Unvested partnership interests as compensation.

• Author: Schlueter, Joseph F.

This may be a good time to revisit the use of unvested partnership interests as compensation because these situations can come up and the applicable authority is perhaps not widely known. The author recently reviewed two matters of this kind. The present discussion focuses on a company's hiring of a new CEO, where the consultations with the tax adviser about the executive's compensation package addressed a number of issues concerning the use of an unvested capital interest in a limited liability company (LLC) taxed as a partnership.

Much has been written and discussed over the years about profit interests (as opposed to capital interests) issued for services, including those that are unvested. Still governed by the combination of Rev. Proc. 93-27 and Rev. Proc. 2001-43, the tax-free nature of these types of compensatory ownership interests keeps them a favorite of tax planners, employees, and employers alike. However, profit interests have limitations, most notably involving economic risk in the event the value of the subject entity does not rise to ultimately provide the desired level of economic value. The discussion here focuses on the use of unvested capital interests as compensation.

The CEO and the unvested interest

Consider the following scenario:Acme LLC, a closely held manufacturing company, is in search of a new CEO to replace the retiring longtime leader of the business. The existing CEO has led the company through more than two decades of second-generation family ownership. With that generation now aging into their 60s and 70s and there being little direct family involvement in the operations, the owners are looking for an executive who will be able to jump-start growth in some new opportunities and help develop and execute an exit strategy for family ownership.

KJ has been identified as a very strong candidate to be the new CEO, and she has accepted the job, subject to negotiating a full compensation package. Among other things, KJ insists on obtaining a 5% ownership interest in the outstanding common unit ownership of the LLC. A recent appraisal of the LLC places the value of the common shares at $30 million. The LLC's tax adviser suggested considering the use of a profit interest with a "catch-up" capital transaction profit allocation feature as a more tax-advantaged strategy.

With the events of 2020 creating an entirely new landscape in many aspects of business, KJ is unwilling to take the economic risk associated with a...