Carried Interest in the Context of Venture Capitalist’s Business Bad Debt Deduction

Editor: Frank J. O’Connell Jr., CPA, Esq.

Special Industries

In its March 2011 decision in Dagres, 136 T.C. No. 12 (2011), the Tax Court found that a venture capitalist’s $3.6 million bad debt was incurred in connection with his carrying on a trade or business of managing venture capital funds and was fully deductible as an ordinary loss under Sec. 166(a). Contrary to the IRS’s argument that the loan was personal and gave rise to a limited nonbusiness bad debt deduction (i.e., a capital loss), the Tax Court found evidence that the taxpayer engaged in venture capital funds management as a trade or business and that he made the loan in connection therewith.

Background

The organization at issue mirrors the typical private equity–venture capital structure. The entities consisted of venture capital funds, general partner limited liability companies (LLCs), and management companies. The venture capital funds were organized as typical limited partnerships, each with numerous limited partners and one general partner LLC. Each general partner LLC was responsible for the management and investment for its respective venture capital fund. Each LLC agreement provided for several types of members: member managers, special members, and limited members. The management companies (S corporations) provided services to assist the operation of the venture capital funds and the general partner LLCs.

Each general partner LLC was entitled to a fee from its respective venture capital fund for managing the fund and making its investments. The general partner LLC in turn entered into a service agreement with the management company whereby the management company’s employees (including the taxpayer) performed the necessary work of actually managing and investing in exchange for an equivalent fee from the general partner LLC. Those fees were the source from which the management company paid salaries to its employees, including the taxpayer.

The venture capital funds had the usual characteristics of capital commitment and carried interest (carry). Limited partners contributed 99% of each fund’s capital with the remaining 1% committed from the general partner LLC. In addition, the general partner LLC was granted a 20% carry as the typical profits interest. Among other requirements, the limited partnership agreement of each venture capital fund required its general partner LLC to manage the fund’s affairs in a manner to avoid engaging in the conduct of a trade or business for federal income tax purposes. It was agreed in this case that the venture capital funds’ activities were investment and not the conduct of a trade or business.

The taxpayer was a member manager of each general partner LLC. The management companies were owned by the member managers of the general partner LLCs, including the taxpayer who was also a salaried employee. The taxpayer’s responsibilities included finding investment opportunities (target companies) for the venture capital funds, performing due diligence on those opportunities, calling capital, working with each target company to achieve growth, and liquidating investments before termination of the respective venture capital fund holder. In this capacity, the taxpayer developed his own network of business contacts, including attorneys, investment bankers, etc. From 1999 to 2003, the taxpayer received almost $11 million in wages and another $43 million in capital gains from his carry.

The Loan

In 2000, the taxpayer was asked by a business contact for a substantial loan. The taxpayer and his contact were business acquaintances and not personal friends. The contact was influential, part of the taxpayer’s network of leaders and executives in the industry, and was an important source of leads on promising companies for the taxpayer to consider investigating as potential investments for the venture capital funds. In addition, the contact also invested in some of the venture capital funds. With the intent of strengthening his relationship, the taxpayer loaned his contact $5 million in November 2000. The loan was unsecured, evidenced by a demand note, with interest at a rate of 8% annually. It was understood that in return for the loan, whenever his contact thereafter learned about any promising new companies, the taxpayer would be the first he would tell about any such opportunities. The taxpayer believed he would profit from this through his member manager interest in the general partner LLC of the investing venture capital fund.

After an $800,000 repayment in 2002, the taxpayer forgave the original note in December 2002 in exchange for a new nondemand promissory note for $4 million with interest at the short-term applicable federal rate, maturing at the end of 2005, and with required monthly payments of $5,000. After only a few payments in 2003, the taxpayer was notified by his contact in May 2003 that no further monthly payments could be made on the note, and on December 31, 2003, the taxpayer and his contact executed a settlement agreement under which the taxpayer canceled the approximately $3.6 million balance of the loan.

The taxpayer claimed business bad debt losses on his personal income tax returns (Forms 1040, U.S. Individual Income Tax Return) via the attachment of a Schedule C, Profit or Loss from Business, that reported a sole proprietorship for which the profession was described as “loan and business promotions.” He reported no business income and one expense, labeled “bad debt loss,” of approximately $3.6 million in 2003.

