Revenue Procedure 93-27: Profits Interest Safe Harbor and Section 1061

Under Revenue Procedure 93-27, receiving a partnership profits interest in exchange for services is not a taxable event. The safe harbor treats the interest as having zero value at the moment of the grant because a profits interest gives you only a share of the partnership’s future growth, not a claim on assets that already exist. To stay inside the safe harbor, three conditions must hold: the interest cannot be tied to a substantially certain stream of income, you cannot dispose of it within two years, and the partnership cannot be publicly traded.

What Counts as a Profits Interest

The IRS separates a profits interest from a capital interest using a hypothetical liquidation test. Imagine the partnership selling every asset at fair market value on the grant date and distributing all proceeds to the partners. If the recipient would receive nothing in that wind-down, the interest is a profits interest. If the recipient would receive a share of those proceeds, it is a capital interest and the safe harbor does not apply.¹

A capital interest gives the holder a slice of the business as it currently exists. A profits interest only pays off if the partnership earns income or appreciates after the grant date. Because the liquidation test cashes everything out immediately, the interest is assigned a value of zero at the moment it is granted. You are not taxed on wealth that has not been created yet.

For this to hold together, the partnership generally revalues its assets to fair market value before the grant and adjusts the existing partners’ capital accounts accordingly. That book-up ensures the new holder’s capital account starts at zero and only reflects value created going forward. Skipping the step or doing it carelessly can inadvertently give the recipient a share of existing value, which reclassifies the interest as a capital interest and destroys the safe harbor.²

Three Conditions That Break the Safe Harbor

Predictable Income Streams

The safe harbor does not cover a profits interest tied to a substantially certain and predictable stream of income from partnership assets. The IRS gives two examples: income from high-quality debt securities and income from high-quality net leases.¹ The logic is that if the partnership’s assets already generate a reliable, near-guaranteed return, the interest is not really speculative. It looks more like a guaranteed payment for services. Operating businesses with variable revenue rarely trigger this exception. A partnership whose main asset is a portfolio of investment-grade bonds or a single triple-net lease can.

Disposition Within Two Years

Selling or otherwise disposing of the profits interest within two years of receiving it also disqualifies you.¹ If you flip the interest quickly, the IRS infers you cashed out value that was already there on the grant date, which undercuts the premise that the interest was worth zero. A disposition inside that window pushes the taxable event back to the grant date and taxes the income at ordinary rates up to 37 percent rather than at long-term capital gains rates.

Publicly Traded Partnerships

A profits interest in a publicly traded partnership, meaning one whose interests trade on an established securities market or are readily tradable on a secondary market, falls outside the safe harbor entirely.¹ These entities are generally taxed as corporations under Section 7704, which imposes its own rules that override the administrative guidance in Revenue Procedure 93-27.³

Who Qualifies to Receive One

The safe harbor applies only when the profits interest is granted to someone providing services to or for the benefit of the partnership, and the services must be provided in the person’s capacity as a partner or in anticipation of becoming a partner.¹ An outside consultant hired for a one-off project who receives an interest but never joins the partnership does not fit. The recipient has to be integrated into the venture as a member or on a clear path to membership.

Section 721 of the Internal Revenue Code makes contributions of property to a partnership in exchange for an interest a nontaxable event.⁴ Revenue Procedure 93-27 extends a parallel concept to contributions of labor and expertise, but that treatment depends on the recipient genuinely acting as part of the venture rather than as a third-party contractor being paid in equity.

Unvested Profits Interests

Most profits interests come with vesting schedules, often annual vesting over three to five years. Revenue Procedure 93-27 did not originally address whether the grant date or the vesting date was the relevant tax moment. Revenue Procedure 2001-43 fills that gap. If the partnership and the service provider meet three conditions, the IRS treats an unvested profits interest as received on the grant date:

The partnership and the service provider treat the recipient as the owner of the interest from the grant date, and the recipient reports their distributive share of partnership income throughout the entire holding period.
Neither the partnership nor any partner deducts the fair market value of the interest as wages or compensation, at either the grant date or the vesting date.
All three Revenue Procedure 93-27 conditions still apply: no predictable income stream, no disposition within two years, and no publicly traded partnership.

When those conditions are met, neither the grant nor the vesting event is taxable for the partner or the partnership.¹ Revenue Procedure 2001-43 states that taxpayers meeting these requirements do not need to file a Section 83(b) election. Most tax advisors still recommend filing one as a protective measure.

Filing a Protective 83(b) Election

The election is called protective because it serves as a fallback. If the safe harbor turns out not to apply, say the recipient sells inside the two-year window, the election locks in the grant date as the taxable moment and the grant-date value (zero) as the amount included in income. Without the election, appreciation between the grant date and the vesting date could be taxed as ordinary income.

