Carried interest in the context of venture capitalist's business bad debt deduction.

• Author: Keller, Brian E.

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

Background

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

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

The venture capital funds had the usual characteristics of capital commitment and carried interest (carry). Limited partners contributed 99% of each fund's capital with the remaining 1 % committed from the general partner LLC. In addition, the general partner LLC was granted a 20% carry as the typical profits interest. Among other requirements, the limited partnership agreement of each venture capital fund required its general partner LLC to manage the fund's affairs in a manner to avoid engaging in the conduct of a trade or business for federal income tax purposes. It was agreed in this case...