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Tax Treatment of Carried Interests: Comparing Carried Interests to Capital Interests, 83(b) Elections, and Issues with the New Three-year Rule

Posted by : FGMK on : September 11, 2019 | 8:00 am

Part I: Capital Interests vs. Carried Interests

 

What is a carried interest?

 

A carried interest (also referred to as a profits interest) is a typical piece of the compensation package for managers of private equity funds.[1] Many private equity funds purchase businesses, operate them for a short period, and then sell them for profit. The managers of these funds generally identify investments, operate businesses, and perform administrative tasks in exchange for a carried interest, which equals a right to receive a percentage of the fund's profits over time. A carried interest does not include a right to receive money or other property upon liquidation.

 

What is the difference between a profits interest and a capital interest?

 

A partner in a partnership may receive a profits interest, a capital interest, or both. A capital interest is more than a mere interest in future profits of the company. It is an interest that gives the holder of such an interest a share of the proceeds if the partnership interest were sold at fair market value and then the proceeds were distributed in complete liquidation of the partnership.[2] Another way to identify a capital interest is to ask whether this partner's interest will cause a reduction in the other partners' interests.

 

A profits interest is an interest that is not a capital interest.[3] The determination is made at the time of the transfer of the interest to the partner, regardless of whether it is a vested or unvested interest.[4]

 

The value of a profits will normally be zero when it is granted, whereas the value of a capital interest is the amount the partner would receive upon liquidation. When a capital interest is granted, the amount the partner would receive upon liquidation would likely be the amount of the capital contribution made by the partner.

 

How is a capital interest taxed?

 

If a partner receives a vested capital interest for services provided to the partnership, it creates taxable income for the partner under general tax principles. The transfer of a capital interest is taxed as a guaranteed payment, meaning the taxpayer is taxed at ordinary income tax rates and the partnership gets to take a deduction on the entity's income tax return.

 

If a capital interest is unvested at the time it is transferred to the partner, the partner should consider making an election under Section 83(b) of the Code (a "Section 83(b) Election") and specify that the election includes the capital interest. The election will cause the taxpayer to be treated as a partner from the time of receipt of the interest and will also cause the holding period on the gain to begin to run. Even if the taxpayer believes that the capital interest is vested, the taxpayer should consider making a protective Section 83(b) Election to ensure that the holding period begins to run.

 

With a capital interest the fair market value at the initial transfer will likely be more than zero. Therefore, tax will arise at the initial transfer, unlike a profits interest which will likely have a zero value at initial transfer, and thus not result in tax. In addition to triggering the beginning of a holding period for purposes of long-term capital gain on future gain recognition, the upside of the election is that the partner will receive outside basis in the partnership interest, and thus will not be taxed on the receipt of cash distributions to the extent of an outside basis interest in the partnership interest under Section 731(a). Conversely, if the election is not made for an unvested interest, the taxpayer will recognize cash distributions as compensation for services taxed under Treasury Regulation Section 1.83-1(a)(1) at ordinary income tax rates. However, as a partner, the taxpayer will be taxed to the extent that the partnership allocates income to the partner.

 

If the interest is unvested at the time of the election, the taxpayer should understand that if the partnership interest never vests, e.g. partner does not meet the vesting requirements, the partner may create a situation where ordinary income is recognized upon the election, but no off-setting ordinary loss is obtained at a later date. Once the partnership interest vests, the taxpayer would recognize a potential loss as an ordinary loss to the extent of basis, which was generated by the election and recognition of income under Section 83(a). However, if the loss is triggered prior to vesting, then the taxpayer's loss would be a capital loss, and the receipt of any interest for which the partner made no payment would provide no loss to offset the previously recognized ordinary gain upon the Section 83(b) election. Therefore, taxpayers should review all facts and circumstances and consult a tax advisor when considering all options.

 

How is a carried interest taxed?

 

The remainder of this article focuses on the tax treatment of carried interests. The taxation of a carried interest depends on whether or not an election under Section 83(b) is made, as explained below.

 

Part II: New Three-Year Rule

 

What is the new three-year rule for profits interests?

 

Recently, Congress passed 2017 Tax Reform and included a new provision meant to address the criticism that carried interests provide favorable tax treatment (deferred gains that are treated as long-term capital gain, which are taxed at 15% or 20% depending on a taxpayer's filing status and taxable income) for wealthy partners who receive profits interests. All other workers must report their income as ordinary and pay taxes at the higher ordinary income tax rate (currently 37% for taxpayers in the top tax bracket).

