How Carried Interest Legislation Could Change Real Estate Investing


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Journal of Real Estate Taxation

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How Carried Interest Legislation Could Change Real Estate Investing

  1. 1. HOW CARRIED INTEREST LEGISLATION COULD CHANGE REAL ESTATE INVESTING More important than any political discussion is the effect such proposals would have on real estate and other partnerships. Author: CHESTER W. GRUDZINSKI, JR. CHESTER W. GRUDZINSKI, JR. is Head of the Tax Section for the law firm of Kelly Hart & Hallman and is located in the Fort Worth, TX office. [pg. 147] A "carried interest" is defined neither by the Code nor the regulations. 1 The term refers to a partnership or similar interest given to one who performs services for an investment partnership or other form of investment fund (hereinafter referred to as a Fund or Funds). 2 While a carried interest is received in exchange for services, the income associated with a carried interest has the same character as reported by the Fund. In many instances, the income allocated to the carried interest holder is capital in nature under current law and can be reported and taxed as long-term capital gain, rather than, as some may suggest, as ordinary compensation income for services. 3 Several proposals have been made over the past five years to tax income and loss from carried interests as ordinary compensation income. They have been included in every budget proposed by President Barack Obama, and in discussions about former governor Mitt Romney's tax returns. More important than any political discussion, however, is the effect such proposals would have on real estate and other partnerships, as well as on hedge funds, private equity funds, and other types of investment vehicles. General issues Funds formed to invest in real estate may hold the real estate directly or through disregarded entities. Some use a "fund of funds" approach to investing. 4 Although some Funds have been formed as limited liability companies (LLCs, treated as partnerships for federal income tax purposes), they are generally formed as limited partnerships. 5 Issues related to the compensation of Fund managers are always a significant consideration in structuring an investment vehicle. Funds pay some amount of management fee and provide a carried interest. The
  2. 2. Fund managers are always interested in tax efficiencies in operating the Fund and in receiving their carried interest and manager fee. The structural context. The structure of a typical Fund is shown in Exhibit 1 on page xxx. 6 Investors contribute cash to become limited partners in the Fund ("LP investors"). In most cases, a separate management entity ("management company") controlled by the organizers of the Fund ("Fund managers") manages the Fund's assets. The Fund managers also usually own a capital interest as a general partner in the Fund, [pg. 148] and usually acquire it for a relatively small amount of contributed capital (small, at least, in relation to amounts of capital contributed by the LP investors). Some organizers also may own a more significant limited partner interest in the Fund. The Fund managers do not own these interests directly. Their general and limited partnership interests usually are held in separate entities (the "GP entity" and the "LP entity"). In Exhibit 1, as is often the case, these entities are limited partnerships. The Fund managers hold limited partnership interests in the GP and LP entities directly, but hold the general partnership interests in them through intervening LLCs. The GP and LP entities hold the Fund manager's interests in the Fund. The Fund pays a management fee to the management company, which fee is ordinary income to the management company. 7 Fund organizers receive a carried interest from the Fund. As is usually the case, the carried interest in the Exhibit 1 structure is held by the GP entity. Exhibit 1. Typical Fund Structure Utilizing Carried Interests
  3. 3. The carried interest. As used in this context, a carried interest is the right to receive a percentage of the Fund's profits without any corresponding capital contribution by the Fund managers. Any such carried interest can take many forms and involve many calculations. The organizers will refer to the management fee and the carried interest as "2 and 20," or whatever the combination is for the Fund. The "2" refers to a 2% management fee and the "20" refers to a 20% carried interest. Some managers have traded off a larger carried interest [pg. 149] for a lower management fee and some have done the reverse. One significant issue is whether the carried interest amount will be calculated asset-by-asset or overall for all capital contributions and all distributions. 8 The tax benefit for Fund managers is that, as a result of receiving a carried interest rather than additional management fees, they get to report the related taxable income as having the same character as the income reported by the Fund. To the extent of any long-term capital gains or qualifying dividends, the Fund managers currently pay federal income tax on that income at the 15% tax rate. 9 In real estate Funds, Fund managers may also benefit to the extent the Fund generates tax-sheltered cash flow (e.g., due to depreciation). Issuing carried interests rather than paying management fees has potential tax benefits to the other partners. Many Funds allocate book gains and losses on a periodic basis, and the initial allocation made for each period for a carried interest is done solely for book purposes. Tax allocations generally follow book allocations with some adjustments. 10 A partner holding a partnership interest includes in income the distributive share (whether or not actually distributed) of partnership items of income and gain, including capital gain eligible for the lower income tax rates. A partner's basis in the partnership interest is increased by any amount of gain thus included and is decreased by losses and distributions. These allocations will typically have some long-term capital gain and, until 2013, will not be subject to the Medicare tax. 11 As a result, the partners do not have to be concerned with deducting an additional management fee since they have, in effect, received such deduction by allocating taxable income of the Fund to the Fund manager. Another benefit to other partners is the reduction or avoidance of additional Section 212 expenses. 12 Real estate Funds involve issues that distinguish them from most investment partnerships. These issues could produce unwanted consequences under the proposed legislation (described below) that would change the treatment of carried interests. For example, real estate Funds typically generate leveraged losses from depreciation and other deductions, and these losses will reduce or eliminate a qualified
  4. 4. capital interest, as will be discussed below. Current law Although the issuance of carried interests in Funds and in many other partnerships has become very common and is rarely challenged, some commentators still consider the tax treatment uncertain. In discussing this issue, one commentator states: [T]he tax consequences of the issuance and receipt of a partnership interest in connection with the performance of services are among the most unsettled in the partnership area. The issues have never been dealt with legislatively, are dealt with only opaquely by existing Regulations, and have been thoroughly confused by a welter of inconsistent and poorly analyzed court decisions. Further, the era of relative administrative certainty initiated by the issuance of Revenue Procedure 93-27 closed with the issuance of Proposed Regulations on May 24, 2005. 13 [pg. 150] Nevertheless, carried interests are issued in many transactions and the issuance is generally considered to be a low-risk, low-exposure item if the applicable administrative guidance has been followed. 14 Almost all investment funds are partnerships for federal income tax purposes. When a carried interest is issued by such a partnership, it almost always takes the form of a profits interest (not a capital interest). 15 A profits interest in a partnership is just that-it gives the recipient the right to receive a portion of the partnership's future profits. For an interest to be a profits interest, the recipient must not have the right to receive any money or other property upon the immediate liquidation of the partnership. Tax advisors have long said that the issuance of a profits interest should not be a taxable event to the partnership or the recipient at the time of issuance. 16 By contrast, it previously was generally accepted that the issuance of a capital interest received for services was includable in the partner's income, and some thought it might be taxable to the partnership under generally applicable rules relating the transfer of property for the performance of services. 17 A partnership capital interest for this purpose is one that would entitle the receiving partner to a share of the proceeds if the partnership's assets were sold at fair market value and the proceeds were distributed in liquidation. 18 For a newly formed partnership that accepts only cash contributions, determining if an interest is a profits interest or a capital interest generally is a mere formality, since the partnership should not have to worry about valuation issues. 19 For existing entities, however, the partnership assets must be valued and the value must be distributable to the existing partners in a deemed liquidation immediately
