Long term incentive plans offered by an entity that is taxed as a partnership present an additional problem compared to their corporate A-side counterparts.  If an employee is given an equity interest in the partnership, the individual will generally no longer be considered an employee for tax purposes.  Instead, that individual is considered a partner in a partnership, will receive a K-1 for future pay (rather than a W-2), must pay estimated taxes, becomes ineligible for certain benefits, etc.  This dual status issue is generally nonexistent within corporate entities – indeed, it is commonplace for employees to also be shareholders, perhaps as a result of a traditional restricted stock or option grant.

We’ll turn our attention back to this dual status issue in a moment, but first – let’s talk about the good news if you live in the partnership parallel dimension.  Partnerships are permitted to offer a unique form of long-term incentive award that can be highly tax efficient – profits interests.  If you were to look at profits interests through corporate-colored lenses, you would see them as part option, part restricted stock. Like options, profits interests are an appreciation-only award (meaning the business value must grow for the award to become valuable), but unlike options, profits interests are considered equity issued on grant.  If properly structured, the recipient has no income inclusion at grant, and appreciation in the value of the profits interests award has the potential to be taxed at capital gains rates – something that most options cannot or do not achieve.

Despite these tax advantages, the use of profits interests as a long-term incentive award is typically fairly limited due, in part, to the dual status issue described above.  One strategy to eliminate dual status issues that we are seeing used more often is the use of a management holding company structure. Under this structure, an upstream entity is created (the management holding company) and profits interests are issued back-to-back, first from the operating company to the management holding company, and second from the management holding company to the participants.  If this arrangement is structured properly and respected, the participants in the long-term incentive plan can remain employees of the operating company while being a partner in the management holding company (with economic equivalence on their equity award).  The form and substance of the arrangement is critical so that the two entities are truly regarded as separate entities for tax purposes.  Will this trend become a chart topper?  I have my doubts, but at the moment, it is a hit for some companies.