2595 Dallas Parkway, Suite 420 Frisco, Texas (214) Carrying On About Carried Interests

Transcription

1 2595 Dallas Parkway, Suite 420 Frisco, Texas (214) Carrying On About Carried Interests

2 Dan G. Baucum Dan Baucum represents clients in tax and business planning and federal tax controversies. After graduating from N.Y.U. s graduate tax law program he practiced law in Dallas until he was offered the position of Special Assistant to the IRS Assistant Chief Counsel (Passthroughs & Special Industries) in Washington, D.C. He spent the next decade of his career in Washington working at the IRS and then as Director of IRS Practice in the National Tax Office of a Big Six accounting firm, while teaching in Georgetown s graduate tax law program. Today, Dan combines the perspective he gained in Washington with almost four decades of experience representing clients in tax and business planning and controversies before the IRS and in court. Dan practices law in Dallas, where he represents clients throughout the United States. He also teaches as an Adjunct Professor at SMU s Dedman School of Law and is counsel to Freeman Law PLLC and Munsch Hardt Kopf & Harr PC.

3 THE BASICS

4 What is a Carried Interest? It s a Profits Interest (a/k/a promote or carry ). A Profits Interest is the right to receive future profits in the partnership; A Profits Interest holder has no right to money or other property upon the immediate liquidation of the partnership; There are two types of interests in a partnership; a Profits Interest is any interest other than a Capital Interest.

5 Partnership profits interest for services Taxation of the receipt of a profits interest in exchange for the performance of services has been a subject of controversy. Sol Diamond Case (Diamond v Comm., 56 T.C. 530 (1971), aff d 492 F.2d 286 (7 th Cir. 1974)(value included currently into income where value easily determined by a sale of the profits interest soon after receipt). Campbell Case (Campbell v. Comm., 943 F.2d 815 (8 th Cir. 1991)(value not included because interests were speculative and without fair market value). Campbell led to an IRS Notice memorialized in Rev. Proc , C.B. 343.

6 Rev Proc Receipt of a capital interest for services is taxable. Treas. Reg (b)(1). See also I.R.C. 61 and 83. Capital interest gives holder a share of proceeds if pship s assets sold at FMV and then proceeds distributed in liquidation of pship. Receipt of a profits interest for services is not taxable, unless Substantially certain and predictable stream of income from pship assets, Within 2 years of receipt partner disposes of profits interest, or The profits interest is an LP interest in a publicly traded partnership. A profits interest is a partnership interest other than a capital interest.

7 Rules under Section 83 Section 83 governs the timing and amount of income and deductions attributable to transfers of property in connection with the performance of services. Service provider must recognize income for the taxable year in which property received is substantially vested (i.e., transferable or not subject to a substantial risk of forfeiture). Amount includible in income if the excess of the FMV of property received over the amount (if any) paid for the property. Deduction allowed the person for whom services performed in the amount includible in income by the service provider. Capital Accounts revalued upon grant of a p ship interest for services. Reg (b)(2)(iv)(f)(5)(iii).

8 2015 Proposed Reg Squares With Section 83 Compensatory transfer of a partnership interest includible in in service provider's gross income: (i) When substantially vested, or (ii) If substantially nonvested at the time of grant if 83(b) election is made. Reg Safe Harbor Election - Fair market value equal to the liquidation value. Typically that value is zero for a true profits interest.

9 Another way to skin the carried interest cat? Prop. Regs. Under 707(a)(2)(A)(July 22, 2015) An arrangement would be treated as a disguised payment for services if: A service provider performs services to or for the benefit of a partnership as a partner or in anticipation of becoming a partner; There is a related direct or indirect allocation and distribution of income or gain and cash to the service provider; and The performances of services and the allocation and distribution, when viewed together, are properly characterized as a transaction between the partnership and the partner acting other than in the capacity as a partner (i.e. an outsider). No entrepreneurial risk to the transaction (i.e., payment of gross receipts, etc.) Results in compensation payment at ordinary income rates. Directed at Partnership Management Fee Waivers.