  5. 5. after the issuance of the carried interest, which can be done with an elective book-up of the capital accounts under Section 707(a)(2)(A) or by amending the partnership agreement to specifically provide for such an allocation. Transfers of property for services. With respect to the transfer of property for services, Section 61(a)(1) provides that gross income includes compensation for services and Reg. 1.61-2(d) provides that gross income includes property received as compensation for services. Section 721 generally makes contributions of property to a partnership a nontaxable event, [pg. 151] but Reg. 1.721-1(b) generally states that the value of a capital interest transferred to a partner as compensation for services constitutes income to the partner under the general rules of Section 61 . Reg. 1.721-1(b) also states, however, that "to the extent that any of the partners gives up any part of his right to be repaid contributions (as distinguished from a share in partnership profits) in favor of another partner as compensation for services (or in satisfaction of an obligation), section 721 does not apply." It has been argued that the parenthetical referring to an interest in partnership profits makes all profits interests not taxable. 20 Under Section 83 , the person for whom such services are performed is allowed a deduction equal to the amount included in gross income by the service provider. 21 The deduction must be timed, however, to the end of the tax year during which service provider included that amount in income. Thus, the recipient's deduction may not be taken until the tax year during which that tax year of the provider ends. If that tax year of the service provider ends on the same day as the service recipient's tax year, the recipient may take the deduction for that year. Property is subject to a substantial risk of forfeiture if the individual's right to the property is conditioned on the future performance of substantial services or on the nonperformance of services. In addition, a substantial risk of forfeiture exists if the right to the property is subject to a condition other than the performance of services, provided that the condition relates to a purpose of the transfer and there is a substantial possibility that the property will be forfeited if the condition does not occur. The risk that the property will decline in value does not result in a substantial risk of forfeiture. Whether a substantial risk of forfeiture exists depends on the surrounding facts and circumstances, including whether the service requirement or other condition will in fact be enforced. Property that is subject to a substantial risk of forfeiture is referred to as nonvested property; property that is not (or is no longer) subject to a substantial risk of forfeiture is referred to as vested property. With respect to carried interests, a typical risk of
  6. 6. forfeiture is that the carried interest can be repurchased for a nominal amount upon termination for any reason during some specified time (e.g., if the service provider quits within three years). Property is considered transferable if a person can transfer his or her interest in it to anyone other than the transferor from whom it was received. However, property is not considered transferable if the transferee's rights in the property are subject to a substantial risk of forfeiture. A temporary restriction on the transferability of property is disregarded in determining the value of the property for purposes of Section 83 . A permanent restriction on the transferability of property is taken into account in determining the value. Rev. Proc. 93-27 . After years of litigation, 22 the Service issued Rev. Proc. 93-27, 1993-2 CB 343 , which is considered the starting point in analyzing the potential issuance of any carried interest. The stated purpose of Rev. Proc. 93-27 was to provide guidance on the treatment of the receipt of a partnership profits interest for services provided to or for the benefit of the partnership. 23 In an attempt to provide a definition to be used to determine if a profits interest has been issued, Rev. Proc. 93-27 defined a capital interest and stated that a profits interest is a partnership interest other than a capital interest. A capital interest is defined as an interest that would give the holder a share of the proceeds if the partnership's assets were sold at fair market value and then the proceeds were distributed in a complete liquidation of the partnership. 24 Under Rev. Proc. 93-27 , if a person receives a profits interest for the provision of services to or for the benefit of a partnership, and receives it in his or her capacity as a partner in anticipation of being a partner, the receipt of such an interest will not be treated as a taxable event for the partner or the partnership. 25 This general rule does not apply in any of the following instances: (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.) The partner disposes of the profits interest within two years of receiving it. 26 (3.) The profits interest is a limited partnership interest in a publicly traded partnership. Rev. Proc. 93-27 was clarified in 2001 to provide guidance on the treatment of the grant [pg. 152] of a substantially nonvested profits interest for the provision of services to or for the benefit of the partnership. Under Rev. Proc. 2001-43, 2001-2 CB 191 , a substantially nonvested profits interest will be
  7. 7. treated as having been received on the date of its grant (rather than at the time it vests) provided that all of the following conditions are met: (1.) The partnership and the service provider treat the service provider as the owner of the partnership interest from the date of the grant, and the service provider takes into account the distributive share of partnership income, gain, loss, deduction, and credit associated with the interest in computing the service provider's income tax liability for the entire period during which the service provider has the interest. (2.) Upon the grant of the interest or at the time that the interest becomes substantially vested, neither the partnership nor any of the partners deducts any amount (as wages, compensation or otherwise) for the fair market value of the interest. (3.) All other conditions of Rev. Proc. 93-27 have been satisfied. 27 Taxpayers to which Rev. Proc. 2001-43 applies do not need to file an election under Section 83(b) . Although Rev. Proc. 93-27 made only one somewhat vague reference to Section 83 , Rev. Proc. 2001- 43 made two direct references and clearly implied that Section 83 must be examined and applied to the issuance of partnership interests for services. Additionally, both revenue procedures directly referenced Sections 61 , 83 , and 721 , as well as Reg. 1.721-1 . The revenue procedures seem to provide clear guidance for the issuance of a profits interest that meets the applicable requirements, but crucial issues remain. 28 The primary issue relates to the valuation of the partnership and whether the recipient of the partnership interest received the right to any property upon an immediate liquidation. Another issue relates to the receipt of a profits interest from a partnership for service to another partnership that is related to or affiliated with the partnership that issues the profits interests. If the carried interest fell outside of the provisions of the revenue procedures, it was then arguably valued at its full fair market value, including the option value associated with the right to get a piece of future profits. Example 1. Assume that a profits interest is issued to a service provider at the end of Year 1, and that the service provider will forfeit that interest if he voluntarily terminates his employment during the next five years. Under Rev. Proc. 2001-43 , the income inclusion and the valuation will occur upon the issuance at the end of Year 1. If the profits interest qualifies as such under Rev. Proc. 93-27 , no income would be included upon the issuance at the end of Year 1 and the vesting at the end of Year 6 will not be a transfer or a taxable event as long as the conditions in the revenue procedures are followed by the partnership and the service provider. Additionally, the service provider does not have to file a Section 83(b) election with respect to the profits interest. 29 Alternatively, if the service provider receives 20% of the profits interest at the end of each of the five years, the provisions of Rev. Proc. 2001-43 will not apply. Instead,
  8. 8. the interest received will be valued and included in income at the end of each of the five years. In this case, a Section 83(b) election would not be possible because the profits interest would not have been transferred as of the end of Year 1. It might be possible to have Rev. Proc. 93-27 apply if the applicable liquidation value is zero on each vesting date. If the delay in vesting caused the interest to become a capital interest, the valuation under the revenue procedures may include the option value of the interest. Proposed regulations. In 2005, proposed regulations were issued to address the issuance of partnership equity for services. 30 The Preamble to the proposed regulations directly referred to a proposed amendment to the regulations under Section 721 that was issued in 1971 31 but had by then been withdrawn. The proposed regulations start by trying to put an end to any controversy over the inclusion of partnership interests as property for Section 83 purposes. The Preamble provides that Section 83 applies to all partnership interests without distinguishing between partnership capital interests and partnership profits interests. 32 Thus, a compensatory transfer of a partnership interest is includable in the service provider's gross income at the time that it first becomes substantially vested (or, in the case of a nonvested partnership interest, at the time of grant if a Section 83(b) election is made). Unlike the guidance in Rev. Proc. 2001-43 , the preamble states that a nonvested interest is not treated as being held by the [pg. 153] service provider unless a Section 83(b) election has been made. The proposed regulations also specifically apply only to a transfer by a partnership of an interest in that partnership in connection with the performance of services for that partnership. The Treasury and the Service requested comments on the income tax consequences of transactions involving related persons-for example, the transfer of an interest in a lower-tier partnership in exchange for services provided to the upper-tier partnership. One key point was that the proposed regulations provide that a partnership will not recognize any gain or loss upon (1) the transfer or substantial vesting of a compensatory partnership interest or (2) the forfeiture of a compensatory partnership interest. For this purpose, a compensatory partnership interest generally is an interest transferred in connection with the performance of services for the partnership without any distinction for being a capital interest or a profits interest. 33 The proposed regulations also contain a rule permitting a partnership and a partner to elect a safe harbor under which the fair market value of a compensatory partnership interest is treated as being equal to the liquidation value of that interest. Therefore, under the proposed regulations, the grant of a vested profits
