A carried interest, also known as a profits interest, is a general partner's allocation of residual investment gains after prior allocations and distributions. A fund's return percentage generally must exceed a specified threshold before the general partner receives such an allocation, typically 20%. To avoid ordinary income tax rates, a fund manager usually forgoes a management fee in exchange for a carried interest. No capital commitment or contribution is made by the fund manager. The interest does not have associated capital or a liquidation value and may be subject to vesting restrictions.
Because of these carried interests, fund managers have a unique opportunity to transfer significant amounts of wealth at a relatively low gift tax "cost." In a successful fund, the residual allocations associated with a carried interest have the potential to grow exponentially. If fund managers transfer these carried interests prior to the growth of the residual allocations, they can achieve significant wealth transfers. However, risks are associated with valuing carried interest transfers.
Income Interest Valuation
Prior to 1993, the income tax consequences to a fund manager receiving a carried interest were unclear. It was ambiguous whether receipt of a future profits interest resulted in current income recognition since there was no liquidation value, and profits received in the future would be reported on a Schedule K-1 and be subject to income tax. Prior to the release of Rev. Proc. 93-27, ambiguous case law highlighted the courts' struggles with determining the timing of income recognition associated with carried interests.
In Diamond, 492 F.2d. 286 (7th Cir. 1974), the taxpayer sold a profits interest for $40,000 three weeks after receiving it. The taxpayer argued the $40,000 was a short-term capital gain that was offset by a short-term capital loss. The IRS asserted that the taxpayer had to recognize the $40,000 as ordinary income when he received the interest. The Seventh Circuit agreed with the IRS, denying the taxpayer's claims that the interest was valueless and should not be taxed on receipt.
Nine years later, in St. John, No. 82-1134 (C.D. Ill. 11/16/83), the IRS argued the taxpayer's profits interest should be recognized upon receipt as ordinary income equal to the fair market value (FMV) of the services provided, which was $25,500. The taxpayer's argument was that the interest's value was its liquidation value, which, based on an oral agreement among the partners, was nothing. The court did not decide whether the interest was taxable upon receipt but accepted the taxpayer's contention that the interest's value "was undetermined and speculative" and that "[i]t was not clear when, if ever, the partnership would be profitable." Accordingly, the court concluded that the profits interest had no value.
Then, in Campbell, 943 F.2d 815 (8th Cir. 1991), aff'g in part and rev'g in part T.C. Memo. 1990-162, the Eighth Circuit reversed the Tax Court's holding that the taxpayer's interests were taxable upon receipt and agreed with the taxpayer that "[a]ny predictions as to the ultimate success of the operations were speculative." The court also stated that "[the taxpayer's] interests were not transferable and were not likely to provide immediate returns." The court held that the interests "were without fair market value at the time [the taxpayer] received them and should not have been included in his income for the years in issue." The court agreed with the Tax Court's comment that FMV is " 'the price at which property would change hands in a transaction between a willing buyer and a willing seller, neither being under compulsion to buy nor to sell and both being informed' of all the relevant circumstances."
After years of ambiguous case law, Rev. Proc. 93-27 brought some clarity to the issue, stating:
Other than as provided below, if a person receives a profits interest for the provision of services to or for the benefit of a partnership in a partner capacity or in anticipation of being a partner, the Internal Revenue Service will not treat the receipt of such an interest as a taxable event for the partner or the partnership.
However, this favorable treatment does not apply if:
1. The profits interest relates to a substantially certain and predictable stream of income from partnership assets, such as income from high-quality debt securities or a high-quality net lease;
2. Within two years of receipt, the partner disposes of the profits interest; or
3. The profits interest is a limited partnership interest in a "publicly traded partnership" within the meaning of Sec. 7704(b).
The IRS followed with Rev. Proc. 2001-43, which clarified the safe harbor provided in Rev. Proc. 93-27 while extending a similar safe harbor to unvested interests as long as the following conditions are met:
1. Both the partnership and the service provider treat the service provider as a partner beginning with the date of grant;
2. The service provider picks up the Schedule K-1 items associated with the partnership interest on his or her Form 1040, U.S. Individual Income Tax Return;
3. No compensation deduction is taken by the partnership or any partner in connection with the grant of the partnership interest; and
4. All of the requirements of Rev. Proc. 93-27 are satisfied.
In 2005, Treasury issued proposed regulations (REG-105346-03) that have not yet been finalized. The proposed regulations treat the receipt of profits interests as currently taxable property for the purposes of Sec. 83 but create a safe harbor that would allow partnership interests received as compensation to be valued based on their liquidation value, essentially zero, preserving the nontaxable character.
Valuation for Transferring Carried Interests
Carried interests can be transferred using traditional estate planning techniques but are subject to a unique set of concerns. Under Regs. Sec. 25.2512-1, "[t]he value of . . . property [for transfer tax purposes] is the price at which such property would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or to sell, and both having reasonable knowledge of relevant facts." The valuation guidelines for transfer-tax purposes do not mirror those used for income tax purposes.
Guidance from Rev. Proc. 93-27 and Rev. Proc. 2001-43 addressed the timing of income recognition but not valuation. Many tax advisers are relying on Campbell, which used the "willing buyer, willing seller" test and held that the profits interest had no value, but in Campbell the carried interest units were not transferable. The 2005 proposed regulations bring attention to valuation but provide a zero valuation based on the liquidation value and not the "willing buyer, willing seller" test.
Transfers are best done early on, before the taxpayer receives significant income or realizes appreciation. Factors that could significantly reduce the value of a transfer include:
1. Uncertainty regarding the appreciation of the fund investments (returns generally must reach a defined threshold before the fund manager receives any payout);
2. Clawback provisions that could require any profits previously distributed to be restored;
3. Vesting restrictions; and
4. Lack of marketability of the interest and minority interest discounts.
Zero valuations, for transfer-tax purposes, should be used cautiously. While there is currently no case law rejecting a zero valuation, the support for them is unclear.
Mindy Tyson Weber is a senior director, Washington National Tax, for RSM US LLP.
For additional information about these items, contact Ms. Weber at 404-373-9605 or firstname.lastname@example.org.
Unless otherwise noted, contributors are members of or associated with RSM US LLP.