 

The new Section 1061 requires a partner to wait three years before it can receive long-term capital gain treatment for recognized carried interests. Before the three-year holding period is reached, recognized gain on such interests would be treated as short-term capital gain, and the partner have such income taxed at ordinary income rates. The three-year holding period seems to relate to the sale of the partnership interest itself, as well as gains distributed to a partner with respect to the sale of assets by the partnership. Therefore, to be sure that one can benefit from long-term capital gain treatment, both the partner's interest in the partnership and the assets of the partnership should be held for three years.

 

What kind of interests are subject to the new three-year rule?

 

The three-year rule will apply if all the following are true:

 

  • The interest transferred is a profits interest and not a capital interest;[5]
  • The profits interest is transferred in connection with the performance of substantial services by the taxpayer (or a related person) in certain specific trades or businesses;[6]
  • Specifically, the trade or business must consist of (1) raising or returning capital and (2) investing, identifying, or developing specified assets including securities, commodities, real estate, cash or cash equivalents; and[7]
  • The trade or business must be conducted by the partnership on a regular, continuous and substantial basis.[8]

 

Can a partner transfer the interest to someone else to avoid the three-year rule?

 

The three-year long-term capital gain requirement continues to apply when the partnership interest is transferred to a related person.[9] Related person means spouses, children, grandchildren, parents, or a person who also performs services for a trade or business for which the taxpayer performed services.[10] Specifically, if the service partner transfers the partnership interest to a related person, then the transferor partner recognizes gain at that time. The gain is treated as short-term capital gain to the extent that the gain is attributable to the sale or exchange of any asset held for three years or less.

 

Nevertheless, if the transfer to related person is made quickly after the carried interest is granted to the transferor partner, gain would be unlikely to accrue to the original holder. The new holder (as a related person) would be subject to the three-year requirement on the interest that he or she now holds.[11]

 

Part III: The Section 83(b) Election

 

What is the tax result of a Section 83(b) election?

 

Without a Section 83(b) Election, a taxpayer who receives a carried interest, will be taxed in the year the interest becomes vested.[12] Therefore, if a taxpayer is granted a carried interest that becomes vested later (after a certain number of years of service or amount of income earned), the taxpayer would not have income in the year the carried interest is granted. Instead, the taxpayer would have taxable income in the later year when the interest becomes vested, meaning that the rights to such property interest are freely transferrable or not subject to a substantial right to forfeiture.[13]

 

However, if a Section 83(b) Election is made, a taxpayer who receives property in exchange for services will have taxable income in the year in which the property is transferred. Therefore, even if the profits interest was not vested upon transfer to the service partner, the partner would include the value of the profits interest in its income in the tax year of receipt. The amount included would be the fair market value of the profits interest at the time it was transferred to the partner[14] – this amount would likely be zero since no profits would have been earned yet. If there was any income in the year of the transfer, it would be taxed as ordinary income to the partner.

 

As the partnership earns income, it allocates income to the partners, including the carried interest holder. Prior to the TCJA, most of the income allocated to the carried interest would be earned based on assets held for more than a year and therefore, historically, would be taxed as long-term capital gain which has a lower tax rate than ordinary income. Section 1061, as described above, now requires a three-year holding period of such assets in order for the partner with the carried interest to receive long-term capital gain treatment.

 

Likewise, prior to the TCJA, if the partner sold his or her partnership interest, the sale would create long-term capital gain as long as the interest itself was held for more than one year. Section 1061 also likely extends the three-year holding period to such partnership interests in order for the partner to receive long-term capital gain treatment on the sale, as discussed above.

 

How is a Section 83(b) Election favorable to a taxpayer?

 

First, the Section 83(b) Election allows the taxpayer to take the carried interest into income in the tax year it is granted rather than in a later tax year when it is sold. Since the value of a carried interest in the tax year it is granted is likely zero, the election produces a benefit because the taxable income from the carried interest will be zero.

 

Second, the character of the income taxed in the later tax year can receive long-term capital gain treatment. If the sale of the partnership interest receives long-term capital gain treatment (held for more than three years), it will be taxed at the lower long-term capital gain tax rate than the ordinary income tax rate. Simply stated, the Section 83(b) Election pushes a larger portion of the gain to a later tax year and causes it to be taxed at the lower long-term capital gain rate.

 

When does an interest become vested for tax purposes?

