as its share of partnership income and gain) will forever retain its character as compensation; it is never “cleansed.”[ii]

Too Far?

The Administration is overreaching. It disregards the principles underlying Section 83 of the Code (described above) which govern the tax treatment of compensation that is paid in-kind. Moreover, the Administration’s approach is internally inconsistent.

Indeed, the Administration’s budget proposal undermines its own rationale for changing the tax treatment of profits interests by limiting the reach of the proposed amendment to individuals who hold a profits interest in an “investment partnership” (“IP”). Why treat a profits interest in an IP differently from an identical arrangement in a partnership that is not an IP? If one must be treated as compensatory and, therefore, taxed in the manner proposed, shouldn’t the other as well? [xxxvii] Or perhaps the current treatment is fine for profits interests in both kinds of partnerships and no change is required.

Step Back?

Perhaps recognizing this misstep, the Green Book[xxxviii] states, “to ensure more consistent treatment with the sales of other types of businesses,” the Administration will work with Congress to “develop mechanisms to assure the proper amount of income recharacterization where the business has goodwill or other assets unrelated to the services” of the IP holder.

Can someone tell me what that means? What is intended by “the proper amount of income recharacterization”? How will we determine whether the “assets” of a business are “unrelated to the services” of the profits interest holder? Will this turn into a major IRS regulatory project? Will the exceptions swallow the rule, in which case why bother?

How will this rule interact with the proposed rules for the deemed sale of a partnership interest when the holder of the profits interest dies or makes a gift of such interest?[iii] Presumably, the recognition of the compensation income will be accelerated.

How much simpler would it be to recognize the economics underlying the profits interest and to address the valuation issue – if any – at the time of issuance?

Investment Partnership

The Administration’s proposal would tax as ordinary income a partner’s share of income or gain for a taxable year with respect to the partner’s profits interests in an IP, regardless of the character of the income at the partnership level (for example, as long-term capital gain), if the partner’s taxable income (from all sources, including the IP) exceeds $400,000.

Likewise, the proposal would tax the gain on the sale of a profits interest in an IP as ordinary income, not as capital gain – regardless of the partner’s holding period for the interest and regardless of the composition of the partnership’s assets – if the profits interest holder’s taxable income for the year of the sale (including the gain from the sale) is above the $400,000 income threshold.

For purposes of these proposed rules, a partnership is an IP if “substantially all” of its assets[xxxix] are investment-type assets (certain securities, real estate,[iv] interests in partnerships, commodities, or cash or cash equivalents), but only if more than half of the partnership’s contributed capital is from partners in whose hands the interests constitute property not held in connection with a trade or business.[xl]

By contrast, the share of partnership income or gain allocated to a partner who received an unvested partnership interest in exchange for services, and who elected under Section 83(b) of the Code to include the fair market value of such interest in their gross income currently, will retain the same character, as ordinary income or as long-term capital gain, that it has in the hands of the partnership.

The same would be true for a profits interest holder in a partnership that is not an IP, or for the holder of a profits interest in an IP if such individual’s taxable income does not exceed $400,000.

Effective Date

The Administration’s proposals would be effective for taxable years beginning after December 31, 2021.[xli]

What’ s Next?

My practice does not revolve around the world of hedge funds. Those whom I advise are the owners of closely held operating businesses that would not fit within the definition of an IP, described above.

It is difficult to separate these owners from their businesses or vice versa, and it is often difficult to find employees who can relieve these owners of some of their responsibilities.

When an owner is fortunate enough to have found and employed such an individual, they need to consider how to retain them for the long haul.

Some of the more common equity-based compensation incentives were described earlier.[v] In general, these involve the payment of consideration by the employee to its employer, or the payment of income and employment taxes by both the employee and the employer – a not insignificant cost.

Where the business is organized as an LLC, the profits interest has provided a means by which the employer-owner may reconcile their interests with those of the key employee: the grant of an equity interest to the employee without the requirement of a cash outlay by either party. Moreover, the tax consequences of this arrangement have matched their economic consequences, as they typically should.

The Administration’s proposal, however, challenges the continued viability of this arrangement. Yes, its reach is limited to partnerships that are IPs, at least for now, but the reasoning presented in support of the proposal allows it to be expanded beyond the IP.

Some may point out that such ax expansion should be of little concern; after all, wouldn’t the partner (the former employee) be subject to ordinary income tax and self-employment tax in any case?

My response: what about the gain from the sale of all or part of the business? As indicated earlier, it is very likely that capital gains will continue to enjoy a rate preference, albeit a reduced one. If the profits interest holder is denied this benefit, why would they ever accept an ownership interest in the business? Why would they expose themselves to capital calls, or agree to guarantee the lease and loan obligations of the business? Why would they increase their risk of liability as a responsible person for employment taxes and sales taxes?

[i] .

[ii] IRC Sec. 11.

On June 5, the top finance officials in the Group of Seven (the “G-7”) announced their commitment to push for a global minimum tax of at least 15%. The Administration supports this floor even as it proposes a rate hike to 28% domestically; it views the floor as a way of keeping U.S. corporations competitive.

[iii] IRC Sec. 1374.

[iv] 25% seems to be in the running, thanks in no small part to Sen Manchin of W. Va.

[v] It is already scheduled to return to that rate after 2025.

Under the proposed brackets, the top rate would become effective at an amount of taxable income that is almost $120,000 less than the entry point for the current top bracket.

