Taxation of Carried Interest
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Real Estate Roundtable Position Background & Rationale Questions & Answers 1.) What type of ventures use partnerships with carried interest structures? 2.) Why is a partnership structure used as opposed to a corporation or other entity? 3.) Why is the flexibility to share partnership returns important? 6.) How does a carried interest differ from service income paid to a consultant? 13.) How will re-characterizing carried interest returns as ordinary income affect tax complexity? 14.) What impact will the effective date for the contemplated proposal have on transactions? The Real Estate Roundtable is highly concerned by a proposal to alter the tax treatment of "carried interests" that is under consideration by congressional tax writers. We believe current tax law, which has evolved over many decades, appropriately addresses the taxation of carried interests. Senate committee members are questioning whether returns on a carried interest should be treated as compensation for services and taxed at ordinary income rates (maximum 35%). In real estate, these returns typically are long-term capital appreciation taxed at the long term capital gains rates (maximum 15%). This development is troubling for the real estate and venture capital industries, because they make use of the same limited partnership structure with carried interests that are employed by hedge funds and private equity funds. The pending proposal would disrupt settled law and very likely hinder entrepreneurial risk taking in real estate and other industries affecting capital flows and job creation. We are actively communicating this position to policymakers and key staff members and in the process educating them about the real estate industry's use of the carried interest and its significance. Roundtable members are urged to contact members of Congress immediately — particularly those on the Senate Finance and House Ways and Means committees — to share their concerns. This communication is critical to our industry's time-sensitive efforts on this important tax policy issue.
Summary — Current Taxation of Carried Interests Real estate investment funds and many real estate ventures are organized as limited partnerships or limited liability companies (LLCs) under state law. [1] Investors become limited partners (LPs) in the partnerships and commit capital to the fund. A general partner (GP) manages the partnership in exchange for an annual management fee, often two percent of the fund’s committed capital, sometimes less. The GP also receives a share of any profits; this profit-sharing right is often called the “promote,” “carry,” or “carried interest.” The GP typically receives twenty percent of the profits. The carried interest helps align the incentives of the GP with the goals of the LPs: because the GP can earn significant return on its interest if the fund performs well, the fund managers are driven to ensure the success of the partnership venture as a whole. The GP also contributes some of its own capital to the fund so that it has some “skin in the game.” This amount ranges from one to ten percent of the total amount in the fund. After formation, the GP deploys the capital by investing in a portfolio of diversified properties designed to produce a certain risk/return profile. In the case of venture capital funds, the portfolio companies are start-ups the partnership believes will achieve success and can be sold for a large profit. In the case of private equity funds, the fund might buy out underperforming public companies, divisions of public companies, or privately-held businesses. Their investment goal is to sell of parts of the company for a profit and/or turn the company around under new management and eventually take it public. Hedge funds are investment vehicles, much like mutual funds, that invest in securities and use a combination of sophisticated investment strategies such as taking both long and short positions, using leverage, swaps and derivatives, and investing in many markets. They are limited by law, in most cases, to no more than 499 very high net worth investors. After some period of time (often for real estate between five to 10 years) the fund sells its interest in the portfolio of properties or individual assets in the portfolio. The proceeds are then distributed to the partners, and when all the partnership’s investments have been exited, the fund itself liquidates. The carried interest creates a powerful economic incentive for the GP. The GP is itself often a partnership or LLC with industry professionals as members. The GP receives a management fee that covers administrative overhead, diligence and operating costs, and pays the managers’ salaries. The management fee is fixed and does not depend on the performance of the fund. The carry, on the other hand, is performance-based. The tax treatment of a fund manager’s compensation depends on the form in which it is received. There is no arbitrary conversion of income from ordinary income to capital gain. The GP is a partner in the fund and receives an allocable share of whatever the partnership’s income is – determined at the partnership level. The management fee, however, is not a partnership distribution. It is a partnership obligation in the classic “fee for service” context. Therefore, it is treated as ordinary income to the GP, taken into income as it is received on an annual or quarterly basis. The treatment of a carried interest is more complicated. When a GP receives a profits