The Power of Profits Interest in Partnerships

by | Apr 8, 2024 | Insight-Post, PKF Texas - The Entrepreneur's Playbook®

Join Jen Lemanski and Chris Dodd, CPA, Tax Director, as they discuss the potent role of profits interests in maximizing employee loyalty within partnerships. Explore how profits interest not only provides a unique tax advantage but also serves as a compelling long-term incentive for management teams. Learn about the flexibility in partnership compensation, including traditional bonuses and phantom equity, and the strategic considerations for businesses aiming to retain their key talent. Tune in for valuable insights into optimizing your compensation strategies for lasting employee commitment

Jen: This is the  PKF Texas – The Entrepreneur’s Playbook®, I’m Jen Lemanski, and I’m back once again with Chris Dodd, one of our Approachable AdvisorsTM and a director on our tax team. Chris, welcome back to the Playbook.

Chris: Great to be here, Jen.

Jen: So, in previous episodes we’ve talked about entity selection, partnerships, corporations, that kind of thing. What else do we need to know about some of the benefits for corporations in particular?

Chris: As you said, we talked about partnerships, we talked about that corporation, the double taxation. But what I really want to talk about and give a high level prime or two, so people talk to their CPA is a 1202 stock exclusion, which can exclude up to 100% of the gain on the sale of corporate shares.

Jen: Okay.

Chris: So, why is that important? It’s the Tax Cut and Jobs Act that came about and that everyone had to start re-looking at their entity selection. So, when the Tax Cut and Jobs Act came they reduced the top rate for individuals to 37%. Additionally, for certain pass-through entities, it provided for a 20% reduction in their taxable income. There was an effective tax rate of 29.6% for pass-throughs. The Tax Cut and Jobs Act also reduced the corporate rate from 35% down to 21%. So, you’re saying, okay, yeah, that’s, that’s better than the effective rate on a pass-through entity. However, again, there’s that nasty thing, double taxation. So, the shareholders are going to be taxed on all their distributions. So, there’s a potential tax to the individual of 39.8% effective rate.

Jen: That’s something to really consider.

Chris: Yes. But you have the 1202 stock exclusion, which can possibly exclude up to 100% of that gain.

Jen: Okay. So, that’s something to ask your CPA about. What else do you need to know about 1202 then?

Chris: So, just a little bit of history, because a lot of people are like, well, why hasn’t, my CPA talked about this. 1202 was enacted in 1993 and the original exclusion was 50% of the gain, the gain that wasn’t included in the exclusion was taxed at 28%. Then in 2009, that that exclusion was increased to 75%, and 2010 it was increased to 100%. So, why weren’t people using it? Well, it’s because the long-term capital gains rate was reduced so much that it almost nullified the use of a 1202 stock exclusion. But now we have the Tax Cut and Jobs Act reducing the corporate rate to 21%, and we have the 100% exclusion. So, that interplay brings corporations back into the mix.

Jen: So, why would somebody want their CPA to re-look at this 1202 exclusion for them?

Chris: Well, great question. So, the exclusion is the greater of 10 times the shareholders basis, or a $10 million cumulative limitation. And this is on a per shareholder per corporation basis, but there, unfortunately, there are also some limitations. For one, this is only available to C corps. So, this is not available to S corp stock. Additionally, it’s only available to non-corporate entities. So, that excludes C corp owning another C corp and it’s also only limited to original issued stock. So, you can’t buy stock secondhand and get the same exclusion, so it must be a C corp and must meet the active business requirements. Unfortunately, the substantially all requirement is not defined in the code. So, that’s also a reason that you need a qualified CPA. Now, when I say active business, I mean 80% of the assets by value must be used in the active trader business of an eligible corporation. Additionally, it has to be a qualified trader business. So, what I mean is that it has to be a domestic C corporation. It can’t be a disc, it can’t be a regulated investment company. Additionally, the qualified business, it can’t be a business whereby the principal asset is the reputation of one or more employees. So, that means it’s not architecture, it’s not engineering, healthcare, or law. Additionally, it’s not banking, it’s not farming, it’s not any business whereby you get the 613 deduction for production or extraction. And it’s not farming.

Jen: So, it’s kind of a little bit more of a narrow focus then.

Chris: Yes. It’s a lot of a narrow focus. And that’s why I wanted to give you a primer on discussing this with your CPA. If ever you’re about to invest in a business, if ever you’re thinking about selling your business or starting a business, this is one of the things that you want to talk with your CPA about.

Jen: Perfect. Well, it sounds like we’ve got some more to talk about all sorts of different facets of business. Sound good? We’ll get you back.

Chris: Yes. Perfect.

Jen: Alright, perfect. This has been another Thought Leader production, brought to you by  PKF Texas – The Entrepreneur’s Playbook®. For more information about this and other topics, visit our website pkftexas.com/insights. Tune in next week for another chapter.

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