 

The point at which an interest becomes vested is important to determine when and how the interest will be taxed. It also helps to determine whether a Section 83(b) Election will be necessary.

 

For these purposes, "vested" means that the property is transferable or not subject to a substantial risk of forfeiture, whichever comes first. In other words, if the interest is subject to a substantial risk of forfeiture or not transferable, then the interest is unvested. Many carried interests are unvested when they are granted because they will only become transferable and not subject to a substantial risk of forfeiture when certain income goals are met by the partnership.

 

When is an 83(b) Election Necessary?

 

Although the Section 83(b) Election is in the Code, the IRS has promulgated guidance over the years which technically makes the election unnecessary in some cases. However, "protective" elections are often made in case there is a mistake of fact or law and because the tax consequences of a failed election are serious. These rules differ depending on whether the interest is vested or unvested.

 

1.Vested Carried Interest

 

If a taxpayer receives a carried interest that is already vested, and the taxpayer receives the interest in a partner capacity or in anticipation of being a partner, it is not a taxable event at the time of receipt unless one of the following is true:

 

  • 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;
  • The partner sells the interest within two years of receipt; or
  • The interest is a limited partnership interest in a publicly traded partnership.[15]

 

The most important factor here is that the taxpayer must receive the interest in its capacity as a partner or in anticipation of being partner.

 

Therefore, a Section 83(b) Election for a vested carried interest may not be necessary if the elements above are met. However, even if the vested interest is excluded from tax under these rules, a protective election may be made in case the interest somehow falls into an exclusion.

 

2. Unvested Carried Interests

 

An unvested carried interest is not taxable upon receipt or upon vesting, as long as the following facts are true:

 

  • It meets the requirements of Rev. Proc. 93-27 (which are the converse of the noted exceptions above);
  • The partnership and the partner treat the partner as a partner (owner of the partnership interest) from the date of its grant;
  • The partner takes into account the distributive share of partnership income, gain, loss deduction, and credit associated with that interest in computing the partner's income tax liability during the entire period during which the partner has the interest; and
  • Upon the grant of the interest, or at the time that the interest becomes substantially vested, neither the partnership nor any of its partners deducts any amount (as wages, compensation, or otherwise) for the fair market value of the interest.[16]

 

If the above requirements are met, the transfer of an unvested carried interest should not be taxable to the partner upon receipt. Rather, the partner is treated as if a valid Section 83(b) Election were made and the profits interest was valued at zero.

 

However, a protective Section 83(b) Election may still be advisable in case the requirements of the revenue procedures are not met. There is no downside to filing an unnecessary Section 83(b) Election.

 

How is a Section 83(b) Election Made?

 

To make a Section 83(b) Election, the taxpayer must file a copy of a written statement with the IRS office where the taxpayer files its income tax return.[17] A copy of the election must also be sent to the partnership.[18] The election must be made within 30 days of the transfer of the interest.[19]

 

The written statement must include the following:

 

  • The name, address, and taxpayer identification number of the taxpayer;
  • A description of each property (meaning each partnership interest) with respect to which the election is being made;
  • The date or dates on which the property is transferred and the taxable year of the election;
  • The nature of the restrictions to which the property is subject;
  • The fair market value at the time of transfer of each property;
  • The amount (if any) paid for such property; and
  • A statement that copies have been furnished to the partnership.

 

Before 2016, the taxpayer was required to attach the Section 83(b) Election to its annual income tax return. However, that requirement has been deleted from the Treasury regulations.

 

Regardless, taxpayers should send two copies of the election by certified mail (return receipt requested) with a self-addressed stamped envelope. In a cover letter, the taxpayer should request that the IRS send back one of the copies with a file stamp to show it was timely filed. In addition, copies of the elections and the mail receipts should be kept in a safe place.

 

Part IV: Issues with the New Three-Year Rule

 

What did the Code say about carried interests before Section 1061 was enacted?

 

Prior to the enactment of the three-year holding period requirement in the Code under Section 1061, Congress had not officially blessed the IRS treatment of carried interests. Section 83(b) does not mention partnership interests specifically or the valuation of carried interests. It is the proposed regulations from the Department of Treasury and the IRS which specifically identify a partnership interest as a type of property to which Section 83(b) may apply. Therefore, in an attempt to claw back the preferential treatment of carried interests in other guidance, Congress may have actually lent more authority to the special treatment for carried interests by codifying carried interest treatment in Section 1061.

 

Does the new three-year rule help taxpayers differentiate between service providers and investors?

