Summary: In our latest real estate-focused webinar, Aprio thought leaders explored how businesses can use partnership interests to retain and reward top talent. Get a recap below and learn key tax, legal, and strategic tactics you can use to structure these grants for long-term growth.
As real estate businesses navigate rising interest rates, tighter margins, and heightened competition, their leadership teams are looking for more creative ways to incentivize talented employees and keep them motivated for the long term.
With that, many real estate leaders are increasingly looking toward equity-based compensation to attract and retain top talent, specifically through capital or profits partnershipinterests. This approach has dual benefits: it allows talented employees to share in the company’s growth and offers employers significant tax and cash flow advantages.
Aprio’s latest webinar takes a deeper dive
In October, Alan Vaughn, Aprio’s Real Estate Segment Leader, moderated a panel of thought leaders and advisors on this topic, exploring how companies can effectively use partnership interests as executive compensation tools. During the session, our panelists also covered the tax, legal, and strategic implications that can come with this approach.
Before granting equity to your key employees, it’s important to understand your options. According to Cardell McKinstry, Tax Partner of Mergers & Acquisitions at Aprio, most companies leverage one of three forms of equity compensation:
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- A capital interest: This form provides employees with true ownership in the company and a right to current value; the interest may be immediately taxable upon receipt as ordinary income.
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- A profits interest: This form allows employees to only participate in the future growth of the company above a specified hurdle, typically without immediate tax consequences.
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- Synthetic or phantom equity: This form mirrors the value of ownership without granting employees actual ownership rights.
Among the three options, profits interest is a particularly popular tool among real estate developers and partnerships because it can reward employees for contributing to the appreciation in future property value without creating current tax burdens.
The beauty of profits interest is that it aligns employees’ incentives with the company’s growth while preserving cash flow.
How profits interest differs from capital interest
Panelist Jason Bierly, Tax Partner in Aprio’s Technology and Manufacturing practices, explained that the primary difference between capital interest and profits interest lies in the claim to value upon liquidation.
Capital interest gives employees an immediate share of liquidation value and is therefore taxable upon grant. In contrast, profits interest only provides employees with a liquidation value beyond its current fair market value, meaning there’s no taxable event when the interest is granted.
During the webinar, Jason illustrated the difference between the two compensation forms with a simple example: If a partnership worth $1 million grants a 5% capital interest to an employee, they immediately receive $50,000 of value and must pay tax on it. On the other hand, if an employee is granted a 5% profits interest with a $1 million hurdle, then there is no immediate value and therefore it is not taxable at grant.
This key difference makes profits interest particularly appealing for real estate partnerships, for whom long-term appreciation is often a key driver of compensation.
Structuring for retention and performance
Once you have chosen the grant type you plan to offer key employees, you must make sure that the compensation structure reinforces your organizational goals. You can accomplish this by implementing vesting schedules based on time, performance, or a combination of both.
If you choose a time-based vesting schedule, then you may release ownership gradually over five years to encourage employee retention. If you opt for a performance-based vesting schedule, then you will likely tie employees’ rewards to measurable outcomes, such as achieving professional development milestones, revenue targets, or ROI thresholds.
It’s important to note that flexibility is key in these situations. For instance, not all your employees need to follow the same compensation model; some of them may vest over time, while others may earn equity based on hitting specific business goals. The point is to design a structure that motivates the right behavior and allows you to retain top talent for the long term.
Finally, make sure you are cognizant of and fully understand the implications of the IRC Section 83(b) election on your employees’ taxability. The election allows employees to recognize income when a grant is made rather than when it vests. By filing this election within 30 days of the grant, you and your employees can avoid future tax complications.
Key tax considerations and potential pitfalls
Dan Murphy, a Tax Partner with Aprio’s Real Estate practice, outlined compensation benefits and tax risks in his portion of the webinar presentation. With partnerships, real estate leaders can grant equity and be rewarded with valuable deductions, while their employees benefit from potential long-term capital gains treatment. However, mistakes in valuation or timing can quickly turn a tax advantage into a liability.
“With equity grants, valuation is everything,” he said. “If your valuation isn’t current or defensible, you risk IRS scrutiny and unintended tax exposure.”
Dan also warned of a common error committed by many partnerships: missing the 83(b)-election window or misclassifying a profits interest as a capital interest. If you don’t file within 30 days of the grant or issue the wrong type of interest, you could create phantom income (and significant headaches) for your employees. Therefore, it’s important for you to properly structure and document all grants to make sure both you and your employees fulfill appropriate reporting responsibilities.
Legal considerations: Why documentation matters
When real estate companies issue partnership interests, it’s essential that they pay just as much attention to legal structure as they do to tax structure.
Jeff Meyerson, a Partner at Aprio Legal, explained that a profits interest often requires leaders to either revise or restate their company’s operating agreement to include provisions for hurdle values, vesting schedules, forfeiture conditions, and distribution waterfalls. According to Jeff, “You can’t just insert a profits interest clause into an old operating agreement; it’s often cleaner and more cost-effective to restate the entire agreement.” He added that companies should also develop formal grant agreements and joinder documents for each recipient to help ensure clarity. These documents define your employees’ specific rights, restrictions, and vesting schedule.
To protect ownership control, many real estate companies also issue non-voting units, which gives their employees economic participation in a company’s success without governance power. In addition, unvested or forfeited units typically revert to the company for future use; these are often referred to as “golden handcuffs” by people in the industry because they encourage retention.
Viewing compensation through a strategic lens
While tax and legal compliance are essential to compensation strategy, it’s also critical to remember that partnership interest grants are ultimately a strategic business tool.
After all, when you’re talking about granting 10% or 15% of your company’s value to employees, you want to be sure that equity is going to the right people and that it’s structured to accelerate your company’s growth. Other strategic factors to consider include:
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- Making sure there is a balance between retention and performance incentives.
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- Identifying the degree of dilution that you and other stakeholders are willing to accept.
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- How your lenders, investors, and external stakeholders might perceive the structure.
Remember that you should structure your equity compensation packages to align employee success with company success. At the end of the day, your packages should reward the employee contributions that actually increase long-term enterprise value.
Lessons from real-world examples
During the webinar, our panelists shared real examples of how incentive structures can unintentionally create the wrong outcomes for real estate companies. In one case, a real estate development firm granted equity tied to individual projects. As a result, its employees focused solely on their own projects’ profitability rather than the company’s broader success. The takeaway? You should structure your employee compensation packages and incentives to encourage teamwork and overall company growth, not siloed performance.
In another scenario, a company failed to file 83(b) elections and report equity correctly on its employees’ tax documents. When the company sold, employees who expected capital gains instead owed ordinary income tax on millions of dollars. This was a painful yet preventable mistake that could’ve protected both the company’s and employees’ bottom lines if the owners conducted proper strategic planning.
Final thoughts
If you are a real estate leader looking to retain top performers and reward long-term value creation, then implementing equity-based compensation using partnership interests can be a game-changer. But to make the program a success, you need to be strategic and intentional.
Aprio’s integrated team of real estate tax professionals, business strategists, and legal advisors can help you design and implement executive compensation strategies that drive results while protecting your business interests.