397 ALI-ABA Course of Study Sophisticated Estate Planning Techniques Cosponsored by Massachusetts Continuing Legal Education, Inc. September 4-5, 2008 Boston, Massachusetts Planning for Private Equity Professionals By Marc J. Bloostein Ropes & Gray LLP Boston, Massachusetts
409 This may, however, impact valuation if the appraiser took the potentially unvested nature of the interests into account. (iii) It is important that the vesting provisions in the Fund GP document clearly spell out what happens with a transferred interest. (1) Generally, where a Fund Principal may transfer both vested and unvested interests, the Fund Principal and the transferee are treated as a unit for vesting purposes, and each is impacted proportionally if interests are forfeited. (2) Alternatively, it is possible to have the Fund Principal forfeit his or her interests first, before any of the transferee s interests are forfeited. This could, however, impact valuation (see (ii) above). B. Valuation 1. Fair Market Value The appeal of carried interests as a currency for gifts is their relatively low current value. For income tax purposes, these interests have been valued at zero, first under general valuation principles supported by case law and then because the Service conceded that the receipt of a carried interest was not a taxable event. Under the case law that developed in this area, there was reason to think that the speculative nature of a carried interest entitled one to claim it had a zero value for both income tax purposes and gift tax purposes. However, as the law has developed in the income tax area, it has become clear that one should not rely on the old income tax cases for the proposition that carry has no gift tax value, but instead that carried interests should be valued for gift tax purposes using general valuation principles. (a) Treatment of Carried Interests for Income Tax Purposes The income tax consequences to a partner receiving a profits interest were for many years unclear. (A profits interest is the right to receive profits from a partnership; a carried interest is a kind of profits interest.) There was much disagreement about whether receipt of a profits interest (as opposed to a capital interest) should be taxed as current income, since the only thing the partner receives is the right to receive future profits. Those future profits might or might not materialize, and if receipt of the profits interest were taxed, taxing the profits if and when later earned would result in double taxation. -11-
410 (i) Case Law The following three cases give the flavor of the debate about the tax consequences of receiving a profits interest. Generally, courts had a hard time adopting the broad-brush rule that the receipt of a profits interest should not be taxed, but at the same time generally found profits interests to be so speculative in value upon receipt that there was nothing to tax. (1) Diamond v. Commissioner, 492 F.2d. 286 (7 th Cir. 1974), presented particularly bad facts for the taxpayer. The taxpayer received a profits interest and sold it three weeks later for $40,000. The taxpayer claimed the $40,000 was short term capital gain realized upon selling the interest; that gain would have been sheltered by offsetting short term losses for the year. The Service countered that the $40,000 was ordinary income earned upon receipt of the interest. The court agreed with the Service, rejecting the arguments that the profits interest should not have been taxed upon receipt and that it had no value when the taxpayer received it. (2) In St. John v. United States, 84-1 U.S.T.C. 9158 (C.D. Ill. 1983), the Service asserted that the profits interest the taxpayer received had a fair market value of $25,500, which the Service claimed was the fair market value of the services provided. The taxpayer argued that the profits interest should be valued based on the liquidation value of the partnership, which was zero. The court accepted without deciding that a profits interest is taxable upon receipt at its fair market value, but agreed with the taxpayer that the interest in question was undetermined and speculative and that [i]t was not clear when, if ever, the partnership would be profitable. (3) In Campbell v. Commissioner, 943 F.2d 815 (1991), the Court of Appeals was unwilling to hold that the receipt of profits interest is not taxable per se, but it agreed with the taxpayer s argument that the profits interest he received had only speculative, if any, value. Id. at 823. The court noted that fair market value is the price at which property would change hands in a transaction between a willing -12-