interest in a partnership upon the formation of a fund, that receipt is treated as a taxable event. However, because it’s difficult to pin down a fair market value at the time of grant, there usually is little or no tax owed. Section 83 of the Tax Code allows partners receiving a profits interest to opt to value the interest on receipt based on its liquidation value. Since the interest is not an interest in capital and only an interest in profits, if the partnership were to liquidate on the day the profits interest was granted, the interest would have no value since there would be no profits to distribute. Further, valuation is difficult because the partnership interest is typically non-transferable, highly speculative, and depends on the efforts of the partners themselves (and thus would have a lower value in the hands of an arms-length buyer). In the context of corporate equity compensation, section 83 gives executives a choice: they may make a section 83(b) election and recognize income immediately on the current value of the property, or they can wait-and-see. If they make the election, any further gain or loss is capital gain or loss. If they wait-and-see, however, the character of the income is ordinary. From a revenue standpoint, the stakes of this choice are fairly low: any conversion or deferral of income, which lowers the executives’ tax bill, is roughly offset by the conversion or deferral of the corporate deduction for compensation paid. The treatment of partnership equity is different than corporate equity. The tax law tackles the problem of partnership equity by dividing partnership interests into two categories: profits interests and capital interests. A profits interest is an interest that gives the partner certain rights in the partnership (thus distinguishing it from an option to acquire a partnership interest) but has no current liquidation value. A capital interest gives the partner certain voting rights in the partnership and also has a positive current liquidation value. When a partner receives a capital interest in a partnership in exchange for services, the partner has immediate taxable income on the value of the interest. Determining the proper treatment of a profits interest is more difficult, however. It lacks any liquidation value, making its value difficult to determine. The tax treatment of a profits interest in a partnership has been fairly consistent historically. There was a brief period of uncertainty following the 1971 case of Diamond vs. Commissioner, where the Tax Court (affirmed by the Seventh Circuit) held that the receipt of a profits interest “with determinable market value” is taxable income. A profits interest in a partnership rarely has a determinable market value and it has become accepted that the receipt of a profits interest is not normally a taxable event. The IRS later provided a safe harbor, in Revenue Procedure 93-27, for most partnership profits interests. The Treasury has proposed regulations (and an accompanying notice) that would reaffirm the status quo. The proposed regulations, like Rev. Proc. 93-27, require that, in order for the receipt of a profits interest to be treated as a non-taxable event, the partnership’s income stream cannot be substantially certain and predictable, that the partnership cannot be publicly traded, and that the interest cannot be disposed of within two years of receipt. The typical carried interest falls within the parameters of the proposed regulations. The interest has no current liquidation value; if the fund were liquidated immediately, all of the drawn-down capital would be returned to the LPs. And while the carried interest has value, it is not related to a “substantially certain and predictable stream of income from partnership assets.” On the contrary, the amount of carry is uncertain and unpredictable. The receipt of a partnership profits interest, therefore, is not a taxable event under current law. In the partnership context, characterizing a payment for services can be a difficult issue when the recipient, like the fund manager, is a partner in the partnership. Section 83 provides the general rule that property received in connection with the performance of services is income. Section 707 addresses payments from a partnership to a partner. So long as the payment is made to the partner in its capacity as a partner (and not as an employee) and is determined by reference to the income of the partnership (i.e. is not guaranteed), then the payment will be respected as a payout of a distributable share of partnership income rather than salary. In sum, a profits interest in a partnership is treated more like a financial investment rather than payment for services rendered. Partnership profits are treated as a return on investment capital.
Carried Interests and Real Estate Partnerships 1.) What type of ventures use partnerships with carried interest structures? A. Ventures large and small in all types of business areas use partnerships as their business entity of choice and include some form of carried interest incentive. This structure allows entrepreneurs to match their expertise and risk assumption with a financial partner and align the parties’ economic interests so that entrepreneurial risk taking is viable. The real estate industry employs partnerships with carried interests on projects ranging from small property development to large multi-billion dollar investment funds. Other industries using the same entity model include: oil and gas, cellular telephone, cable television, biotech, healthcare and restaurant.
