Profits interest - converting compensation to capital gains and other planning ideas.

• Author: Wells, Thomas O.

A "profits interest" (also referred to as a "carried interest") is generally a right to receive a percentage of profits from a partnership without any obligation to contribute capital to the partnership and is awarded to the general partner, investment manager, or other service provider to the partnership. Profits interest has recently come under great scrutiny by members of Congress due to certain senior managers of hedge funds that have gone public generating significant value for themselves in exchange for investment services and advice to such funds. For example, Blackstone co-founders Stephen Schwarzman and Peter Peterson received $684 million and $1.9 billion, respectively, from the $4.7 billion Blackstone IPO in June 2007--all taxed at the 15 percent long-term capital gains rate instead of the 35 percent federal ordinary income tax rate and the 2.9 percent Medicare tax rate typically imposed on compensatory pay. This preferential tax treatment is based on established tax law and the rationale that this "risk" capital should be taxed in a manner similar to other entrepreneurial returns.

The purpose of this article is not to debate whether hedge fund managers should be taxed at a lower rate than other executives. Rather, this article focuses on an explanation of the tax treatment of a profits interest. It sets forth the potential uses of a profits interest in structuring executive compensation packages by entrepreneurial ventures, in estate planning to transfer wealth to younger generations, as a bail-out from the double tax regime for potential appreciating property owned by a C corporation and as a restructuring of contingency fees for personal physical injuries. Finally, this article reviews one of the proposed Congressional changes to the taxation of a profits interest.

Introduction and Terminology

As background, hedge funds typically have a two percent management fee and a 20 percent carried interest. Alfred W. Jones is credited as launching the first hedge fund in 1949 and establishing the practice of awarding the general partner with a 20 percent carried interest. (1) The carried interest may be subject to a "hurdle rate" in which the profits interest is only paid after the fund has returned its capital or a specified rate to its investors. The carried interest may also be subject to a "clawback" under which the profits interest recipient must repay amounts previously paid if in a later year the agreed profit targets of the fund are not satisfied. A fund may use a "high water mark" provision in which a profits interest is suspended if the cumulative profitability of the fund at any point drops below a hurdle rate.

Explanation of Tax Treatment of Profits Interest

In analyzing a profits interest, a threshold question is whether the person who receives a profits interest is a partner. The Internal Revenue Code does not specifically address the issue of the tax treatment with respect to the issuance of a profits interest in exchange for services, and only a handful of cases have attempted to resolve this issue. Generally, assuming the profits interest is held by the recipient over a period of years and does not have other characteristics of compensation, the recipient should be recognized as a partner.

* Treasury Regulation [section] 1.721-1(b)(1). The confusion and ambiguity surrounding the treatment of a profits interest begins with Code [section] 721, which provides for nonrecognition of gain or loss on a contribution of property in exchange for a partnership interest. There is no mention of a contribution of "services" in Code [section] 721. The first mention of a profits interest is found in Treas. Reg. [section] 1.721-1(b)(1), which provides that the nonrecognition treatment of Code [section] 721 does not apply to the issuance of a capital interest as compensation for services, but specifically states that such exclusion from the nonrecognition treatment of Code [section] 721 does not apply to a "share in partnership profits." (2) Without further guidance from the Code or the Regulations, the courts were left to decipher the tax implications of this phrase as it applies to a variety of situations.

* The Diamond Case--The Diamond case, 492 F.2d 286 (7th Cir. 1974), aff'g, 56 T.C. 530 (1971), stood for the rule that in certain circumstances, a profits interest is taxable upon receipt. Diamond provided services to a real estate project by securing the financing for such project resulting in his receipt of a 60 percent profits interest in the partnership formed to own the real estate project. Less than three weeks after the formation of the partnership, Diamond sold the profits interest for $40,000. Diamond treated the granting of the profits interest as a nonrecognition event and reported a short-term capital gain from the sale on his tax return to offset a capital loss. The Tax Court and the Seventh Circuit both found that the grant of the 60 percent profits interest was a taxable event. The Seventh Circuit deferred to the Internal Revenue Service and treated the profits interest as having an ascertainable market value upon grant. This holding was based upon the...