The Parties’ Positions

The taxpayer argued that he was in the trade or business of venture capital (either personally or by imputation from entities he participated in) and that he properly claimed a business bad debt that was fully deductible under Sec. 166(a)(1). The IRS’s primary argument was that the taxpayer’s loan was personal and that the 2003 loss was a nonbusiness bad debt, deductible only as a short-term capital loss under Sec. 166(d)(1) and subject to the limitations imposed by Sec. 1211(b).

The IRS’s alternative argument was that the taxpayer’s loan was proximately related to his status as a management company employee (rather than to a trade or business of managing venture capital funds), so it yielded an employee business bad debt expense as a miscellaneous itemized deduction as defined in Secs. 63 and 67 (i.e., subject to the 2% floor imposed by Sec. 67 and not deductible in computing alternative minimum tax under Sec. 56(b)(1)).

Tax Court’s Conclusion

The Tax Court found that the general partner LLCs were not merely investors in the funds but were in the business of managing investment capital funds and that this business was attributable to the taxpayer as a member manager of the general partner LLCs. It further found that the taxpayer made the loans in connection with this business and not as an investor or employee. Thus, the taxpayer’s loan was a business bad debt, and the taxpayer could deduct the portion of the loan he canceled under Sec. 166(a)(1).

A key point in the case is the Tax Court’s distinction between investing on one’s own behalf and providing investment services to others. Investing one’s own money and managing one’s own investments do not amount to a trade or business. The court found that investors who invest their own funds in public or privately held companies earn investment returns; they are investing, not conducting a trade or business, even when they make their entire living by investing. However, the court stated that

an activity that would otherwise be a business does not necessarily lose that status because it includes an investment function. . . . Bankers, investment bankers, financial planners, and stockbrokers all earn fees and commissions for work that includes investing or facilitating the investing of their clients’ funds. Selling one’s investment expertise to others is as much a business as selling one’s legal or medical expertise.

Here, the general partner LLCs and management companies worked to invest the venture capital funds’ money with the intended purpose of realizing capital appreciation of the funds’ underlying investments. As an owner and member, the taxpayer profited from investing the money of others.

The Tax Court explained that

in cases where business promotion activities are found to rise to the level of a trade or business, a common factor for distinguishing mere investment from conduct of a trade or business has been compensation other than the normal investor’s return: “income received directly for his own services rather than indirectly through the corporate enterprise.” That is, if the taxpayer receives not just a return on his own investment but compensation attributable to his services, that fact tends to show that he is in a trade or business.

In the taxpayer’s case, the general partner LLCs owned a 1% interest in the venture capital funds as investors, and this was a nonbusiness activity, but that was minuscule compared to the 20% carry the general partner LLC received as compensation for successfully managing the venture capital funds.

The IRS had also argued that the fact that the income the general partner LLCs received through the carried interest was treated as capital gain indicated they were investors with respect to the funds. The Tax Court stated that although the treatment of the carried interest might be “anomalous,” the character of the income did not prove that the LLCs were investors and not in a trade or business.

The Tax Court found that when he made the loan, the taxpayer’s dominant motivation for lending the money was to gain preferential access to companies and deals to which his debtor might refer him so that he could use that information in the venture capital activities he undertook as a member manager of the general partner LLCs. Thus, the court decided that the taxpayer’s loan was proximately related to those venture capital management activities and to his personal intention to obtain carry from the general partner LLCs, and he made the loan in connection with his trade or business.

Regarding the IRS’s alternative argument that the loan was related to the taxpayer’s employment with the management company, the Tax Court explained that per the Supreme Court’s decision in Generes, 405 U.S. 93 (1972), to determine which trade or business a loan is proximately related to, a court must evaluate the taxpayer’s dominant motive for making the loan. Once again, the court based its decision on the relative size of Dagres’s income from his trade or business as a manager of venture capital funds (the amount of the carried interest). Because the carried interest amount dwarfed the amounts of income he earned as an investor in the fund or as an employee of the management company, the court concluded that his dominant motive in making the loan was protecting or enhancing his trade or business as a venture capital fund manager. Thus, the court rejected the IRS’s characterization of the loan as related to his employment.

EditorNotes

Frank J. O’Connell Jr. is a partner in Crowe Horwath LLP in Oak Brook, IL.

For additional information about these items, contact Mr. O’Connell at (630) 574-1619 or frank.oconnell@crowehorwath.com.

Unless otherwise noted, contributors are members of or associated with Crowe Horwath LLP.