The $0 Liquidation Value: How to Grant Profits Interest Without Triggering a Tax Bill
Your client just called. They want to give their star employee 5% of the company to keep them from jumping ship to a competitor. But there is a catch: "I don't want them to have to pay any tax on it right now."
You know the answer is a Profits Interest. You know the Rev. Proc. 93-27 Safe Harbor exists.
But knowing the rule and proving compliance are two different things. If you cannot mathematically prove that the interest has a liquidation value of exactly $0.00 on the day of the grant, you aren’t granting a profits interest. You are granting a Capital Interest—and you just handed that employee a massive tax bill for immediate ordinary income.
Here is how to structure the grant correctly and, more importantly, how to support it with your workpapers.
The "Capital Hurdle" Concept
To satisfy the Safe Harbor, a Profits Interest holder generally cannot receive any proceeds if the partnership were to sell all its assets for fair market value and liquidate immediately after the grant.
They only participate in future appreciation.
To achieve this, you must create a "Hurdle" in your allocation structure.
Determine FMV: Establish the value of the partnership on the grant date (e.g., $5,000,000).
Set the Hurdle: The Operating Agreement must state that the first $5,000,000 of proceeds goes entirely to the existing partners.
The Profits Interest: The new partner only participates in distributions above $5,000,000.
Why Standard Excel Templates Fail
This is where most tax pros get into trouble.
If you use a standard "percentage ownership" spreadsheet, you are likely calculating allocations based on a flat 5%.
If the company sells for $5,000,000 tomorrow, your spreadsheet says the new partner gets $250,000 (5%).
Result: You failed the Safe Harbor test. That $250,000 is taxable income today.
You cannot use a "Forward-Allocating" model for this. You need a model that works backward from the liquidation event.
The Solution: Targeted Capital Accounts
To support a Profits Interest, you need a workpaper that performs a Hypothetical Liquidation at Book Value (and FMV for the grant test).
Your workpapers need to explicitly show:
Tier 1: Return of Capital / Pre-Existing Value (100% to Old Partners).
Tier 2: The "Catch-Up" or Residual Split (Where the New Partner enters).
By running this simulation, you generate a "Target Capital Account" for the new partner that equals Zero. This provides the documentation you need to defend the tax-free nature of the grant if the IRS ever comes knocking.
Don't "plug" the numbers. Model the waterfall.
Stop guessing on liquidation values. The Targeted Allocation Engine allows you to build custom distribution tiers with hurdle rates in minutes. Prove the $0 liquidation value, protect your client’s Safe Harbor, and standardize your partnership workpapers.