 

According to the legislative history, Congress wanted to create separate treatment for service providers and passive investors. In Section 1061(b), Congress instructed the IRS to develop rules to avoid applying the three-year holding requirement to income or gain attributable to an asset not held for portfolio investment on behalf of third-party investors.[20] This is an attempt to apply the three-year rule only to service providers and not to every day investors. However, no regulations on this issue have been issued yet and the identification of passive investors as opposed to service providers is not clear at this time.

 

Section 1061(b) states that to the extent provided by the Secretary of the Treasury, the three-year rule shall not apply to gain attributable to any asset "not held for portfolio investment on behalf of third party investors." In other words, if there is an investment that is not related to portfolio investment and it is made on behalf of a third-party investor, then the three-year rule shall not apply. The legislative history indicates that a third-party investor means an investor who is not providing services and who holds an interest in the partnership that is not property held in connection with an applicable trade or business, as described above.[21] However, the meaning of portfolio interest is not defined.

 

It appears that this rule is an attempt to separate genuine investors from the carried-interest holders, but Treasury regulations have not yet been published and the rule remains unclear.

 

Does the three-year rule apply to the underlying assets, the partnership interest or both?

 

There is ambiguity about whether the three-year rule applies to both income from allocations to the partner from a partnership's sale of an underlying asset and gains on the sale of the partner's partnership interest. The Code states that the three-year rule applies to "net long-term gain with respect to such interests." It is unclear what Congress meant by gain "with respect to" such interests. When commenting on the House version of the TCJA, the Ways and Means Committee Report states that the three-year rule applies to income allocated to a partner from the sale of partnership property. Therefore, one could understand that allocations resulting from the sale of partnership assets are subject to the three-year rule.

 

Regarding gain from the sale of partnership interests, the Code is also unclear, but Section 1061(d) refers to the transfer of a partnership interest in the context of transfers to related parties. Therefore, it may be reasonable to assume that the three-year rule applies to the transfer of partnership interests.

 

How will the three-year rule apply when the underlying assets or the partnership interest are transferred?

 

It is currently unclear how the three-year rule will apply. What if the partnership interest is held for more than three years, but the underlying assets are not? What if the underlying assets are held for more than three years, but the partnership interest is not? Will the three-year rule apply proportionately in these situations? Guidance has not been issued on these points.

 

Overall, as shown by the number of uncertainties, this is an area of tax law that requires careful planning.

 

 

Christie R. Galinski
Senior Manager
Specialty Tax Practice
312.818.4339
CGalinski@fgmk.com

 

The summary information in this document is being provided for education purposes only. Recipients may not rely  on this summary other than for the purpose intended, and the contents should not be construed as accounting, tax, investment, or legal advice. We encourage any recipients to contact the authors for any inquiries regarding the contents. FGMK (and its related entities and partners) shall not be responsible for any loss incurred by any person that relies on this publication.

 

 

[1] Managers might also receive other types of compensation such as a management fee, which might not be treated as a carried interest for tax purposes. In addition, other employees who are not managers could receive a carried interest.

[2] Rev. Proc. 93-27, 1993-2 (June 9, 1993).

[3] Rev. Proc. 93-27, 1993-2 (June 9, 1993).

[4] Rev. Proc. 2001-43, 2001-43 (August 3, 2001).

[5] IRC §1061(c)(4)(B).

[6] IRC §1061(c)(1).

[7] IRC §1061(c)(2) and (3).

[8] IRC §1061(c)(2).

[9] IRC §1061(d).

[10] IRC §1061(d)(2).

[11] IRC §1061(c).

[12] IRC § 83(a) ("Vested" is defined as the person receiving such interest for the performance of services has rights in such property that are transferrable or are not subject to a substantial risk of forfeiture).

[13] IRC § 83(c) provides that a taxpayer's rights in property are subject to a substantial risk of forfeiture if such person's right to full enjoyment of such property are conditioned upon the future performance of substantial services by such person.

[14] Notice 2005-43, 2005-1 CB 1221 (May 20, 2005), Section 4.02.

[15] Rev. Proc. 93-27, 1993-2 (June 9, 1993).

[16] Rev. Proc. 2001-43, 2001-43 (August 3, 2001).

[17] Treas. Reg. § 1.83-2(c).

[18] Treas. Reg. § 1.83-2(d).

[19] Treas. Reg. § 1.83-2(b).

[20] IRC §1061(b).

[21] Conference Report to accompany H.R. 1, page 266.