U.S. Profits Interests: What Are They & How Are They Taxed In Canada?—A Canadian Tax Lawyer's Analysis

Introduction - U.S. Profits Interests

For U.S. federal income-tax purposes, one may hold one of two sorts of interests in a partnership—or any entity that the U.S. taxes as a partnership, such as a limited liability company (LLC): a capital interest or a profits interest.

A capital interest gives its owner the right to a share in the partnership's or LLC's net assets upon the entity's dissolution.

A profits interest, on the other hand, gives its owner the right to receive a percentage of the partnership's or LLC's future profits. It is, in other words, the right to share in the future growth of the business—that is, the amount by which the business's value has increased from the date that the profits interest was granted. So, subject to the terms of the specific profits interest, a profits-interest holder may participate in the entity's profits and capital appreciation from the date of the grant, but the holder is not entitled to receive any capital that existed or any profits that accumulated before the date that the interest was granted.

U.S. business owners, who operate using a partnership or LLC, use profits interests to compensate valued or senior employees. As a part of an employee-compensation package, corporate employers often include employee stock options (ESOs), which gives the employee the right to purchase shares in the employer corporation at a fixed price during a set period.

In that sense, a profits interest is like an employee stock option. But partnerships and LLCs don't issue shares, so a stock option isn't available. In addition, unlike a stock option, a profits interest is by itself an ownership stake in the partnership or LLC. A stock option, by contrast, is the right to acquire an ownership stake in a corporation.

Because a profits interest gives its holder an ownership interest in the issuing partnership or LLC, it also confers upon its holder all the rights and obligations that come with ownership. If you, for example, hold a profits interest in a general partnership, you, like the other partners, are jointly and severally liable for the partnership's debts.

The concept of a profits interest doesn't exist in Canadian law, and the Canada Revenue Agency hasn't given any specific guidance on how the proceeds from a profits interest are taxed. Moreover, parties have some flexibility when structuring the details of any particular profits-interest arrangement. These factors might lead to some uncertainty for Canadians who...