2.) Why is a partnership structure used as opposed to a corporation or other entity? A. A partnership is an entity used for investment ventures more than ongoing businesses. The timeframe for the venture usually is fairly limited and certain. It pre-supposes taking an investment idea from cradle to maturity then cashing in on the success of the venture. Real estate development, proving up of an oil well, discovering a new biotech technology are typically done through partnerships. The partnership allows the parties considerable flexibility in how they share the returns of the partnership over the life of the partnership. The return sharing ratio between the general and limited partners can, and often does, change several times throughout the life cycle of the partnership.
3.) Why is the flexibility to share partnership returns important? A. Entrepreneurial ventures often entail taking on significant economic risk. In a typical entrepreneurial partnership you have an expertise partner, such as a real estate expert, who has an idea, experience, know how and some amount of risk investment. However, this partner does not have the capital to take on the contemplated venture. What is needed is a finance partner(s) to put up the capital. In typical real estate funds, finance partners put up eighty to ninety percent of the capital. Given that the finance partners have the most at risk, they want their risk capital returned as quickly as possible plus a return. The partnership is ideal in facilitating this because the partners can agree to pay all partnership income (in a real estate deal typically rental income) to the finance partners until their capital contribution, plus some negotiated return on investment, is paid. Thereafter, the partners can agree to share partnership income in any combination of ways they want to reflect the economics of the deal. When the partnership assets are sold, the carried interest kicks in, assuming agreed upon profit targets are met, and the proceeds are shared in accordance with that agreement.
4.) Who are likely investors in real estate funds and do they support giving the general partner a carried interest? A. In many real estate funds, the finance partners are institutional investors, domestic and foreign, such as pension funds, endowments, charities and universities as well as high net worth individuals. Real estate investment is an alternative investment for these investors. It provides diversification and return potential needed to meet the investor’s goals. The success of the venture is critical to the investment being worth the investor’s while. Otherwise, they could simply invest in bonds and get a safe, but modest return. The end of the deal “upside” is the most desirable feature of the investment. Therefore, the investors very much want the general partner to have incentive to maximize the return. The carried interest provides this incentive and keeps the general partner “in the game” until the end. If the general partner received much of its return up front, it wouldn’t be motivated to see the deal through to its maximum fruition and the investor’s return would suffer.
5.) What is the rationale behind the tax staff considered proposal to possibly require the taxation of carried interest returns at ordinary tax rates? A. There is no written proposal available regarding changing the taxation of carried interests. Tax staff members of the Senate Finance Committee have stated simply that they view the carried interest as compensation for services. Such compensation is taxed as ordinary income for other service providers; therefore, compensation for services received via a carried interest should be taxed similarly. The fact that the partnership pays the compensation in the form of a profits interest may not be compelling enough, to staff, to justify capital gain treatment. Staff is particularly focused on hedge fund managers.
6.) How does a carried interest differ from service income paid to a consultant? A. Income derived from services is usually an amount certain, paid within the tax year (often contemporaneous with the provision of the services) and clearly acknowledged to be a fee as opposed to an investment interest. Sometimes, the income is incentive based (e.g. a bonus for exceeding a sales quota). While similar in this regard to a carried interest, it is paid in the same tax year the services are provided and, therefore, cannot be long-term capital gain. A carried interest is, first and foremost, an interest in the partnership. Its amount and timing depends on the success, or lack of success, of the partnership venture. Because it is a long-term, risk–based investment, it is not paid contemporaneously, nor is it guaranteed. Regardless of paper profits that might exist throughout the course of the investment, actual profit only exists when the asset is sold. The types of services a real estate general partner provides include: raising capital; identifying properties for acquisition or development, arranging financing; acquiring the properties, leasing and management of the properties; and selling the assets. As an investor, the carried interest holder is exposed to all the risks of the underlying partnership investment. In the case of real estate partnerships, a carried interest often isn’t paid for 5, 7 or 10+ years when the partnership property ultimately is sold. To the extent the profits of the partnership reflect capital appreciation of the property; the carried interest is long-term capital gain.
7.) Is there an economic distinction between a carried interest and a contingent profit fee? If not, why should there be different tax treatment? A. Both a contingent profit fee and a carried interest are both based on and derived from the profits of a venture. So, economically, there isn’t a distinction — a share of the profits is a share of the profits. However, state laws and the tax code allow ventures to be structured differently and these differing structures can result in different tax treatment. It’s not unusual and is a fundamental part of tax planning whether it be for corporations, partnerships, sole proprietorships or individuals.
