“Sweat Equity” is when one partner is deemed to have a certain percentage interest in a joint venture based on the time and effort put into a deal, as opposed to a cash capital contribution.

However, if not structured properly as a “profits interest,” it can create unintended tax consequences for the person receiving the sweat equity, and you can end up with a tax bill you did not plan for.

First Principles:

Starting with first principles, when a person receives goods or money in exchange for services, that is considered “income” to the person receiving it, which is generally taxed in the year the person receives it.

When a person receives a vested interest in a partnership in exchange for services, 26 U.S.C. 83 states that the interest should also be included in the gross income of the recipient, but there are nuances contained in further IRS revenue procedures on how this exactly works. Not all partnership interests are treated equally, and the structure and drafting of these interests is critically important.

“Capital Interests” vs. “Profits Interests”:

Every partnership interest issued for services is either a “capital interest” or a “profits interest”.

A “capital interest” gives you a share of the venture’s existing value. The test: if the partnership sold all its assets at fair market value and liquidated the day you received your interest, would you receive anything? If yes, you hold a capital interest to that extent.

A “profits interest” is everything else - a right to share only in future profits and appreciation. Run the same hypothetical on day one and a pure profits interest holder receives nothing. (Fn. 1)

That distinction is important. Under longstanding IRS guidance, the IRS generally will not treat the receipt of a profits interest for services as a taxable event. (Fn. 2) The receipt of a capital interest for services generally is taxable - compensation, equal to the value transferred. So when you take 50% of a venture you did not capitalize, the first question is not “how much do you own?” but “what would you collect if we sold everything today?” If the answer is anything above zero, part of what you received may be a capital interest and taxable as compensation.

‍JV Language on Profits Interests:

When drafting a JV which includes an interest intended to be a profits interest, it’s important to include the following concepts:

1. ‍A Liquidation Hurdle – When profits interests are issued, the partnership should run a calculation at that time of the amount that all the partners would get under the applicable distribution waterfall if all of the partnership’s assets were sold at fair market value. That amount is the “hurdle”, which should be memorialized in writing at the time the profits interests are granted, and must be distributed in the future before the holder of a profits interest can receive distributions. ‍
2. “Treat as a partner from grant” language tracking Rev. Proc. 2001-43 – The holder of the profits interest should be an actual partner in the company agreement. So, if it is an LLC, the holder should be a member (but can be a non-voting member or a different class of member with more limited rights).‍
3. A capital-account book-up. Provide a mechanism for the partnership to revalue the existing partners’ capital accounts to fair market value when the interest is issued, so the books reflect the built-in gain that sits ahead of the new holder.
4. Safe-harbor/ liquidation-value election language. The 2005 proposed IRS regulations (Notice 2005-43) were never finalized, but the market drafts to them: agree to treat the interest’s fair market value as its liquidation value and to make the safe-harbor election if it becomes available.‍
5. A waterfall that respects the hurdle. The distribution waterfall must actually return the other members’ capital and their day-one value before the profits interest holder participates.‍

Vesting of Interests: Why Timing Matters

For profits interests that vest over time, would you rather be taxed on Day 1, when the value of these interests is essentially $0, or when the interests vest later, when the value presumably has risen?

The answer seems obvious, of course you would want to make sure that the IRS looks to the Day 1 value of these interests and not Day 1 + 1 year, 2 years or 4 years when the interests presumably would have appreciated in value.

This is what filing an 83(b) election does. An 83(b) election allows a person who received a partnership interest in exchange for services to file a form and elect under 26 U.S.C. 83(b) to include the value of the interest in the year such interest was granted to him/her (regardless of vesting schedule).

You may be thinking: “Earlier you said issuance of a profits interest is not deemed a taxable event under IRS regulations, so why would it matter if I file an 83(b) election, electing to be “taxed” essentially on the $0 valuation at the outset?” And it’s a good question. The answer is that you should never leave such an important tax issue up to chance, and it is industry standard practice to file the 83(b) election when a person receives interests that vest over time.

Even though Revenue Procedure 2001-43 says that the profits-interest analysis is tested at grant, not vesting, provided the partnership and recipient follow certain guidelines (namely, they (i) treat the recipient as the owner from the grant date and report the distributive share accordingly, and (ii) take no compensation deduction for the interest on grant or vesting), there is a theoretical risk that the guidelines are not followed exactly or a different interpretation is taken, so to avoid any risk of being taxed on the interests as they vest, file the 83(b) election. It is free and easy to file and highly protective.

Potential Pitfalls:

Under Revenue Procedure 93-27, if any of the following circumstances are in play for a profits interest, you fall outside of the safe harbor and could have issues:

1. ‍Substantially Certain, Predictable Income Stream – If a profits interest is almost guaranteed to produce revenue later on, despite having a $0 value on paper on Day 1, then it is suspect. ‍
2. Disposition Within 2 Years: If the recipient actually disposes of the interest within two years of receipt, the safe harbor is lost.
3. ‍Limited Partnership Interest in Publicly Traded Partnership: Safe harbor doesn’t apply to these interests.

The Bottom Line:

A profits interest is one of the most tax-efficient ways to reward the people who create value in a JV: under current IRS guidance the grant generally isn’t a taxable event, and the future income is taxed in whatever character the venture earns - capital gain on a sale (subject to the required holding period specific to services-based interests), ordinary income on operating cash flow. But that result is engineered - through a properly set hurdle, a clean waterfall, the right safe-harbor language, and, for vesting grants, a timely 83(b) election.

Skip those steps and the same interest can flip into ordinary compensation taxed up front, on value you cannot yet touch. Before you sign a JV that hands you equity you didn’t pay for, run the liquidation hypothetical and look hard at the waterfall.

If you’d like to talk through how a particular profits interest or waterfall should be structured, feel free to reach out at laura@maherlawpllc.com.

A few disclaimers on this article:

1. ‍This article addresses general principles under current IRS administrative guidance. Tax outcomes turn heavily on specific facts, and the interaction of Sections 83, 704, and 1061, the capital-account rules, and the still-proposed profits-interest regulations is complex. Anyone issuing or receiving a profits interest should have the structure vetted by qualified tax counsel and/or a CPA or other tax advisor before closing.
2. Nothing in this article reflects the terms of any particular joint venture I have handled for any client. It reflects general principles and my experience structuring deal economics over the years.
3. Much of this area rests on IRS administrative guidance and regulations that remain in proposed form; it can change. Confirm the current state of the law before relying on it.
4. Nothing in this article is intended as legal or tax advice.

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Fn. 1: Rev. Proc. 93-27, 1993-2 C.B. 343, §§ 2.01–2.02 (a capital interest is one that would give the holder a share of the proceeds on a hypothetical FMV liquidation immediately after receipt; a profits interest is any partnership interest that is not a capital interest).

Fn. 2: Rev. Proc. 93-27, § 4.01. This is an IRS non-taxation / non-challenge position if the conditions are met, not a statement that the interest lacks fair market value in all contexts.

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