  9. 9. interest in a partnership (or, if a Section 83(b) election is made, the grant of a nonvested profits interest) results in no income inclusion under Section 83 because the fair market value of the property received by the service provider is zero. 34 The proposed safe harbor is subject to a number of conditions. For example, the election cannot be made retroactively and must apply to all compensatory partnership transfers that occur during the period the election is in effect. Certain operating rules for the proposed safe harbor were included in Notice 2005-43, 2005-1 CB 1221 , which contained a proposed revenue procedure that would be effective only with the final regulations. For purposes of the safe harbor, "liquidation value" is determined without regard to any lapse restriction. The term means the amount of cash that the service provider would receive if, immediately after the transfer, the partnership sold all of its assets (including goodwill, going concern value, and any other intangibles associated with the partnership's operations) for cash equal to the fair market value of those assets, and then liquidated. If this becomes effective, existing partnership agreements will have to be amended to enable the partnership to qualify to make the safe harbor election. The proposed regulations probably will not be finalized until the carried interest legislation has been resolved. 35 Upon the issuance of the revenue procedure contained in Notice 2005-43 , both Rev. Proc. 93-27 and Rev. Proc. 2001-43 will be obsoleted. Oil and gas. The term "carried interest" has a somewhat different meaning in the oil and gas business. In that context, carried interests generally involve the cost of drilling and equipping wells on the property, though they can include other costs. The interest generally is part of an [pg. 154] arrangement in which one party (the "carrying party") agrees with the owner of an operating interest (the "carried party") to pay all, or a disproportionate part, of the cost to develop and operate a mineral property in exchange for the right to receive repayment of those costs out of the proceeds from the first production from the property. After the carrying party has been repaid ("payout"), any subsequent production is shared by the carrying and carried parties according to a previously agreed-on split. The carried party is not obligated to pay its share of the expenses for the development and operation until payout. 36 The carried party might retain an overriding royalty interest in the property during payout, with the right to convert the overriding royalty interest to a working interest after payout. 37 Because the carrying party owns the entire working interest in the minerals until payout, it can deduct all of the intangible drilling costs incurred in drilling the well, and can capitalize and depreciate all equipment costs associated with the lease and well. The carrying party is taxable on all net profits from the well prior
  10. 10. to payout, and is eligible for depletion in accordance with its economic interest. Any overriding royalty interest retained by the carried party is not income to the developer, and the carried party can claim depletion against the overriding royalty income. After payout, the carrying party must capitalize as leasehold acquisition costs (recoverable through depletion) the portion of the remaining undepreciated basis of equipment equal to the working interest percentage acquired by the carried party after payout. 38 Another carried interest arrangement is a "farmout," which involves a carried party transferring a working interest to the carrying party in exchange for its obligation to contribute services and materials to the development of the property. Since the carried party transfers a working interest to the carrying party in exchange for services and costs, it would appear that the carrying party might recognize taxable income upon receipt of such working interest. 39 If, however, the carrying party's contribution is made only with respect to one property, the carried party would not realize any taxable income from the carrying party's contributions to the property, and the carrying party would not recognize any taxable income from the receipt of the working interest in exchange for its contributions. The carrying party is not viewed as performing services for compensation, but as acquiring a capital interest through an undertaking to make a contribution to the pool of capital. Likewise, the carried party is not viewed as having parted with a capital interest in the property, but has merely given the carrying party a right to share in production in consideration of an investment made. 40 This pool of capital doctrine applies only to the extent that the working interest transferred to the carrying party is the same property, as the term "property" is used in Section 614 , that was being developed by the carrying party. 41 Receipt of the working interest is tax free under the pool of capital doctrine only if the obligations of the carrying party are incurred for the acquisition, exploration, or development of the oil and gas reserves. 42 The Service narrowly [pg. 155] construes the pool of capital doctrine as applied to services that are not directly related to the acquisition, exploration, and development of specific properties. 43 The carrying party must also be concerned with the ability to deduct intangible drilling costs and other costs relating to the development obligation. Specifically, if a carrying party is not entitled to "complete payout" of all of its costs of developing the property (including operating costs up to the point of complete payout) prior to reversion of the carried party's operating interest in the property, the developer may deduct only the fraction of costs attributable to its permanent operating interest, and must capitalize the fraction of the costs of equipment and intangible drilling costs attributable to the operating interest held by the carried party as leasehold acquisition costs. 44 The carried party may not deduct any of those costs
  11. 11. because it did not fund them. 45 Example 2. The carrying party agrees to pay all the costs of drilling and completing a well on a property owned by carried party in exchange for 75% of the working interest in the property without any separate payout provisions. The carrying party can elect to deduct only 75% of the intangible drilling costs. Example 3. The carrying party agrees to pay all of the costs of drilling and completing a well on a property owned by the carried party for 100% of the working interest until the end of the complete payout period. The carried party retains a 1/12 overriding royalty in the property and has the option to convert such royalty to 20% of the working interest if payout has not occurred within three years. The carrying party can deduct only 80% of the intangible drilling costs, even if payout occurs within three years and even if the carried party does not exercise its option. Due to the limitations of the application of the pool of capital doctrine and the fractional interest rule, many such oil and gas agreements include an attached exhibit for a tax partnership with special allocations. The tax partnership is not an entity for state law purposes and nothing is filed with the appropriate state authorities for entities. For federal income tax purposes, however, the carrying and carried parties have formed a partnership that partnership owns the entire operating interest at all times (before and after payout). Based on Section 704(b) substantial economic effect, the intangible drilling costs and other deductions are allocated 100% to the carrying party. The tax partnership will need a tax identification number and will file annual tax returns and must follow all applicable partnership rules. For larger transactions, a limited partnership or a limited liability company that is taxed as a partnership is formed with the properties actually transferred to such entity, and some partners are issued traditional carried interests in such partnerships. Proposed legislative changes There have been many proposals since 2007 to change the federal income tax treatment of carried interests. They have been included in all of President Obama's budget proposals, and have been the subject of separately introduced bills as well. The most recent bill, introduced by Rep. Sander M. Levin (D-MI), is the Carried Interest Fairness Act of 2012 (CIFA). 46 CIFA could lead to harsh results for real estate Funds, which, in some cases, have issues that distinguish them from most investment partnerships. For example, real estate Funds may have negative capital accounts with built-in "phantom" income, and there is no provision in CIFA for such income, including phantom income in existing entities. Real estate Funds are more likely than other Funds to make leveraged distributions, which can lead to reductions of the qualified capital interest (as defined below). Such Funds also typically generate leveraged tax losses that would also reduce or eliminate any qualified