10 What s a Partnership Management Fee Waiver? A management company that provides services to a fund in exchange for a fee may waive that fee, while a party related to the management company receives an interest in future partnership profits the value of which approximates the amount of the waived fee. The steps: (i) Fund Mgt Co. waives right to receive mgt fee, (ii) LPs contribute capital to the fund in respect of waived amounts; (iii) Mgt Co. Owner -Fund Manager receives profits interest in the fund. Proposed Regs ask whether there is any entrepreneurial risk to a profits interest. If not may be recharacterized as a fee taxable as ordinary income. Proposed Regs are broader than partnership management fee waivers,. If finalized may be another tool in the toolkit to go after so-called carried interests.

11 Passthrough Tax Treatment of Partnerships

12 Passthrough Character of Income and Gain Partnerships compute classes of income and deductions as separate items, and then passes through these items to the partners who take them into account on their federal income tax returns. Income, gain, loss, deduction or credit characterized at the partnership level rather than the partner level. Gain retains its character in the hands of a Partner. Prior to TCJA, gain from partnership s sale of a capital asset held for more than one year would pass through to partner as long-term capital gain taxed at favorable rates.

13 Net Long-term Capital Gain On the sale or exchange of a capital asset by a partnership any gain generally is passed through to the partners and included into income. If capital asset held for more than one year then long term capital gain or loss. If capital asset held for one year or less is short term capital gain or loss. Net long-term capital gain means the excess of long-term capital gains over long-term capital losses for the year.

14 Private Equity s Use of Profits Interests

15 Use in Private Equity Funds, Hedge Funds, Similar Investment Vehicles Limited Partnership issues profits interests to General Partner (key service provider). Profits Interest is not taxable at grant. General Partner s (i.e., Fund Manager) compensation is percentage of gains taken, regardless of that partner s capital investment, if any.

16 Example Fund raises $100 million and sells its investments for $150 million, resulting in $50 million gain. Assume manager (profits interest partner) has a 20% carried interest and received $10 million of capital gain taxed at 23.8% (20% cap gains rate plus 3.8% Net Investment Income Tax (NIIT)). Net after-tax return of $7.62 million. Alternatively, if manager not a partner and received a management fee equal to 20% of gross profits, rather than an allocation of carried interest, taxed at 39.6% (pre Tax Cut and Jobs Act),the fund manager generated a net after tax return of $6.04 million.

17 Carried Interests under Section 1061 Three-Year Holding Period for certain net long-term capital gain with respect to an applicable partnership interest.

18 New Section 1061(a) If one or more applicable partnership interests are held by a taxpayer at any time during the taxable year, the excess (if any) of (1) the taxpayer s net long-term capital gain with respect to those interests for that tax year, over (2) the taxpayer s net long-term capital gain with respect to those interest for that tax year computed by applying Code Sec. 1222(3) and Code Sec. 1222(4) by substituting 3 years for 1 year, shall be treated as short-term capital gain (ordinary income rates), notwithstanding section 83 or any election in effect under section 83(b). * *Added by the Senate in Conference.

19 notwithstanding section 83 or any election in effect under section 83(b). The conferees wish to clarify the interaction of section 83 with the provision's three-year holding requirement, which applies notwithstanding the rules of section 83 or any election in effect under section 83(b). Under the provision, the fact that an individual may have included an amount in income upon acquisition of the applicable partnership interest, or that an individual may have made a section 83(b) election with respect to an applicable partnership interest, does not change the three-year holding period requirement for long-term capital gain treatment with respect to the applicable partnership interest. Thus, the provision treats as short-term capital gain taxed at ordinary income rates the amount of the taxpayer's net long-term capital gain with respect to an applicable partnership interest for the taxable year that exceeds the amount of such gain calculated as if a three-year (not one-year) holding period applies.

20 Conference Report & Senate Amendment Applicable Partnership Interests ( API ) does not include the value of profits interest taxed under Section 83 upon receipt (e.g., 83(b) election) or vesting. Conference Report. The interest is not an API to that extent. How do you square the above statement with- notwithstanding section 83 or any election in effect under section 83(b).