8.) Isn’t a carried interest intended as a way to defer tax on service income that should be recognized currently? A. No. The general partner is compensated for its services partly through management fees, guaranteed payments and its share of the “split” of partnership income distributed prior to the carried interest performance hurdle being met. The general partner takes into income distributions equivalent to its carried interest in the year the carried interest is triggered by performance and paid. Partnerships do not typically retain significant amounts of partnership income. Usually, the partnership agreement requires that the partnership distribute income to partners quarterly or annually unless there is a specific growth investment use of the proceeds identified or for capital maintenance of existing assets. So, when the general partner’s carried interest comes due, it is paid. It cannot be paid any sooner unless the partnership was to borrow against assets to advance the general partner its return. Such an eventuality would frustrate the sharing between the partners of the economic returns of the partnership. The risk burden would shift from equilibrium to the capital partners effectively reducing their return.
9.) Why should a carried interest holder be taxed any differently than a corporate executive compensated on a performance basis? A. There is a valid comparison to be made between a general partner of a partnership and a corporate executive compensated based on the performance of his/her company. Both provide services designed to create a profitable enterprise and their compensation reflects their relative success. An important distinction, however, is that the corporate executive receives his or her compensation in the current year. It is not based on returns of an investment asset held more than 12 months. Therefore, it does not qualify as long-term capital gain eligible for the 15 percent capital gain tax rate. A real estate general partner’s carried interest, in the typical real estate fund, is paid almost entirely, if not entirely, out of long-term capital appreciation of the partnership properties.
10.) Is a carried interest holder taxed differently than a corporate executive who receives compensation in the form of stock options that can be exercised in subsequent tax years? A. Yes, but not necessarily more advantageously. With few exceptions, an executive has no tax upon receipt of a nonqualified stock option. When an option is exercised, the executive pays the strike price and then pays tax at ordinary income rates on the bargain element of the option – that is the difference between the strike price (the price paid per share under the option) and the value of the stock on the day of purchase. If the stock appreciates above the bargain element, this gain is capital gain taxable at long or short term capital gain rates depending on whether the stock is held 12 months or more. Therefore, after the taxable bargain element event, the executive becomes an investor in his/her company and receives tax treatment that applies to an investment in stock. Thus, dividends are taxed at a 15 percent tax rate as is long-term capital gain. . The bargain element of a stock option is analogous to the value of a carried interest when granted to a general partner. Both values are taxable at ordinary rates. However, ascertaining the value of a carried interest upon receipt is speculative. Case law, rulings and regulations have addressed this issue and determined that in order to tax the carried interest on receipt, the partnership’s income stream must be substantially certain and predictable, the partnership must be publicly traded, or the interest can be disposed of within two years of receipt. A carried interest granted at the beginning of a partnership venture is not going to have a substantially certain and predictable income stream so no value can be determined on which to impose tax. A liquidation value approach is also used as a measure. Since the profits interest is not an interest in capital and only an interest in profits, if the partnership were to liquidate on the day the profits interest was granted, the interest would have no value since there would be no profits to distribute. Like the executive who exercised his/her stock option, the carried interest holder is an investor and is taxed on his/her investment return. Noteworthy, however, is that in the case of a real estate carried interest, if rental income is received from the partnership, then the carried interest holder is taxed at ordinary income rates. The tax rate on depreciation recapture is 25 percent and the tax rate on long-term appreciation is 15 percent. Clearly, not as tax advantageous as a stockholder whose return is in the form of dividends and capital appreciation (15 percent tax rate). It can best be summarized to say that there are tax tradeoffs between a stock option and a real estate carried interest. Each has their relative advantages and disadvantages.