  12. 12. capital interests. Finally, management by a related party could lead to application of CIFA to a partnership that does not contain any carried interests. The proposed changes could result in another repricing of the real estate investment market. In some instances, the language seems to go beyond any reasonable approach with respect to real estate Funds, which is probably due to Section 710 being drafted primarily to deal with the hedge fund industry. Changing the rules for leveraged losses and leveraged distributions will likely result in changed behavior, which may include tying up more equity in existing real estate deals rather than [pg. 156] freeing up equity through a leveraged distribution. 47 These issues will be discussed in more detail below. Like prior legislative proposals on carried interests, CIFA includes a new Section 710. Under Section 710, an amount equal to the net capital gain or loss with respect to an investment services partnership interest (ISPI) generally would be treated as ordinary income or ordinary loss. The amount treated as ordinary loss could not exceed the amount previously reported as ordinary income, less any prior amounts treated as ordinary loss. The amount treated as ordinary income would be allocated ratably among the items of long-term capital gain taken into account in determining the net capital gain. Likewise, the amount treated as ordinary loss would be allocated ratably among the items of long-term and short-term capital loss taken into account in determining the net capital loss. Any such income would be compensation income subject to all employment taxes. Net capital gain, long-term capital gain, and long-term capital loss with respect to any ISPI would be determined under Section 1222 , except that Section 1222 would be applied (1) without regard to the recharacterization of any item as ordinary income or loss under Section 710, (2) by taking into account only items of gain and loss taken into account by the holder of the interest under Section 702 with respect to the interest for that tax year, and (3) by treating property taken into account in determining gains and losses to which Section 1231 applies as capital assets held for more than one year. A special rule would provide that " Section 1202 shall not apply to any gain from the sale or exchange of qualified small business stock (as defined in Section 1202(c) ) allocated with respect to any ISPI." 48 Under Section 1222 , net capital gain means the excess of the net long-term capital gain for the tax year over the net short-term capital loss for that year. Net long-term capital gain means the excess of long-term capital gains for the tax year over the long-term capital losses for the year. At a minimum, an ISPI could have ordinary income (or loss), long-term capital gains, and short-term capital gains, but only the long- term capital gains would be subject to rechracterization. Example 4. Assume $100x of long-term capital gains and $125x of ordinary loss. Under some of the prior
  13. 13. legislative proposals, the partnership would have had a net loss and nothing would have been recharacterized. Under CIFA, however, the $100x of long-term capital gain would be recharacterized as ordinary income. If the ordinary loss were deductible, a net ordinary loss of $25x would be the result. The result could be materially different if the ordinary loss consisted of items that would be Section 212 expenses or other expenses that would not be deductible to offset ordinary compensation income. No dividend allocated to any ISPI would be treated as qualified dividend income for purposes of Section 1(h) . Additionally, with respect to corporations, no deduction would be allowed under Section 243 or 245 with respect to any dividend allocated to an ISPI. Dispositions. With respect to dispositions of partnership interests, any gain on the disposition of an ISPI would be treated as ordinary income and recognized notwithstanding any other provision of the Code. However, the foregoing disposition rule would not apply to (1) a disposition by gift or (2) a transfer at death. In those cases, the ISPI would continue to be an ISPI in the hands of the person acquiring it. Additionally, any amount that would have been treated as ordinary income under Section 710 had the decedent sold the ISPI immediately before death would be treated as income in respect of a decedent (IRD) under Section 691 . This version of proposed Section 710 apparently would allow gifts and bequests to persons other than a related person, as defined in Section 267(b) . Any loss from the disposition of an ISPI would be treated as an ordinary loss, but only to the extent of net ordinary income previously recognized under Section 710 with respect to that ISPI. The ISPI could be contributed to another partnership if the transferor made an irrevocable election to treat the partnership interest received in exchange as an ISPI and complied with such reporting and recordkeeping requirements as the Treasury prescribed. 49 It does not appear that the transferor would have to control the partnership after the transfer, so this could be a very significant exception to the limited rules discussed above, but any interest received would always carry the taint of an ISPI in the hands of the [pg. 157] transferor. The disposition rule is a very significant departure from existing law, turning transactions that had previously been non-taxable into taxable transactions. With the limited exceptions above, any transfer of the ISPI would be taxable. Example 5. Assume that, upon the formation of a partnership, an ISPI was issued to an individual giving him or her the right to receive 20% of all profits in the partnership. Later, the ISPI is transferred to a corporation in a transaction that would otherwise qualify under Section 351 . At the time of that transfer,
  14. 14. the ISPI had a basis of zero and a value of $100x (of which $70x represented the value upon liquidation and $30x represented the value of the future profits interest). Under proposed Section 710, the transferor of the ISPI would recognize the full amount of the gain ($100x) and that gain would be ordinary income subject to all employment taxes. It appears that the transfer would be taxable even though the interest apparently would remain an ISPI if more than 50% of the value of the corporation was owned, directly or indirectly, by or for the transferor. 50 Example 6. Assume the same ISPI as in Example 4. The individual transfers the ISPI as a gift to his nieces and nephews. Since nieces and nephews are not related to the individual for this purpose, the transfer would have been a taxable disposition under an earlier carried interest proposal. CIFA, however, would exclude this gift from being a taxable disposition. The recipients presumably would have a zero basis. The ISPI would continue to be an ISPI while held by the nieces and nephews or anyone receiving it from them as a gift or bequest. Alternatively, if the individual transferred the ISPI to a trust for the benefit of her nieces and nephews, the gift would exclude such a transfer. Although the trust and a beneficiary would be related parties under Section 267(b) , it does not seem clear that a subsequent distribution by the trust would not be a disposition by gift under proposed Section 710. As another alternative, assume that the individual holds the ISPI until death and leaves it outright to his nieces and nephews. The nieces and nephews would continue to hold the interest as an ISPI after receipt from the executor (even though no services will be performed by any beneficiary or related person). Any built in gain would be IRD and there would, in effect, be no step-up in basis for that amount. If partnership property is distributed to a partner with respect to an ISPI, the excess of the property's fair market value over its adjusted basis in the hands of the partner (determined without applying proposed Section 710) is recognized as gain by that partner. Any such gain recognized is treated as ordinary income to the same extent, and in the same manner, as the increase in the partner's distributive share of taxable income of the partnership would have been treated if, immediately prior to the distribution, the partnership had sold the distributed property at fair market value and all of the gain had been allocated to that partner. Following the gain recognition required under proposed Section 710, however, the basis of such property in the hands of the distributee partner would be the fair market value of such property. The provisions of proposed Section 710 do not appear to specifically address a distribution of cash in excess of basis unless it is meant to be treated as a partial disposition of the ISPI. 51 The basis adjustments also are not clear, and the rule that a partner holding two interests is treated as holding one partnership interest when determining basis would have to be applied. 52 Due to possible distortions, it perhaps would be desirable under proposed Section 710 to provide for separate tracking of the basis of such interests. For example, the basis and the distribution could be allocated to the ISPI and any other
  15. 15. interest owned by such person in the applicable partnership. Example 7. Assume an ISPI is issued by a partnership to an LLC. In Year 2, the ISPI has a book capital account of $25x and a tax capital account and basis of zero. The partnership distributes to the LLC, with respect to the ISPI, an asset with a long-term holding period and a fair market value of $25x and a basis to the partnership of zero. Assume that Section 731(c) does not apply to the distribution. Without proposed Section 710, the LLC would hold the asset with a zero basis and would not recognize the gain until it disposed of [pg. 158] the asset. Under proposed Section 710, however, the LLC would recognize the $25x gain as ordinary income and would get a basis in the asset equal to $25x. Alternatively, assume the partnership had a $15x basis in the asset. The LLC would calculate the gain under proposed Section 710 by using a zero basis for the stock and would recognize the $25x gain, but it would appear that only $10x would be recognized by the LLC as ordinary income. Presumably, prior to the application of proposed Section 710, the stock basis of the LLC would be reduced to zero under Section 732 and then proposed Section 710 would apply. The partnership should be able to make a Section 754 election, but that is generally not very helpful for many partnerships. 53 ISPI. Proposed Section 710(c)(1) defines an ISPI as any interest in an investment partnership acquired or held by any person in connection with the conduct of a trade or business, described below, by that person (or any person related to that person). 54 An interest in an investment partnership held by any person: (1.) Would not be treated as an ISPI for any period before the first date on which it is so held in connection with the trade or business. (2.) Would not cease to be an ISPI merely because such person holds such interest other than in connection with the trade or business. (3.) Would be treated as an ISPI if acquired from a related person in whose hands the interest was an ISPI. For this purpose, a trade or business includes the performance of any of the following services with respect to assets held (directly or indirectly) by the applicable investment partnership: 0• Advising as to whether to invest in, purchase, or sell any specified asset.
