Using the "zero-value" approach for carried interests.

• Author: Warren, Rebecca

A carried interest, also known as a profits interest, is a general partner's allocation of residual investment gains after prior allocations and distributions. A fund's return percentage generally must exceed a specified threshold before the general partner receives such an allocation, typically 20%. To avoid ordinary income tax rates, a fund manager usually forgoes a management fee in exchange for a carried interest. No capital commitment or contribution is made by the fund manager. The interest does not have associated capital or a liquidation value and may be subject to vesting restrictions.

Because of these carried interests, fund managers have a unique opportunity to transfer significant amounts of wealth at a relatively low gift tax "cost." In a successful fund, the residual allocations associated with a carried interest have the potential to grow exponentially. If fund managers transfer these carried interests prior to the growth of the residual allocations, they can achieve significant wealth transfers. However, risks are associated with valuing carried interest transfers.

Income Interest Valuation

Prior to 1993, the income tax consequences to a fund manager receiving a carried interest were unclear. It was ambiguous whether receipt of a future profits interest resulted in current income recognition since there was no liquidation value, and profits received in the future would be reported on a Schedule K-1 and be subject to income tax. Prior to the release of Rev. Proc. 93-27, ambiguous case law highlighted the courts' struggles with determining the timing of income recognition associated with carried interests.

In Diamond, 492 F.2d. 286 (7th Cir. 1974), the taxpayer sold a profits interest for $40,000 three weeks after receiving it. The taxpayer argued the $40,000 was a short-term capital gain that was offset by a short-term capital loss. The IRS asserted that the taxpayer had to recognize the $40,000 as ordinary income when he received the interest. The Seventh Circuit agreed with the IRS, denying the taxpayer's claims that the interest was valueless and should not be taxed on receipt.

Nine years later, in St. John, No. 82-1134 (C.D. 111. 11/16/83), the IRS argued the taxpayer's profits interest should be recognized upon receipt as ordinary income equal to the fair market value (FMV) of the services provided, which was $25,500. The taxpayer's argument was that the interest's value was its liquidation value, which, based on an oral...