June 11, 2007
The number of newly formed partnerships and limited liability companies has increased dramatically in recent years. This is evident with private equity funds, technology ventures, real estate developers, and others. The increase results, in part, from the expanded usage of variable equity interests, such as profits and carried interests, preferred returns, guaranteed payments, options, warrants, restricted equity grants, and various catch-up and waterfall allocation and distribution rights. Used properly, these variable equity interests allow investors and managers to structure ventures in a highly tax efficient manner.
The usage of variable equity interests by hedge and private equity funds has generated attention in the press and on Capitol Hill. For example, related articles have appeared in the New York Times and the Wall Street Journal, and commentary has been provided on National Public Radio. The question presented is whether certain partners should be denied the benefit of today’s favorable capital gains tax rate. This issue is likely to generate significant debate during the year. Ultimately, it may result in higher taxes on partners in all industries, including real estate and technology ventures.
Background
Partners pay tax on their allocable share of partnership income. Generally, the rate of tax depends upon the type of income earned by the partnership. Gains from the partnership’s sale of stocks and securities normally are taxed to the partners at capital gains rates.
But what if the partner receives its partnership interest in exchange for its promise to render services to the partnership? Should all or a portion of the income received in the future by the partner be taxed as ordinary income? It is helpful to consider these questions from a corporate context. If a corporation were to issue stock to an employee for services, the employee would be subject to ordinary income tax determined by reference to the value of the stock issued, and the employee would take a tax basis in the stock equal to the value taxed. Importantly, if the employee later sells the stock at a gain, tax would be imposed at favorable capital gains rates.
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The partnership world is not much different. A partner who receives a partnership interest in exchange for services also is receiving “property” subject to tax. As with the corporate employee, the partner will be subject to tax at ordinary income rates on the value of the interest received. However, there can be significant differences in value between a share of stock and an interest in a partnership. This difference is attributable, in part, to restrictions placed on a partner’s right to share in the partnership’s existing built-in gains. These restrictions can significantly reduce the economic value—and the tax cost—of issuing equity to service partners.
The Internal Revenue Service has long acknowledged this tax result. Nevertheless, some are questioning whether this tax benefit—described in more detail below—should be curtailed.
Tax Distinction Between Capital and Profits Interests
In the corporate world, every holder of common stock is allowed to share both in the capital and the profits of the company. Each shareholder will receive, whenever distributed, a share of the corporation’s existing capital (representing prior year undistributed profits plus any built-in gain that might exist in the company’s assets). In addition, each shareholder will receive, whenever distributed, a share of the corporation’s future profits.
In the partnership world, partners can agree to split the components of their equity interests. New partners may be granted a right only to receive a share of future profits. This is typically referred to as a “profits interest” or a “carried interest.” Conversely, existing partners may wish to retain all rights to the partnership’s existing assets (measured by reference to the assets’ current fair market value). This is typically referred to as a “capital interest.” In this way, partners who receive a newly issued profits interest receive nothing if, immediately following grant of the interest, the partnership were to sell all of its assets for fair market value and liquidate.
By way of example, assume a partnership issues a 30 percent profits interest to New Partner. Also assume the partnership’s existing tangible and intangible assets have a fair market value of $10 million. If the partnership were to later sell its assets for $14 million, New Partner would be entitled to a distribution of $1.2 million, which represents 30 percent of the $4 million appreciation in asset value. The remaining partners would be entitled to 100 percent of the partnership’s built-in asset value of $10 million (determined as of the date on which the profits interest was issued to New Partner), and 70 percent of the subsequent $4 million appreciation.
In Revenue Procedure 93-27, and again in Revenue Procedure 2001-43, the IRS affirmed that, subject to certain requirements, New Partner would not be subject to tax upon receipt of a profits interest—even if the interest were issued in exchange for services rendered. Because New Partner will share only in future profits, the IRS concluded that the interest had no taxable value at the time of grant. Instead, future profits will be fully taxable to New Partner when earned by the partnership.
As a result, profits interests have been issued by partnerships in a broad range of industries. For example, profits interests are commonly issued to real estate developers, and to scientists and engineers in technology ventures. The recent Congressional attention, however, is focused on the issuance of profits interests to managers of hedge and private equity funds.
The Perceived Tax Abuse
As discussed above, a partner receiving a profits interest will pay tax on future partnership profits, as earned. If those profits arise from the partnership’s sale of capital assets, the partner will pay tax at the capital gains rate (today at 15 percent). And if those asset sales are deferred until future years, the partner will benefit from a tax deferral while the assets presumably appreciate in value. Because of these tax benefits, commentators have questioned whether service partners holding “profits interests” are receiving an unfair tax advantage.
In considering this question, it is important to recognize that service partners may be entitled to receive a minimum amount of “guaranteed” compensation, which usually is subject to ordinary tax rates. The opportunity for capital gains tax arises when the partner is granted a right to share in future appreciation. Of course, even when the partnership’s assets do appreciate, the service partners may receive only a portion of the gain. In many transactions, cash investors are entitled to a priority distribution to repay their investment and fund their return; the service partner shares in profits only to the extent funds remain after this distribution.
Nevertheless, there are distinct tax advantages to using a profits interest. The elimination of these advantages reportedly would produce a substantial increase in tax revenue. That is a significant incentive, especially when costly items such as AMT reform are being considered by Congress. And therein lies the risk facing partners and investors today.
Possible Outcomes
Any number of outcomes may result from this increased Congressional attention. For example, Congress may conclude that a portion of the income earned by a service partner is disguised compensation subject to tax at ordinary income tax rates. This treatment would give rise to several questions. How do you determine the amount that should be taxed as compensation—especially when the amount is subject to portfolio performance that could vary significantly year-to-year (perhaps with early stage losses offset by later stage gains)? What are the tax effects of clawback and other repayment obligations of the service partner? Will the 20 percent excise tax under Section 409A apply if this is characterized as “deferred compensation”? To whom will the offsetting compensation deduction be allocated?
Alternatively, Congress may require that partnership “profits interests” be subject to tax at the time of issuance, based on true fair market value, i.e., the amount a third-party buyer would pay for the same interest. This tax result is similar to that which applies today to outright grants of corporate stock to corporate employees. Presumably, however, the value of a profits interest would be less than a comparably capitalized corporation, because the holder of a profits interest is ineligible to receive any portion of the company’s existing assets (determined at current fair value). This could reduce the ordinary income tax payable by a service partner.
Obviously, these questions can only be answered once Congress decides whether or not to act. In the interim, taxpayers may wish to focus more closely on the economic and tax benefits that variable equity interests provide to partnerships and limited liability companies.
© 2007 McGuireWoods LLP. All rights reserved.
Robert McElroy ([email protected]) is a Partner in the Richmond, Virginia office of McGuireWoods LLP. Mr. McElroy's practice is focused on tax law and business planning, including mergers, acquisitions, divestitures, and capital restructurings. In additional to his representation of U.S. multinational companies, Mr. McElroy represents private equity funds and emerging market and technology companies in structuring partnerships and other tax-efficient joint ventures.