  16. 16. 1• Managing, acquiring, or disposing of any specified asset. 2• Arranging financing with respect to acquiring specified assets. 3• Any activity in support of any service described above. A partnership would be an "investment partnership" under proposed Section 710 if, at the end of any calendar quarter ending after the date of enactment of Section 710, (1) substantially all of the assets of the partnership are "specified assets" (determined without regard to any Section 197 intangible within the meaning of Section 197(d) ), and (2) more than half of the capital of the partnership is attributable to "qualified capital interests" that (in the hands of the owners of such interests) constitute property not held in connection with a trade or business. "Specified assets" would include most types of securities, real estate held for rental or investment, interests in partnerships, commodities, cash or cash equivalents, and options or derivative contracts with respect any of the foregoing. If an interest received in exchange for a contribution to partnership capital by any member of a controlled group of entities would constitute property held in connection with a trade or business, any such interest would be treated as an interest that is property held in connection with a trade or business. A "controlled group of entities" generally would refer to a controlled group of corporations under Section 1563 (with some provisos) plus entities controlled by members of that group as provided in Section 954(d)(3) . In determining whether any interest in a partnership constitutes property not held in connection with a trade or business, except as otherwise provided by regulations, (1) any election under Section 475(e) or (f) would be disregarded, and (2) attribution of services from a partner to a partnership would not apply. 55 Although not included in proposed Section 710, the look-through rule under the investment partnership rules for Section 721(b) should be considered for inclusion in carried interest legislation. Specifically, consistent with the intent to have this apply to investment partnerships if a partnership owns 50% or more of the capital or profits interests in a partnership, the applicable partnership should properly be treated as owning its pro rata share of the assets of the subsidiary partnership. 56 Likewise, under [pg. 159] the definition of investment partnership for purposes of determining if a distribution of marketable securities should be treated as cash, an upper-tier partnership is treated as holding a proportionate share of the assets of the lower-tier partnership if (1) the upper-tier partnership actively and substantially participates in the management of the lower-tier partnership or (2) the upper-tier partnership holds 20% or more of the profits and capital interests in the lower-tier partnership. 57 The purposes of these provisions
  17. 17. are substantially similar to those of the definition of investment partnership for purposes of Section 710, and they should be considered in any future versions. Proposed Section 710(d) would provide that a partner's distributive share of partnership items reasonably allocated to the partner with respect to that partner's qualified capital interest will not be recharacterized as ordinary income, so long as the allocations are made to that qualified capital interest in the same manner as to other qualified capital interests held by partners who do not provide any of the services. In addition, if regulations or other guidance properly allocated items of income, gain, loss, or deduction to a partner's qualified capital interest, such items also would not be recharacterized as ordinary income. Similarly, gain or loss from the disposition of an interest in the partnership, or with respect to a distribution of appreciated property to the partner, would not be recharacterized to the extent reasonably allocable to the partner's qualified capital interest. Proposed Section 710 defines "qualified capital interest" as the portion of a partner's interest in partnership that is attributable to (1) the amount of money contributed by the partner and the fair market value of other property contributed by the partner (determined without regard to Section 752(a) ), (2) any amounts that have been included in the partner's income under Section 83 with respect to a transfer of a qualified capital interest, and (3) the excess of any items of income and gain taken into account under Section 702 over items of deductions or loss so taken into account. The qualified capital interest would be reduced by distributions from the partnership with respect to that interest and by the excess (if any) of the items of deduction and loss over items of income and gain. No increase or decrease in the qualified capital account would result from a termination, merger, consolidation, or division described in Section 708 . The qualified capital interest would not seem to include any amounts related to book-ups under the Section 704(b) regulations. These rules would require significant clarification because the current concept does not seem to include treating the interests as if they were separate and should be tracked, making all adjustments under the general partnership rules to the qualified capital interest and applying the proposed Section 710 provisions only to the ISPI. There also would be no adjustment either for the purchase of an ISPI that would be an ISPI in the hands of the purchaser, or for the purchase of a qualified capital interest by the holder of an ISPI Proposed Section 710(d)(8) would provide that a qualified capital interest does not include capital attributable to the proceeds of any loan or other advance made or guaranteed, directly or indirectly, by any partner or the partnership. Several "anti-abuse" provisions would also be included, as well as broad authority for Treasury to issue regulations. The rules would be extended to other entities under certain circumstances-except that the provisions would not apply to interests in corporations (either S or C), except as provided by the Treasury, or to certain foreign corporations.
  18. 18. The ISPI would be treated as a "hot asset" for purposes of Section 751 . The income of an ISPI would not be qualifying income for purposes of the publicly traded partnership provisions of Section 7704 , except for certain real estate investment trusts and certain publicly traded partnerships that hold interests in other publicly traded partnerships as substantially all of their assets. The legislation would also amend Section 6662 to provide a 40% penalty if a taxpayer reported an amount as not subject to new proposed Section 710 and that treatment was not sustained. However, the 40% underpayment penalty would not apply if the taxpayer (1) adequately disclosed the relevant facts relating to the tax treatment of the item, (2) had substantial authority for such tax treatment, and (3) [pg. 160] reasonably believed that such tax treatment was more likely than not the proper treatment. Recordkeeping and monitoring potential status as an investment partnership under proposed Section 710 would be complex and create administrative burdens. The legislation does not include any clear exceptions. Exceptions should be considered in any future version of the legislation for small partnerships, which could be defined according to the number of partners, capital contributions, value and type of partnership assets, and the relationship of the partners. For example, a partnership that is at least 80% owned by the same family should be excluded from the rules. Some of the modifications suggested for prior legislative proposals also should be considered in any future legislation. 58 Section 710 would generally be effective for tax years ending after the date of enactment. CIFA also provides that, for an individual in the trade or business of providing the services described in proposed Section 710, any amount treated as ordinary income or loss under proposed Section 710 would be treated as self-employment income for purposes of Section 1402(a) of the Code and section 211(a) of the Social Security Act. The Federal Insurance Contributions Act (FICA) imposes a tax on the wages of an individual received with respect to his or her employment. 59 The Self-Employment Contributions Act (SECA) imposes a similar tax on the net earnings from self-employment. 60 The FICA tax has two components. Under the old-age, survivors, and disability insurance component (OASDI), the rate of tax is 12.40%, half of which is imposed on the employer and half of which is imposed on the employee. 61 The amount of wages subject to this component is capped at $110,100 for 2012. Under the hospital insurance (HI) component, the rate is 2.90 percent, also split equally between the employer and the employee. The amount of wages subject to the HI component is not capped. The wages of individuals employed by a business in any form (for example, a C corporation) generally are
  19. 19. subject to the FICA tax. 62 The SECA tax mirrors the FICA tax, and the SECA rate is equal the combined rates for the employer and employee under FICA. Thus, the SECA tax has two components. Under the OASDI component, the rate of tax is 12.40% and the amount of earnings subject to tax is capped at $110,100 (for 2012). 63 Under the HI component, the rate is 2.90% and the amount of self-employment income subject to tax is not capped. This change seems to be directed at relatively lower-paid or retired individuals. Most Fund managers presumably will always pay the maximum OASDI amount, which would mean that the extension of the OASDI tax to carried interest income will only apply to recipients who do not have earned income or net earnings from self-employment in excess of the OASDI maximum ($110,100 for 2012). Additionally, current law provides that all investment income will be subject to the HI tax beginning in 2013 under Section 1411 at the rate of 3.8% for investment income in excess of $200,000 for individuals and $250,000 for joint filers. Therefore, this provision is also more significant for individuals with investment income below such threshold amounts. Potential application CIFA has clearly targeted private equity funds, venture capital funds, leveraged buyout funds, and hedge funds, as well as real estate Funds. As previously stated, specified assets include certain securities defined in Section 475(c)(2) . Section 475(c)(2) states that the term "security" means (1) stock in a corporation; (2) a partnership or beneficial ownership interest in a widely held or publicly traded partnership or trust; 64 (3) a note, bond, debenture, or other evidence of indebtedness; (4) an interest rate, currency, or equity notional principal contract; (5) evidence of an interest in, or a derivative financial instrument in, any security described above, or any currency, including any option, forward contract, short position, and any similar financial instrument in such a security or currency; and (6) certain identified hedge positions. In addition to securities, specified assets include real estate held for rental or investment, interests in partnerships, commodities, cash or cash equivalents, and options or derivative contracts with respect to any specified asset. For this purpose, CIFA provides that a partnership is an investment partnership if substantially all (presumably by value) of its assets are specified assets. For other purposes, "substantially all" has been interpreted as 90% or more [pg. 161] of the value of the assets. 65 The NYSBA Report specifically discussed the potential issues with such a high threshold, including the ability of certain funds to stuff the applicable entities with non-specified assets. 66
  20. 20. Example 8. Assume that, at the end of the first quarter after enactment of proposed Section 710, a partnership has $1,000x of assets, all of which are specified assets. If the partnership otherwise meets the contributed capital requirement, it would clearly be an investment partnership. Alternatively, if on such date $110x worth of its assets were not specified assets, (e.g., oil and gas assets, life settlements, airplanes, equipment, etc.), the partnership might not be treated as holding substantially all of its assets as specified assets. Example 9. Assume that a partnership, which was an investment partnership under Section 710 holding only specified assets, sold half of them and bought non-specified assets. Would this partnership still be an investment partnership under CIFA? Under proposed Section 710(c)(3)(A), it would appear that once a partnership was an investment partnership under proposed Section 710, it would remain an investment partnership. The CIFA rules could lead to significant changes for real estate Funds. Real estate Funds are generally put together to leverage the resources of the general partner and spread the risk. The general partner must evaluate the cost of such equity. Under CIFA, the current 15% tax rate that a general partner enjoys on a carried interest could grow to 37.9%, 67 not including other economic terms of the interests. A general partner might therefore decide that using his or her own funds and getting the 15% rate would make more economic sense. As a result, fewer Funds might be formed. Many real estate Funds generate tax losses based on leverage. Such losses are subject to at-risk, passive loss, and Section 704(b) rules and typically can be used to offset income from similar activities. Under proposed Section 710, such losses would specifically reduce the qualified capital interest. The application of any such reduction is not clear and has no provision for any allocations to restore the amount. In most real estate Funds, this provision will probably eliminate any qualified capital interest. Historically, real estate Funds have used as much leverage as possible and many result in negative capital accounts that are supported under the applicable tax rules by an allocation of the related liability. Example 10. Assume that a partnership is formed with $1,000x of equity. The general partner contributes $100x of that equity and has a carried interest for managing the assets of the partnership. The partnership borrows $9,000x and buys depreciable real property. During the first three years of operations, the partnership recognizes a cumulative tax loss of $1,000x that is allocated to the equity partners of the partnership. The general partner is allocated 10% of that tax loss. Such an allocation would reduce the qualified capital interest under proposed Section 710, which would result in a capital account attributable to that interest of zero. Would that reduction mean that the qualified capital interest has been eliminated? That would seem to be a harsh result and not consistent with the intent of CIFA.