21 Tax Treatment of pass-through long-term Capital Gains Under Section 1061 Section 1061 changes the tax treatment of gains passed thought to a partner holding a profits interest in the partnership (i.e., a carried interest) in connection with the performance of services. The statute changes the asset holding period in section 1222 from one to three years for Applicable Partnership Interests. If the holding period exceeds three years, the taxpayer gets long-term capital gain. If not, the taxpayer ends up with short-term capital gain taxed at ordinary income rates.

22 Applies at the Partnership s Assets level P holds a profits interest in a partnership received in connection with the performance of services. P s separately stated net long-term capital gain in connection with that partnership interest is $200 million. However, only $150 million of that amount is attributable to underlying investments that have been held for more than three years. P will be treated as having received $150 million of long-term capital gain taxed at long-term capital gains rates, and $50 million of short term capital gain taxed at ordinary income tax rate, current maximum is 37%.

23 Does law apply to the Profits Interest? Is a Profits Interest Ever Sold? Early speculation was whether statute only applied to the profits interest itself. History of the taxation of Carried Interests debate refutes this interpretation. If Profits Interest sold then it perhaps had a prior value, which means it would be taxable under Rev. Proc at grant. Where s the value? Speculative income stream? If Liquidation Value measured by capital account is there a capital account? See Treas. Reg (b)(2)(iv)(f)(5)(iii)(grant of interest for services revalues property and adjusts capital accounts.

24 Prior Legislative Approaches to Taxing Carried Interests Is it proper for sponsors providing services to private equity funds (and holding interests in those funds) to be taxed at capital gains rates on what was essentially income for rendering services. Victor Fleischer, Two and Twenty: Taxing Partnership Profits in Private Equity Funds, 83 N,Y.U. L. Rev. 1 (2008). Four possible methodologies proposed- Congressional tax writers considered two of the four approaches- A holder of a carried interest would be taxed at ordinary income rates on income allocable to the partner by the partnership. No tax on receipt of profits interest. Favorable treatment maintained on receipt of profits interest, but blended rate between ordinary income and cap gains tax rate applied. Prior legislative proposals are based on turning gain into ordinary income.

25 Applicable Partnership Interests (API) An API is a partnership interest that is, directly or indirectly, transferred to or held by the taxpayer in connection with the performance of substantial services by the taxpayer in an applicable trade or business. The services may be performed by the taxpayer or by any other related person or persons in any applicable trade or business. An applicable partnership interest does not include an interest held by a person who is employed by another entity that is conducting a trade or business (which is not an applicable trade or business) and who provides services only to the other entity.

26 Regulations to Prevent Gaming the API System It is intended that partnership interests shall not fail to be treated as transferred or held in connection with the performance of services merely because the taxpayer also made contributions to the partnership [capital interest partner?], and the Treasury Department is directed to provide guidance implementing this intent.

27 Applicable Trade or Business Applicable Trades or Businesses are activities that are regular, continuous, and substantial (conducted in one or more entities) and that consist of: Raising or returning capital, and either Investing in or disposing of Specified Assets, or Developing Specified Assets. Developing specified assets takes place if it is represented to investors, lenders, regulators, or others that the value, price, or yield of a portfolio business may be enhanced or increased in connection with choices or actions of a service provider or of others acting in concert with or at the direction of a service provider. Merely voting shares owned does not amount to development; for example, a mutual fund that merely votes proxies received with respect to shares of stock it holds is not engaged in development.

28 Specified Assets Specified Assets include: Securities and commodities, Securities includes partnership interests that are widely held or publicly traded (Fund of Funds) Real estate held for rental or investment (but not a farm if holder operates), Cash or cash equivalents, Options or derivative contracts regarding any of the previously listed assets, or An interest in a partnership (not widely held or publicly traded) to the extent of the partnership s interest in Specified Assets.