Section 83(b) requires the election to be filed no later than 30 days after the property is transferred, and it cannot be revoked once filed.⁵ Treasury regulations specify what the filing must include:

Your full name, address, and taxpayer identification number.
A description of the profits interest, ideally noting that it is intended to satisfy Revenue Procedures 93-27 and 2001-43.
The date the interest was transferred and the taxable year for which the election applies.
A description of any vesting restrictions.
The fair market value of the interest at the time of transfer, typically zero based on the liquidation value test.
The amount you paid for the interest, usually zero when the grant is for services.
A statement confirming that copies have been furnished to the partnership.

File the election with the IRS office where you normally file your income tax return.⁶ You can now submit it electronically using IRS Form 15620, which requires logging in through ID.me for identity verification.⁷ Mail filing is still permitted. If you file by mail, you can use either Form 15620 or your own written statement; electronic filers must use the official form. Either way, provide a copy to the partnership. You are no longer required to attach a copy to your annual return, though many practitioners still do.

Missing the 30-day deadline is one of the most common and costly mistakes in partnership tax planning. If the safe harbor later falls apart and no election was filed, appreciation between the grant date and the vesting date gets taxed as ordinary income at rates up to 37 percent rather than at long-term capital gains rates.

The Three-Year Holding Period Under Section 1061

Clearing the safe harbor at the front end does not settle the tax treatment when you eventually sell. Section 1061 requires a holding period of more than three years for long-term capital gains treatment on an “applicable partnership interest,” rather than the standard one-year holding period.⁸

An applicable partnership interest is broadly defined as any partnership interest transferred to or held by a taxpayer in connection with the performance of substantial services in an applicable trade or business. A profits interest received for services fits that definition. Selling before you have held it for more than three years recharacterizes what would otherwise be long-term capital gain as short-term capital gain, taxed at ordinary rates.⁹

A few categories escape Section 1061. Capital interests that give the holder a right to share in partnership capital proportional to their contribution are excluded, as are interests held directly or indirectly by a C corporation.⁸ S corporations do not qualify for the corporate exception. Interests acquired by an unrelated party in a fair-market-value purchase are also excluded, provided the buyer has no service relationship with the partnership.¹⁰

Two separate clocks matter. The two-year window under Revenue Procedure 93-27 protects the tax-free grant. The three-year holding period under Section 1061 protects long-term capital gains treatment on the eventual sale.

Self-Employment Tax After You Become a Partner

Once you hold a profits interest and become a partner, you cannot be treated as a W-2 employee of the same partnership. The IRS takes the position that partners cannot be employees of their own partnership, and issuing a Form W-2 to a partner is improper.¹¹ You receive a Schedule K-1 reflecting your distributive share of partnership income instead.

Your distributive share of ordinary business income is generally subject to self-employment tax under Section 1402(a).¹² That means paying both the employer and employee portions of Social Security and Medicare taxes: a combined 15.3 percent on earnings up to the Social Security wage base, and 2.9 percent above it. That is a real cost increase compared to W-2 status, where the employer covered half. A statutory exception excludes limited partners’ distributive shares (other than guaranteed payments for services) from self-employment tax, but whether a profits-interest holder in an LLC qualifies as a limited partner for this purpose has been a source of ongoing IRS and judicial debate.

Anyone offered a profits interest in place of a salary increase or bonus should model the self-employment tax impact before accepting. The shift from employee to partner can add several thousand dollars a year in tax liability, and the partnership is not required to make guaranteed payments to offset it. The long-term upside can still be substantial. The near-term tax math is often less favorable than recipients expect.

1
Internal Revenue Service. Revenue Procedure 2001-43
2
eCFR. 26 CFR 1.704-1 – Partners Distributive Share
3
Office of the Law Revision Counsel. 26 USC 7704 – Certain Publicly Traded Partnerships Treated as Corporations
4
Office of the Law Revision Counsel. 26 USC 721 – Nonrecognition of Gain or Loss on Contribution
5
Office of the Law Revision Counsel. 26 USC 83 – Property Transferred in Connection With Performance of Services
6
eCFR. 26 CFR 1.83-2 – Election to Include in Gross Income in Year of Transfer
7
Internal Revenue Service. Section 83(b) Election – Form 15620
8
Office of the Law Revision Counsel. 26 USC 1061 – Partnership Interests Held in Connection With Performance of Services
9
eCFR. 26 CFR 1.1061-4 – Section 1061 Computations
10
eCFR. 26 CFR 1.1061-3 – Exceptions to the Definition of an API
11
Internal Revenue Service. Self-Employment Tax and Partners
12
Office of the Law Revision Counsel. 26 USC 1402 – Definitions