  21. 21. Under the current regulations, such a partnership would [pg. 162] not be subject to any mandatory charge backs under Section 704(b) and the partnership would not have any minimum gain. It would seem-albeit in contradiction to the purposes of proposed Section 710-that since the qualified capital interest has been reduced to zero, any future allocations with respect to the interest would be subject to being recharacterized as ordinary income. In addition, there are many real estate partnerships that have negative capital accounts from prior allocations and, in some cases, from leveraged distributions. Proposed Section 710 contains no special provisions for such situations. It appears such a gain would be subject to recharacterization upon recognition. This obviously would put the general partner in a much different position than the remaining partners and, in many cases, probably would eliminate any incentive on the part of the general partner to sell the real property. It also could create a conflict between the partners, since the other partners would still have the preferential tax treatment. Without some type of grandfather provision, this could result in a significant change to existing partnerships. It is not unusual for real estate partnerships to have potential phantom income with respect to the sale of the property, the partnership interests, or both. For some of these old transactions, the partners may have intended to hold the interests until death and get a stepped-up basis under Section 1014 . Such a step- up in basis will not be available to the holder of an ISPI, however. Although it should be unnecessary, it might be possible to eliminate any such conversion in a leveraged partnership with negative capital accounts. This could be done by making sure that any built-in gain is Section 704(c) built-in gain. This would require some form of restructuring that would result in the property being treated as having been contributed to a new partnership. Alternatively, a transaction that results in a book-up of the capital accounts could be considered under Reg. 1.704(b)(2)(iv)(f). For a real estate partnership, however, any such book-up would require other transactions (e.g., a disproportionate contribution or distribution to or from the partnership). This would probably have to be done prior to the effective date of proposed Section 710. This type of transaction, if it worked at all, would apply only to an interest that otherwise would qualify as a qualified capital interest. Example 11. Assume that a partnership has held real property for 20 years. The property has a value of $2,000x, a basis of $500x, and is subject to debt of $1,500x. Assume that the general partner has a negative capital account of $200x. The real property is sold for $2,000x. The general partner will be allocated gain of $300x and also will receive $100x cash from the sale. The Section 1250 recapture is $500x. Without proposed Section 710, the general partner would owe tax of $55x (i.e., Section 1250 recapture equal to 25% of $100x plus capital gain tax equal to 15% of $200x), but under proposed
  22. 22. Section 710, the general partner would owe $113.7x (i.e., 37.9% of $300x). The general partner would owe more tax than the cash received, producing a rather strong disincentive for selling. Any sale that required the general partner's approval would likely require a sweetener from the other partners. Another significant issue for real estate partnerships is the ability to borrow on a nonrecourse basis and distribute those funds to the partners. In addition to the tax event the general partner apparently would have under proposed Section 710, the general partner would also have any qualified capital interest reduced by such distribution. As stated above for losses, it would appear that if the capital account is reduced to zero by any combination of losses or distributions, the entire interest held by the general partner could become an ISPI subject to proposed Section 710. It would appear that once the capital account reached zero, all additional distributions would be taxable under the general provision of proposed Section 710. This type of leveraged distribution has been used by many real estate investors to make additional investments in other real property. It would undoubtedly reduce such refinancings due to the significant tax cost for the ISPI and for the apparent penalty on any qualified capital interest. This would represent a major change to partnership taxation that would not typically be an issue in a true hedge fund, since leveraged distributions are not generally used in such funds. [pg. 163] Example 12. Assume a partnership owns real property with a tax basis of $500x, a value of $2,000x, and no debt. The general partner has a carried interest. The partnership borrows $1,000x on a nonrecourse basis to distribute to the partners. The general partner has a qualified capital interest with a 10% interest and a capital account of $50x. Under proposed Section 710, the general partner would receive a distribution of $100x with respect to the qualified capital interest and the corresponding capital account will be reduced to zero. Assuming that the first $50x of such distribution eliminates the qualified capital interest, the general partner would have in effect lost that interest and all of the general partner's interest in the partnership would be an ISPI. Would the remaining $50% distribution be treated as a distribution with respect to an ISPI? Alternatively, if the partnership sold the property for $2,000x, the partnership would recognize a gain of $1,500x. Of that, 10% would be allocated to the qualified capital interest and would be taxed under existing tax provisions. Proposed Section 710 would not apply. Application of the related party rules might require a real property partnership interest to be treated as subject to proposed Section 710 even if the partner does not provide services and the allocations are made on a pro rata basis. The activities of a related party could make an interest subject to these rules. Keeping in mind that a qualified capital interest can be reduced by the allocation of losses and
  23. 23. distributions, any application of such rules could result in drastic negative tax consequences. The application of such rules could result in the qualified capital interest of a related party being eliminated and thereafter subject to ordinary income treatment. It would seem that many of these issues could be addressed in additional regulations. History has shown repeatedly, though, that such regulations may be a long time in coming-if they ever come at all. Clarification of these rules is needed and should be included in the statute or in the legislative history. Oil and gas. Since oil and gas investments are not directly included as a specified asset it has generally been thought that CIFA would not include such activities. 68 Unlike many other activities, oil and gas carried interests can be created with a deeded transfer of the applicable mineral interest. 69 Many such arrangements take the form of a transfer of a portion of the mineral interest (or all of the interest until payout) in exchange for a commitment to drill and equip at least one well on the property. Such a transaction should not be covered by CIFA. However, many such transactions have a "tax partnership" provision added to the joint operating agreement covering the property. A single tax partnership should not result in the application of CIFA, but in many instances an actual partnership may own the properties and may engage in a number of such transactions. If a partnership holds interests in either actual or tax partnerships, and such interests represent substantially all of the partnership's assets, CIFA would apply to the partnership. Such arrangements are not unusual in the oil patch. Many advisors suggest using separate entities either to share the development costs or for liability protection structures. It would appear that a disregarded entity should be respected for this purpose and the parent partnership should be treated as the owner of the underlying assets. If the threshold is 90% of the fair market value of the partnership's assets, it would appear that the parent partnership must keep at least that portion of assets outside of a partnership or other entity. As with any other partnership, if a partnership in the oil and gas business holds 100% of specified assets at the end of any quarter after the date of enactment, such partnership would always be an investment partnership for purposes of Section 710. In addition to any other assets, specified assets also include any partnership interest in a publicly traded partnership, whether or not it is excluded from treatment as a corporation under Section 7704 due to its oil and gas activity. 70 Also included in the definition of specified assets is a publicly traded royalty trust. 71 Example 13. On the last day of a quarter after enactment of Section 710, a new partnership is formed to engage in oil and gas activities. It receives $5x contributions in cash with commitments to receive another $245x when capital calls are made by the general partner. Under proposed Section 710, the partnership