29 A Troubling Quote Regarding Specified Assets A partnership interest, for purposes of determining the proportionate interest of a partnership in any specified asset, includes any partnership interest that is not otherwise treated as a security for purposes of the provision (for example, an interest in a partnership that is not widely held or publicly traded). For example, assume that a hedge fund acquires an interest in an operating business conducted in the form of a non-publicly traded partnership that is not widely held; the partnership interest is a specified asset for purposes of the provision. Conference Report.

30 Related Party Transfers Section 1061(d) provides: If a taxpayer transfers an API, directly or indirectly, to a person related to the taxpayer, then the includes in gross income as short-term capital gain so much of the taxpayer s net long-term capital gain attributable to the sale of exchange of an asset held for not more than three years as is allocable to the interest. Related parties are individuals with a family relationship and colleagues who performed a service in the current calendar year or the preceding three calendar years in any applicable trade of business in which or for which the taxpayer performed a service. The House Report directs regulations to prevent abuse of the purposes of the provision, including through the allocation of income to tax-indifferent parties.

31 Corporation Doesn t Mean S Corporation A partnership interest held directly or indirectly by a corporation is not an API. Notice informed taxpayers that S corporations will not be considered corporations for purposes of section Challenge in court? Straight forward question of law. Some partnerships have already converted to LLCs...

32 Corporate Exclusion of a Partnership from API An applicable partnership interest does not include an interest in a partnership directly or indirectly held by a corporation. For example, if two corporations form a partnership to conduct a joint venture for developing and marketing a pharmaceutical product, the partnership interests held by the two corporations are not applicable partnership interests.

33 Capital Interest in Partnership Not Affected API does not include a capital interest in the partnership. By extension API does not include the value of profits interest taxed under Section 83 upon receipt or vesting. The interest is not an API to that extent. What about the Senate language add-on in Section 1061(a)? What if you have both a capital interest and a profits interest?

34 Structural Issues with the Statute Not all long-term capital gain provisions reference Code section The holding period for section 1231 gain is not in section See I.R.C. 1231(a)(3)(A)(i) and (b)(1). The section 1231 regulations support the Code s plain language by seemingly excluding section 1222 from applying to section 1231 assets. The section 1231 regulations state that, [i]f the gains to which section 1231 applies exceed the losses to which the section applies, the gains and losses are treated as longterm capital gains and losses and are subject to the provisions of parts I and II (section 1201 and following), subchapter P, chapter 1 of the Code, relating to capital gains and losses. Treas. Reg (b). This reference to Parts I and II (section 1201 and following), of subchapter P, does not include Code section 1222, which is in Part III of subchapter P. Section 1256 gain similarly seems unaffected by section 1061.

35 Goodwill Section 1061(b) To the extent provided by the Secretary, subsection (a) shall not apply to income or gain attributable to any asset not held for portfolio investment on behalf of third party investors. Goodwill? Third party investor means a person (1) who holds an interest in the partnership that is not property held in connection with an applicable trade or business with respect to that person, and (2) who is not and has not been actively engaged in directly or indirectly providing substantial services for the partnership or any applicable trade or business (and is (or was) not related to a person so engaged). The idea is to segregate the enterprise value basically, the goodwill of an investment management business and keep that out of section How to carve out enterprise value but also put in safeguards has been an issue in previous legislative proposals.

36 Another planning thought or two... The new law has no minimum size of partnership to which it does not apply. A few unsuspecting partnerships at risk: Family Partnerships and LLCs, Home offices; Real estate investment partnerships; Small Business Partnerships. If you can, hold all capital assets more than three years; pay special attention to hold all partnership interests more than three years. These may be unsuspected Specified Assets.

37 Disclaimer Thank you for the opportunity to present for your consideration this federal tax program. I hope that you found it informative. Please take into account that the information included in this presentation is general in nature and meant to stimulate thought and discussion for educational purposes only. This program is no substitute for individual legal advice from a qualified professional who is fully informed of all the facts relevant to your situation and thus this program should not be relied upon by you as legal advice or opinion upon which you can rely.