What is a Capital Interest and How Can it be Used

By Kresimir Peharda, Partner

What is it?

For entities taxed as partnerships, a capital interest is an interest in the company that is realized upon a capital event.  Typical capital events include a sale or liquidation.  A capital interest only has value to the recipient upon the occurrence of a triggering or capital event.

What is a profits interest?

A profits interest, on the other hand, is an interest in the current profits after all expenses of the partnership are deducted.

Capital interest v. stock option

Corporations often establish equity incentive plans that permit the company to issue restricted stock and stock options.  Both restricted stock and stock options are equity interests.  This means that once an optionee exercises the option she/he has an equity interest in the company.  This entitles the person to participate in any distributions (cash or securities) and realize the appreciation in value of the company upon a sale.  Furthermore, upon exercise of the option, the option holder, and upon receipt the restricted stock recipient, respectively, have voting rights.   Capital interest holders, on the other hand, do not have automatic rights to participate in a distribution and have no voting rights.  Their only rights are economic and only if there is a triggering event such as a sale.

Situations where a capital interest may be used

The following situations lend themselves to the grant of a capital interest:

  1. You do not want to grant voting rights to the recipient
  2. You do not want the recipient to share in current profits and losses
  3. You want to motivate the recipient to assist in the growth of the company but want to restrict the interest granted
  4. You do not want to deal with the accounting issues raised by granting a profits interest

 

What type of recipients are best suited to a capital interest?

In general, persons that are not partners in the partnership or members of the limited liability company are often the best candidates for a capital interest.  These persons may include:

  1. Marketing consultants
  2. Distributors
  3. External sales professionals
  4. Business consultants
  5. Former partners or members

 

What issues are raised in granting a capital interest?

Tax issues, including Section 83 of the Internal Revenue Code (IRC), for both the company and recipient are the primary consideration in granting a capital interest.  Other issues may include company valuations under Section 409A of the IRC, and compliance with ERISA.  Specific implementation considerations include:

  1. What happens if, upon sale of the company, the consideration is stock in another entity?
  2. What happens if there is an earn-out/escrow provision in the sale agreement?
  3. Under what conditions is the capital interest forfeited (bad acts by the recipient)?

 

What documentation is required to grant a capital interest?

The following documentation is required:

  1. A document whereby the company grants a capital interest to the recipient which sets out the terms, triggers, and rights of the parties, and
  2. Sometimes, if there are multiple capital interest recipients and/or the interests may be modified, a plan that details how these contingencies are dealt with