  24. 24. would have been formed holding only cash and so would be an investment partnership forever. If the partnership subsequently purchased working [pg. 164] interests in mineral properties and held over 80% of its assets in such working interests, it would nevertheless remain an investment partnerships and any carried interest therein would be an ISPI. Example 14. Another new partnership formed to acquire interests in mineral properties has capital commitments of $250x. The partnership acquires interests in mineral properties through the use of tax partnerships, holds an interest in excess of 50% in every property, and generally holds at least 75% of the working interest through a tax partnership. An entity affiliated with the partnership is the operator of many of the properties in the tax partnerships. The organizers and managers are issued a 20% profits interest. The tax partnerships exceed 90% of the value of partnership assets. The partnership would, in effect, be an oil and gas partnership, but it would also be an investment partnership for purposes of proposed Section 710 and the profits interest would be an ISPI. Conclusion This issue will not disappear. Now that former Gov. Mitt Romney has effectively secured the Republican nomination, the media will at some point doubtless return to the subject of the carried interests he received in the past. Debate on enacting a form of the "Buffet Rule" (requiring that no one pay a lower rate of tax than the average rate of tax) would involve carried interests as well. The Congressional Budget Office has scored some of the proposals and carried interest legislation would be a potential revenue raiser as negotiations to avoid the "fiscal cliff" approach. Depending on the outcome of this November's elections, carried interest proposals could be in the tax debate for years to come. 1 Abrams, "Using Cash and Carried Interests In a Real Estate Partnership," 31 JRET 52 (First Quarter, 2004). 2 Some Funds focus on real estate or oil and gas; others might include such investments as just a diversification strategy.
  25. 25. 3 Carman, "Choice of Entity and the Potential Taxation of Carried Interests," 35 JRET 52 (First Quarter, 2008). 4 In a "fund of funds" arrangement, the Fund invests in other funds and ultimately holds relatively small interests in a number of funds, and each such fund is usually treated as a partnership for federal tax purposes. 5 Many of the pure investment entities use the domestic and foreign feeder structure, which is generally used to attract capital from foreign investors and U.S. tax exempt entities, including retirement plans. 6 Note that many Funds use a master-feeder structure, but those are not used for real estate Funds because Foreign Investment in Real Property Act and effectively connected income rules apply to real estate Funds. Real estate Funds must use blockers and sometimes real estate investment trusts for foreign or tax-exempt investors. 7 The management company usually takes the position that it is an active trade or business and provides the payroll, health insurance, and retirement to all of the employees. 8 This issue is beyond the scope of this article. It generally requires a discussion of unrealized losses, a significant deferral for the management group, or a clawback, and then a potential issue relating to tax cost to the management group. 9 This will go to 23.8% at the end of 2012 if (1) the tax cuts enacted in 2001 expire and (2) the scheduled
  26. 26. Medicare tax increase to 3.8% that was extended to investment income is not repealed. Section 1411 . The preferential rates also would apply to the sale of a carried interest if the gain is long-term capital gain. The sale of the same rights in partnership profits would result in ordinary income if not held in the form of a partnership interest. Ltr. Rul. 9533008 . 10 The timing differences between the book allocations and the tax allocations sometimes results in basis limitations for the managers. In such instances, some of the Funds use special allocations that have been referred to as "stuffing allocations," which have neither been approved or rejected by the IRS. New York State Bar Association Tax Section, "Aggregation Issues Facing Securities Partnerships under Subchapter K" (Report 1220), 9/29/10, available at 11 See Section 1411 for provisions requiring a 3.8% tax on unearned income. 12 This is typically an issue for Funds that are not traders (e.g., private equity, fund of funds, venture capital etc.). Section 212 expenses generally result in limited deductions for most high-income individuals. For example, if the Fund paid an additional management fee of $10x and took an ordinary compensation deduction of $10x, but that deduction resulted in a Section 212 expense, the partners could have an additional $10x subject to tax without any offsetting economic benefit for the deduction. Rev. Rul. 2008- 39, 2008-31 IRB 252 . Even if deductible for general tax purposes, the Section 212 expenses would not be deductible for minimum tax purposes. 13 McKee, Nelson, and Whitmire, Federal Taxation of Partnerships and Partners (Warren Gorham & Lamont, 2012), ¶5.02[1]. 14 This assumes that the interest is issued to the actual service provider or an entity controlled by the
  27. 27. service provider. If the carried interest is issued to relatives or trusts, other issues (such as gift taxes) must be addressed. There is also the issue of receiving an interest in a Fund while providing services to a separate but related entity. 15 This assumes that the interest is issued to the actual service provider or an entity controlled by the service provider. A carried interest issued to relatives or trusts raises other issues, such as gift taxes. There is also the issue of receiving an interest in a Fund while providing services to a separate but related entity. 16 One case required the value to be included currently, and value was easily determined by a sale of the profits interest soon after receipt (Diamond, 56 TC 286 (1971), aff'd 33 AFTR 2d 74-852 , 492 F2d 286, 74-1 USTC ¶9306 (CA-7, 1974)). Another case concluded that partnership profits interests were not includable on receipt, because the profits interests were speculative and without fair market value (Campbell, 68 AFTR 2d 91-5425 , 943 F2d 815, 91-2 USTC ¶50420 (CA-8, 1991)). 17 Sections 61 , 83 ; Reg. 1.721-1(b)(1) ). See Frazell, 14 AFTR 2d 5378 , 335 F2d 487, 64-2 USTC ¶9684 (CA-5, 1964), cert den.; Willis and Postlewaite, Partnership Taxation (Warren Gorham & Lamont, 2012), ¶4.06[7][e]; Rev. Rul. 2007-40, 2007-25 IRB 1426 (transfer of property by a partnership to satisfy a guaranteed payment was a taxable sale of such property under Section 1001 ). 18 Rev. Proc. 93-27, 1993-2 CB 343 . 19 Note that if a capital interest is transferred to a service provider upon formation of a new partnership, the transaction is treated as the transfer of an interest in the property for services and the contribution of the property to a new partnership. This would be a taxable sale by the property owner of the portion deemed transferred to the service provider and compensation to the service provider in the amount of the value of
  28. 28. such property. McDougal, 62 TC 720 (1974). 20 See McKee, Nelson, and Whitmire, supra note 13 at ¶5.02[1]. 21 Section 83(h) . 22 See Diamond, Campbell, supra note 16. 23 In effect, since it describes only the tax treatment of a profits interest, this was the finding in FSA 1998- 157, Vaughn # 286. There, the issuance of the capital interest was determined to be taxable, but the question could not be pursued due to a statute of limitations problem. 24 Rev. Proc. 93-27, 1993-2 CB 343 , citing Diamond and Campbell, supra note 16. 25 The receipt of an interest in a partnership for services to another partnership or another entity will not be covered by Rev. Proc. 93-27 and may have to be valued under general valuation rules applicable to all assets. 26 Note that this refers to a disposition, which generally would include any transfer, including a gift or a transfer to another entity. See Willis and Postlewaite, supra note 17 at ¶4.06[7][b]. 27
