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​​​​​Profits Interests (aka Carried Interests)
   >>> see Forms of Compensation Generally

​          >>> see also: 2019 WeWork Program for CEO

General Info:

  • Only works for Partnerships and LLCs taxed as such, because awards occur with respect to LLC units having financial and other terms dictated by the governing LLC documents.
  • Represents a right to receive a percentage of future appreciation in the value of the Partnership or the LLC (or a designated fund or asset pool).
  • Capital gains potential for passed-through character of annual income.
  • No tax on grant.
  • Annual deemed income per K-1 for distributable share of profits; regular book-ups and complex accounting required.
  • Potential for capital gain treatment on pass-through annual income.
  • Capital gain on settlement in liquidation or sale of LLC.
  • Financial expense subject to complex rules - see accounting consequences.
  • RELEVANT ARTICLES:


2017.03.03  "IRS Looking for Management Fee Waiver Problems in Audits."  In its Daily Tax Reports, the BNA article with this title starts as follows: "The IRS is instructing auditors to look for investment fund management fee waivers that may not comply with the law, an agency official said.  Waivers are common in private equity deals where an investment manager will shift fee income into the fund, converting it to carried interest, which is taxed at lower capital gains rates instead of ordinary rates."


2016.April   SEC Rule 701 and Profits Interests.  See the discussion at the bottom of this page for what seems to be an unanswered question.  Please feel welcome to email Mark with your thoughts about how to best analyze and handle this. 


2016.Feb.   Carried Interest Revenue in Treasury Spotlight.  For FY2017, the Treasury Department's revenue proposals aim to "tax as ordinary income a partner’s share of income on an “investment services partnership interest” (ISPI) in an investment partnership, regardless of the character of the income at the partnership level. Accordingly, such income would not be eligible for the reduced rates that apply to long-term capital gains. In addition, the proposal would require the partner to pay self-employment taxes on such income."


2014.June   457A does not reach Stock Options and Stock-settled SARs.  In Rev. Rul. 2014-18, the IRS concluded that stock options and stock appreciation rights are exempt from Code §457A, provided the underlying award agreement requires that they be settled only in stock (and not in cash, even if at the employer's discretion).  This ruling opens the door for better long-term structures for hedge fund compensation. See, e.g. EisnerAmper Alert (6/30/2014); 

2014.May.20   Carried Interest Tax Regulation -- Likely to Stay on Hold
A Bloomberg BNA article quotes that Clifford M. Warren, special counsel to the IRS associate chief counsel (passthroughs and special industries), as saying “no one is eager to revisit” the 2005 proposed rules (REG-105346-03) which would govern the issuance and vesting of capital and profits partnership interests issued in connection with the performance of services.  After speaking to a PLI session, Warren told Bloomberg BNA that “it doesn't make sense to open that door” (re the issuance of tax regulations addressing carried interests) while Congress has legislation under consideration.

APPLICABLE LAW:

Historical Context: 

Diamond v. Commissioner, 56 T.C. 530 (1971), aff’d 492 F.2d 286 (7th Cir. 1974) involved the provision of services in exchange for a 60% profits interest in a partnership.   Within a month of this grant, Diamond sold the profits interest but chose to treat the profits interest grant as a nonrecognition event. The result was that he reported a short-term capital gain from the sale of the interest. The court disagreed and found that the initial grant to Diamond of the 60% was taxable on receipt as ordinary income. This case established the proposition that the profits interest could be taxed on receipt.  The Diamond case ishistorically a key case but other courts varied on when Profits Interests should have been taxed. See, e.g., Cambell v. Commissioner, T.C.M. 1990-236, rev’d 943 F.2d 815 (8th Cir. 1991). As a result the Service issued Rev. Proc. 93-27 which sets out a safe harbor for the taxation of profits interests.

ARTICLES

  • Taxing Partnership Profits Interest: The Carried Interest Problem, 124 Harv. L. Rev 1773 (2011).
  • A Pragmatic Case for Taxing an Equity Fund Manager's Profit Share as Compensation, 87 Taxes 139 (Mar. 2009). Mark Gergen.
  • Carried Interests: Can They Effectively Be Taxed? 4 Entrepren. Bus. LJ 21 (2009). David Herzig.
  • Two and Twenty: Taxing Partnership Profits In Private Equity Funds, 83 N.Y.U. L. Rev. 1 (2008). Victor Fleischer.
  • Taxing Private Equity Carried Interest Using an Incentive Stock Option Analogy, 121 Harv. L. Rev. 846 (2008). Adam Lawton.
  • The End of Deferral As We Know It (2008), Mark Leeds.

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SEC RULE 701 REGISTRATION OF PROFITS INTERESTS
In general, Rule 701 covers "compensatory benefit plans" which are defined to include “any purchase, savings, option, bonus, stock appreciation, profit sharing, thrift, incentive, deferred compensation, pension or similar plan” established by the issuer, its parents, its majority-owned subsidiaries or majority-owned subsidiaries of the issuer's parent, for the participation of their employees, directors, general partners, trustees (where the issuer is a business trust), officers, or consultants and advisors.”  17 C.F.R. § 230.701(c)(2).   Consultants and advisors need to be natural persons.
The first dollar value limitation under Rule 701 is that the maximum “sales price” of securities sold during any consecutive 12-month period under the Rule may not exceed the greatest of the following:  
(i)            $1,000,000;
(ii)           15% of the total assets of the issuer, measured at the issuer’s most recent balance sheet date; or
(iii)          15% of the outstanding amount of the class of securities being offered and sold in reliance on Rule 701, measured at the issuer’s most recent balance sheet date.

The second requirement is that, if the aggregate sales price or amount of securities sold during any consecutive 12 month period exceeds $5 million, the issuer must provide each purchaser with risk factor disclosure, a copy of the compensatory benefit plan or contract (in this case, a copy of the plan); and (iii) financial statements meeting specified standards.  

The question becomes how to value the profits interests for 701 purposes. Unfortunately, Rule 701 is silent on how to value profits  interests and there is no published authority.  Note however that Rule 701(d)(3) provides generally that “Options must be valued based on the exercise price of the option.”  Because profits interests are closely analogous to stock options (because both have a value based solely on increases in value after the award date), a conservative valuation for a profits interest could reasonably be calculated by multiplying the profit interest percentage by the company’s value on the grant date.  That is because the “liquidation value” of the company on the grant date of the profits interests can be considered the rough equivalent of an option exercise price. 
Alternatively, the value of the profits interest could instead be determined by the financial statement expense associated with the grant. That method would reasonably reflect the Rule 701(d)(3) requirement that “the value of the securities” should control when awards occur solely in consideration of the performance of services. There is, however, no published authority approving either alternative, which makes the former choice safer because it errs on the high side.