11.) Are general partner carried interests and corporate executive stock options comparable economically speaking? A. In many ways, no. When comparing corporate compensation through stock options to carried interests, the following should be considered: a) while most carried interests are subordinate to a preferred return, most options are not; b) while most general partners in most partnerships invest a significant part of their net worth in the partnership, most corporate executives do not; c) while most general partners “individually own” the infrastructure necessary to execute the strategy, most corporate executives do not because they are employees. General partners own the infrastructure to own assets for themselves or in partnership with others and is why they are effectively contributing part of the value of their business to every partnership they sponsor; and d) while most corporate executives have contracts that give them “tax gross ups” on their options upon change of control (as employees), no general partner has this type of tax free treatment in any scenario on its carried interest.
12.) What would be the impact on real estate if carried interest returns were taxable only at ordinary income rates? A. This is a broad sweeping question and the answer is as unique as the individual deal affected. However, there are some generalizations that apply. For smaller ventures, such as one off land development by a local developer, the effect could be significant as risk levels and capital requirements increase with the general partner’s reduced return. These types of entrepreneurs likely do not have the clout to pass the tax increase on to the investing partner. As a result, they may choose to sell the property rather than develop it if the after tax return isn’t worth the risk. Larger, more experienced and sophisticated real estate entrepreneurs may have negotiating leverage to pass off this tax increase to the investing partners in various ways. In other words, re-price the deal. These ways include: requiring larger amounts of up front fees, lowering the preferred return amount, giving the general partner an earlier and/or increased share of partnership distributions, or increasing the carried interest percentage. Whatever the means, the investing partners (pension funds, endowments, charities) will get their investment return reduced. Lower after-tax returns mean fewer deals getting done, which will do collateral damage to investors, entrepreneurs and the workers employed in theses ventures. Larger entrepreneurs also may seek to restructure their partnerships to avoid the tax consequences. This could involve the use of private REITs and restricted stock or nonrecourse loan arrangements from the partnership to the general partner to enable the general partner to purchase a capital interest. Whatever, method of re-structuring is chosen, the result would be a less efficient investment entity which would lead to lower investment returns and diminished capital flow to real estate.
13.) How will re-characterizing carried interest returns as ordinary income affect tax complexity? A. Partnership tax rules are already among the most complex rules in the tax code. The proposal being contemplated would add extraordinary complexity. Since we have not seen any specifics, we are left with many questions. For example, how do you treat the partnership gain that should be allocated to the general partner but isn’t because of the new rule? Does it get allocated to the limited partners? Will the GP’s share of capital gain simply be deemed ordinary income? Is the income service income or investment income? Staff believes the income is service income. If so, the partnership should be entitled a deduction for this amount which would flow through proportionately to all the partners – including the general partner who would offset his/her higher taxes with the deduction. What does the Treasury gain by such an offset? How does this, if at all, affect the certainty of valuing the profits interest upon receipt for Section 83 tax purposes? Once a specific proposal is released, some of these questions may be answered but it’s a certainty that many, many other questions will be raised.
14.) What impact will the effective date for the contemplated proposal have on transactions? A. If the contemplated proposal were to become law, its effective date could be made to apply to existing transactions or it could apply prospectively only to new transactions using a carried interest. If applied to existing transactions, a transition phase-in rule similar to the passive loss rules in 1986 would be appropriate. The passive loss limitation rules were applied to existing transactions but phased in 20 percent per year over five years. If the rule were to apply to existing transactions and transition rules were not adequate, general partners would seek to avoid the additional tax burden. One way would be to try to renegotiate terms with the limited partners. Failing that, they might refuse to make future capital calls and terminate their funds. Depending on economic circumstances, they may sell fund assets or form a new fund and re-constitute the assets. The new fund would be structured differently. For example, the sharing of the partnership’s economics would be re-negotiated to compensate for the general partners new tax liability. Alternatively, the new fund could employ a new structure that avoids, or at least mitigates, the new tax liability on carried interests. Smaller entrepreneurs that did not have the negotiating leverage or tax planning resources would bear the full brunt of the new liability. Thus, the heaviest burden of this new law would fall on them hurting small businesses and stifling entrepreneurship at the most important levels.
# # # [1] University of Colorado law professor Victor Fleisher has written an article on carried interest taxation entitled “Two and Twenty: Taxing Partnership Profits in Private Equity Funds”. In it, he describes the partnership fund structure and the current taxation of a profits interest. This description is excerpted and modified to reflect real estate funds specifically.
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