[vi] When the President announced his American Families Plan. .

[vii] As well as distributions from certain trusts.

[i] IRC Sec. 743.

Or what if an individual shareholder makes a gift of shares of stock in an S corporation – would the transfer be considered in determining whether there has been a “qualified stock purchase” within the meaning of IRC Sec. 338?

[ix] Just saying “private equity” or “hedge fund” in the Capitol is likely to be equated with “falsely shouting fire in a theatre and causing a panic,” to use Justice Holmes’s language from Schenck v. U.S., 249 U.S. 47 (1919).

[x] Assuming I have not paid any consideration for the interest; otherwise, the amount of compensation received (i.e., the bargain element) would be reduced accordingly.

[xi] Reg. Sec. 1.83-3(c). A substantial risk of forfeiture.

[xii] The partnership will not allocate any tax items to me – my interest will not be treated as an outstanding interest. Cf., Reg. Sec. 1.1361-1(b)(3).

[xiii] IRC Sec. 83(a); not at the presumably lower value at the date of issuance – but see IRC Sec. 83(b).

[xiv] IRC Sec. 83(b); Reg. Sec. 1.83-2.

[xv] “Wait,” you might say, “what’s the difference if capital gain will be taxed at the same rate as ordinary income?” As indicated above and in last week’s post, it is doubtful that the preferred rate for capital gains will be wiped out entirely – the rate will be increased, but it will remain less than the ordinary rate by a not insignificant amount.

[xvi] See IRC Sec. 409A and Reg. Sec. 1.409A-1(b)(5)(i).

[xvii] When I will have realized an accretion in value.

[xviii] Reg. Sec. 1.83-7.

[xix] The service recipient, issuing partnership, will sometimes impose a vesting schedule for the exercise of an option; for example, the service provider may not be permitted to exercise the option for one year after its grant.

Likewise, the stock purchased upon exercise of the option may, itself, be subject to risk of forfeiture, thereby further deferring the recognition event.

[xx] For example, the consideration payable to the partnership upon exercise of an option.

[xxi] Based upon the fair market value of the interest.

[xxii] Also known as a “carried interest” or a “promote interest.”

[xxiii] It is possible for the profits interest to be unvested at issuance.

[xxiv] See Reg. Sec. 1.704-1(b)(2)(iv)(f)(5)(iii), which describes the grant of an interest in a partnership as consideration for the provision of services to the partnership as an appropriate time for adjusting the capital accounts of the partners to reflect the manner in which the unrealized gain of the partnership property would be allocated among the existing partners if there were a taxable disposition of such property for fair market value.

[xxv] See also the “safe harbor” under the proposed IRC Sec. 83 regulations: Prop. Reg. Sec. 1.83-3(l), which would treat the fair market value of a carried interest as being equal to its liquidation value; REG-105346-03; and Notice 2005-43.

[xxvii] In 1993, the IRS issued guidance that it generally would not treat the receipt of a partnership profits interest for services as a taxable event either for the issuing partnership or for the recipient service partner. Rev. Proc. 93-27. However, this treatment would not apply if: (1) the profits interest relates to a substantially certain and predictable stream of income from partnership assets; (2) within two years of receipt, the partner disposes of the profits interest; or (3) the profits interest is a limited partnership interest in a publicly traded partnership.

More recent guidance clarified that this treatment applies with respect to a substantially unvested profits interest, provided the service partner takes into income their distributive share of partnership income, and the partnership does not deduct any amount, either on grant or on vesting of the profits interest. Rev. Proc. 2001-43.

[xxix] IRC Sec. 702(b).

[xxx] A shorter period than is required for treatment as long-term capital gain. IRC Sec. 1222.

[xxxi] See Reg. Sec. 1.704-1(b)(2)(iv)(f)(5)(iii), which applies so-called “reverse 704(c) principles.”

[xxxii] IRC Sec. 741.

[xxxiii] IRC Sec. 751(a); “unrealized receivables” and inventory items within the meaning of IRC Sec. 751(c) and (d), respectively.

[xxxiv] P.L.115-97 (“TCJA”).

[xxxv] Rev. Proc. 93-27 provided for a two-year holding period.

For those who are familiar with IRC Sec. 83, this two-year period is reminiscent of the minimum two years of service that most believe is required to support the finding of a “substantial risk of forfeiture” where vesting is based upon years of service following the service provider’s receipt of property from the service recipient. It’s not a coincidence.

[xxxvi] Meaning that the three-year holding period would continue to apply to other taxpayers.

[ii] Some may question whether this matters much in the case of a partnership in which each partner is subject to self-employment tax. It certainly does where the business sells off some property that would otherwise be treated as capital gain.

[iii] Low-value profits interests are ideal objects to be gifted. The appreciation is shifted to the donee, who is typically in a younger generation.

[iv] What if the real estate is actively managed by the partnership – i.e., by its partners and its employees – rather than by an unrelated management company? It may be difficult in some instances to draw the line.

[v] These involved the actual issuance of equity. Others may be drafted to mimic equity ownership, in some sense, without making the key employee an owner; for example, phantom equity plans and equity appreciation rights are common forms of nonqualified deferred compensation. (Beware of IRC Sec. 409A.) Some arrangements do not reward the employee until the sale of the business, at which point the employee may receive a percentage of the net proceeds as a change-in-control bonus. (Beware of IRC Sec. 280G and Sec. 4999.)