411 buyer and a willing seller, neither being under compulsion to buy nor to sell and both being informed of all the relevant circumstances. Id. (citations omitted). (ii) Revenue Procedure 93-27 Litigation in this area came to an end with the issuance of Rev. Proc. 93-27, 1993-2 C.B. 343, which provided that the receipt of a profits interest is generally not a taxable event for either the partnership or the partner receiving it. (1) Rev. Proc. 93-27 provides: Other than as provided below, if a person receives a profits interest for the provision of services to or for the benefit of a partnership in a partner capacity or in anticipation of being a partner, the Internal Revenue Service will not treat the receipt of such an interest as a taxable event for the partner or the partnership. (2) Rev. Proc. 93-27 does not apply: a. If the profits interest relates to a substantially certain and predictable stream of income from partnership assets, such as income from high-quality debt securities or a high-quality net lease; b. If within two years of receipt, the partner disposes of the profits interest; or c. If the profits interest is a limited partnership interest in a publicly traded partnership within the meaning of section 7704(b) of the Internal Revenue Code. (3) Rev. Proc. 2001-43, 2001-2 C.B. 191, clarified Rev. Proc. 93-27 by providing that where a partner receives a profits interest that is not vested the partner will nonetheless be treated as receiving it on the date it was granted. (iii) Notice 2005-43 and the Proposed Section 83 Regulations In 2005 the Treasury issued Notice 2005-43, 2005-24 I.R.B. 1221, in conjunction with proposed regulations -13-
412 under I.R.C. 83, 2005-1 C.B. 1244. These new proposed regulations under Section 83 will, when adopted in final form, render Rev. Proc. 93-27 obsolete. The proposed regulations treat a profits interest as property for purposes of I.R.C. 83, so as a general rule receipt of a profits interest would be taxable currently. However, the new rules would create a safe harbor that would permit partnership interests received as compensation to be valued at liquidation value, in essence preserving the nontaxable character of the receipt of a profits interest under current law. (1) The preamble to the proposed regulations sets out the Treasury and Service s position: The proposed regulations apply section 83 to all partnership interests, without distinguishing between partnership capital interests and partnership profits interests. Although the application of section 83 to partnership profits interests has been the subject of controversy, see, e.g., Campbell v. Commissioner, T.C. Memo 1990-162, aff d in part and rev d in part, 943 F.2d 815 (8 th Cir. 1991), n. 7; St. John v. U.S., 84-1 USTC 9158 (C.D. 111. 1983), the Treasury Department and the IRS do not believe that there is a substantial basis for distinguishing among partnership interests for purposes of section 83. All partnership interests constitute personal property under state law and give the holder the right to share in future earnings from partnership capital and labor. Moreover, some commentators have suggested that the same tax rules should apply to both partnership profits interests and partnership capital interests. These commentators have suggested that taxpayers may exploit any differences in the tax treatment of partnership profits interests and partnership capital interests. The Treasury Department and the IRS agree with these comments. Therefore, all of the rules in these proposed regulations and the accompanying proposed revenue procedure (described below) apply equally to partnership capital interests and partnership profits interests. (2) The proposed regulations will treat profits interests the same as any other property interest received in exchange for services. Thus, the non-recognition -14-
413 rule of Rev. Proc. 93-27 will no longer apply once the changes to the 83 regulations become final. Similarly, the rule of Rev. Proc. 2001-43 treating unvested profits interests as transferred on the date they are granted will no longer apply. (3) The proposed regulations and the proposed Rev. Proc. contained in Notice 2005-43 permit a partnership and its partners to elect safe harbor treatment in valuing partnership interests granted in connection with the performance of services. With a proper election, the fair market value of such a partnership interest will be its liquidation value i.e., what the holder of the interest would receive if the partnership then sold all of its assets and liquidated. Of course, future profits would not be included in liquidation value. For the typical private equity fund, liquidation value at the outset of a new fund would be zero. (b) Valuation of Carried Interests for Gift Tax Purposes (i) (ii) For gift tax purposes, [t]he value of... property is the price at which such property would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or sell, and both having reasonable knowledge of relevant facts. Treas. Reg. 25.2512-1. Of what relevance are the income tax rules? (1) Some of the case law in the income tax area addresses the question of how a profits interest should be valued under the willing buyer/willing seller test, and some of the cases support the notion that the value of a profits interest is entirely speculative. For example, the court in Campbell v. Commissioner, 943 F.2d 815 (1991), applied the willing buyer/willing seller test, and held that the profits interest in that case had no value on account of its speculative nature. (2) Rev. Proc. 93-27 did not address the question of valuation, but instead stated that the Service would not treat the receipt of a profits interest as a taxable event. Thus, the guidance in the income tax area between 1993 and 2005 has not focused on valuation. -15-