  29. 29. A similar result would occur under a "safe harbor" election included in Notice 2005-43, 2005-1 CB 1221 , regarding the compensatory transfer of a partnership interest. REG-105346-03, 2005-24 IRB 1244. See below. These proposed regulations clearly would not apply to an interest that is issued or transferred to the service provider upon the elimination of the applicable substantial risk of forfeiture, and any such interest would be subject to valuation at that time to determine if it is a capital interest for these purposes. 28 See Banoff, "The IRS Ruling on Unvested Partnership Profits Interests: No Income Recognized but Questions Remain," 99 J. of Tax'n 133 (September 2003). See also Ltr. Rul. 200329001 , which applied both revenue procedures to find the issuance non-taxable with very limited facts in the ruling. 29 Many tax advisors file Section 83(b) elections for such partnership interests. 30 REG-105346-03, supra note 27. 31 99 Fed. Reg. 29,675 (2005). This proposed amendment included a partnership interest as property under Section 83 , but did not clearly address the distinction between capital and profits interests. 32 The Preamble specifically excludes a right to receive allocations and distributions from a partnership that is described in Section 707 (a(2(A) from being a partnership interest. 33 Prop. Regs. 1.721-1(b)(2) , (3) . 34 This assumes that the values assigned to the assets are correct and the partnership has either had a
  30. 30. book-up under the Section 704(b) regulations or otherwise has provisions in its partnership agreement to clarify that nothing would be received by the holder of such profits interest upon a liquidation of the partnership immediately after the receipt of such profit interest. 35 " Section 83 Rules on Hold While Congress Considers Carried Interest," BNA Daily Tax Report, 5/2/12; "Partnership Guidance on Hold Pending Legislative Action, Treasury Officials Say," 2009 TNT 100-3, 5/27/09. 36 See IRM If the carrying party is obligated to continue paying all the operating costs after payout and throughout the life of the lease, the carried party's interest after payout is essentially a net profits interest. 37 See, e.g., Rev. Rul. 70-336, 1970-1 CB 145 ; Covey, "Documenting the Oil and Gas Farmout Agreement," 76 Okla. Bar J. 1101 (5/14/05). 38 Rev. Rul. 69-332, 1969-1 CB 87 ; Rev. Rul. 71-207, 1971-1 CB 160 . 39 See Section 83 (transfer of property in connection with the performance of services); Reg. 1.61-6 (gains derived from dealings in property). 40 Palmer v. Bender, 11 AFTR 1106 , 287 US 551, 77 L Ed 489, 3 USTC ¶1026, 1933-1 CB 235 (1933); GCM 22730, 1941-1 CB 214; Rev. Rul. 77-176, 1977-1 CB 77 . 41
  31. 31. Rev. Rul. 77-176, 1977-1 CB 77 (grant of interest in lands adjoining a drill site treated as taxable payment of compensation). 42 James A. Lewis Engineering, Inc., 15 AFTR 2d 9 , 339 F2d 706, 65-1 USTC ¶9122 (CA-5, 1964) (receipt of a production payment as consideration for engineering services associated with production was taxable). Although the court held that the services were outside the scope of the pool of capital doctrine, it expressed "great difficulty accepting a construction of the Code that would fly in the face of the general provisions of the tax laws to the effect that compensation for services [is taxable]." 43 Rev. Rul. 83-46, 1983-1 CB 16 (royalty received for services in locating or acquiring leases, or in supervising development, is not eligible for nonrecognition). 44 Reg. 1.612-4(a)(3) ; Rev. Rul. 71-206, 1971-1 CB 105 ; Rev. Rul.80-109, 1980-1 CB 129 . A right to receive complete payout plus an additional amount followed by a reversion of the entire operating interest to the lessee will be regarded as a right to complete payout. Rev. Rul. 75-446, 1975-2 CB 95 . 45 Marathon Oil Co., 838 F.2d 1114, 60 AFTR2d 87-5974 (CA-10, 1987) ("[T]he party who bears the economic risks associated with the operating interest in an oil and gas lease must also be entitled to claim the deductions associated with that interest." Id. at 838 F.2d 1125). 46 H.R. 4016, 100th Cong., 2d Sess (2/14/12). 47 See "Carried Interest Bill-a 'Death Trap' for Real Estate Partnerships" Tax Notes, 6/22/09.
  32. 32. 48 Proposed Section 710(a)(6). 49 Similar rules would apply to any transfers or deemed transfers from certain mergers, divisions, and technical terminations of a partnership. Proposed Section 710(b)(4)(D). 50 Section 267(b) . 51 Section 731 would treat any such gain from a distribution of cash in excess of basis as being from the sale or exchange of a partnership interest. 52 Rev. Rul. 84-53, 1984-1 CB 159 . 53 In many partnerships, stuffing allocations would be used to cure this step-down in basis, but the stuffing allocations contained in partnership agreements would have to be revised for this type of allocation. It is also not clear how a Section 754 election would work. It would seem that the election and adjustments should be made without the application of Section 710 as it relates to converting the character of the income. 54 This definition does not require the recipient to provide any services to the partnership. 55 For purposes of Section 710, whether property is held by a corporation in connection with a trade or
  33. 33. business would be determined as if the taxpayer were an individual. Section 710(c)(4). 56 Reg. 1.351-1(c)(4) . 57 Reg. 1.731-2(e)(4) . 58 "AICPA Recommends Changes to Carried Interest Legislation," 13 Business Entities 35 (Sep/Oct 2011). American Bar Association, Letter to Senators Max Baucus and Charles Grassley and Representatives Sander Levin and David Camp, "Comments on Carried Interest Proposals in Senate Amendment 4386 to H. R. 4213," 11/5/10. 59 See Chapter 21 of the Code ( Section 3101 et seq.). 60 Section 1401 . 61 Sections 3101 , 3111 . The half (6.2%) payable by the employee was reduced by two percentage points for 2011 and then extended. The employee portion is now scheduled to revert to 6.2% at the end of 2012. 62 S corporation shareholders who are employees of the S corporation are subject to FICA taxes. A considerable body of case law has addressed the issue of whether amounts paid to S corporation shareholder-employees are reasonable compensation for services and therefore are wages subject to FICA tax or are properly characterized as another type of income (typically, dividends) and therefore not
  34. 34. subject to FICA tax. 63 The 12.4% was reduced for 2011 and that reduction was extended for the first 2 months of 2012. News Release 2011-124, 12/23/11. Like the employee portion, the HI portion is scheduled to revert to 12.4% at the end of 2012. 64 The proposed legislation obviously expands on this definition by making it applicable to all interests in partnerships as a separate specified asset. Proposed Section 710(c)(4). This may have been in response to comments in the NYSBA Report (supra, note 10) specifically stating that a fund of funds of closely held partnership interests would not have been included in earlier versions of the proposed legislation. 65 Reg. 1.731-2(c)(2) (with respect to provisions relating to the distribution of marketable securities by a partnership), Reg. 1.704-3(e)(3)(iii)(B)(2) (with respect to certain aggregation rules for allocations by a partnership for purposes of Section 704(c) ). 66 For funds without tax-exempt or foreign investors this may be done without any special allocations. Funds with such partners may need to have special allocations or may be prohibited due to unrelated business taxable income and effectively connected income concerns. Section 710(c)(3)(C) contains a grant of regulatory authority to prevent avoidance of these provisions. 67 This is equal to the current personal income tax rate of 35%, plus the 2.9% hospital insurance (i.e., Medicare) portion of FICA. 68 Some earlier versions of the legislation would have included a partnership with any activities, including
  35. 35. oil and gas. 69 Rev. Rul. 77-176, 1977-1 CB 77 ; GCM 22730, 1941-1 CB 214. 70 Section 7704(c) , Section 7704(d)(1)(E) . 71 Section 475(c)(2)(B) . © 2013 Thomson Reuters/RIA. All rights reserved.