414 (3) The 2005 proposed regulations under I.R.C. 83 return the focus to valuation, but they specify (when the safe harbor applies) that the value of a profits interest is determined based upon the liquidation value of the partnership. (4) Clients focus on the fact that their carry has no value for income tax purposes (whatever the theory), and they sometimes have a hard time accepting that it has real value for gift tax purposes. (5) Practitioners commonly advised valuing carried interests at zero for gift tax purposes in the 1990s and early 2000s. Over time, the concept of valuing carry at something more than zero began to take hold. Any comfort a practitioner took in valuing carry at zero disappeared when the 2005 proposed regulations came out, given that the proposed mechanism for valuing carry for income tax purposes was not the willing buyer/willing seller test. (iii) Valuing a Carried Interest (1) It is advisable to engage a professional appraiser experienced in valuing carried interests. When multiple Fund Principals are transferring carry, it is both advisable and efficient for them to use the same appraiser. (2) Appraisers typically use a discounted cash flow analysis to determine the value of the carry. The analysis is generated from information gathered from the Fund as well as information gathered from other sources. a. Expected cash flow is based on projections of the size of the fund, the holding period for investments and the expected returns. Some appraisers use software to go through a Monte Carlo analysis of possible outcomes, and others take a simpler approach. In either case, the appraiser determines expected cash flow and then analyzes how that cash will be distributed under the provisions of the Fund documents how much will be returned to investors as a -16-
415 return of capital and on account of the hurdle return to which they are entitled, and how much will end up flowing to the Fund GP as its share of the overall profits. b. Once the appraiser determines the expected cash flow, that number has to be discounted to reflect its present value. In addition, there are usually additional discount factors based upon the speculative nature of the interest, specific risks, lack of control and lack of marketability. (3) Simple valuation example a. Assumed facts i. Fund size $ 1 billion ii. iii. iv. Expected return 2x No hurdle; all profits split 20% to Fund GP and 80% to LPs. Total profit $1 billion 1. LPs get 80% or $800 million 2. Fund GP gets 20% or $200 million b. Valuation of a 1% interest in the Fund GP i. The Fund GP will receive future cash flow of $200 million. ii. iii. iv. A 1% interest in the Fund GP is entitled to $2 million, which is its gross value. The interest must be discounted to reflect present value, risk, lack of control and lack of marketability. A typical discount might total 90%. A 1% interest in the Fund GP is therefore worth $200,000. -17-
416 v. Note: this is the value of just the carried interest that comes along with a 1% interest in the Fund GP. The transferee of a 1% interest would be expected to contribute its share of called capital relating to the Fund GP s investment in the Fund. If the Fund GP committed to invest 1% in the Fund, or $10 million, the holder of a 1% interest would have to contribute $100,000 over time. If the transferee did not already have sufficient funds for meeting these capital calls, presumably the transferor would have to give or loan the transferee cash for that purpose. 2. Special Valuation Rules The estate freeze rules of I.R.C. 2701 complicate transfers of carried interests. In most cases Fund Principals have both carried and capital interests in the Fund, so the planner must determine whether 2701 applies and, if so, how to deal with it. (a) Statutory Background In 1990 Congress enacted Chapter 14 of the Internal Revenue Code to crack down on certain kinds of abusive estate planning transactions. Among the targeted transactions was the estate freeze, a technique by which the senior generation could freeze the value of a business entity by recapitalizing it, retaining preferred stock with a value equal to 100% of the entity and giving currently valueless common stock to the younger generation. The future appreciation would increase the value of the common stock, effectively transferring all that value to the younger generation without any gift or estate tax. Under I.R.C. 2701, part of the 1990 legislation, where an enterprise is family controlled and a person transfers a junior equity interest to close family members (generally, descendants and spouses of descendants) while retaining a different kind of interest in the entity that includes a right to receive distributions from the entity, special rules apply to value the transferred interest. Under those rules, the transferred interest is valued by subtracting from the value of all interests held prior to the transfer the value of the retained interest but attaching no value to the right to distributions with respect to the retained interest. In the worst case, the donor would in effect be treated as having transferred the entire value of the retained interest along -18-