Structuring a Carried Interest

A common practice in alternative investment funds, such as private equity and hedge funds and even some family offices, is to grant the managing partner an interest in the profits of the fund.

Unlike management fees, which are a flat fee paid regardless of performance and taxed as ordinary income, an interest in profits incentivizes the general partner (GP) to maximize long-term profits of the fund. Known as a carried interest, that interest in profits allows the GP to both be rewarded for the fund’s successes as well as get the benefit of preferential tax rates from any long-term capital gain and qualified dividends generated by the fund. GPs often raise questions as to whether it is required under tax law (and not simply the partnership agreement and specific economic deals with investors) to invest personal capital in order to get the benefit of those rates rather than being subject to ordinary income tax rates for their services.

Analysis

There is no code section mandating a particular form for a carried interest. A partnership agreement is effectively a contract between partners in a fund, and, if the agreement specifies that one or more partners receive an allocation of profits, IRS will honor that allocation even if the profits interest is not accompanied by a capital interest. In other words, the presence or absence of a capital interest will not by itself change the character of income allocated through a profits interest. Relevant IRS guidance does not require any capital to be contributed in exchange for a profits interest and, in fact, assumes no capital is actually contributed. Nonetheless, attorneys will often advise that the GP make a capital commitment. The simple reason is so the GP will be recognized as a partner in the fund on day one.

As an example, assume the GP and the limited partner (LP) invest in a limited partnership (the Fund). The LP invests $100, the GP invests $0, and the partnership agreement says that the LP will receive its capital commitment back, plus $10 (the preferred return). Thereafter profits will be split 80% to the LP and 20% to the GP. If, in Year 1, there is profit of $20, the first $10 is allocated to the LP for the preferred return, and the remaining $10 is allocated $8 to the LP and $2 to the GP. Capital accounts at the end of the year are $118 for the LP and $2 for the GP.

Alternatively, if in Year 1 there is only profit of $5, it does not exceed the preferred return and is allocated 100% to the LP. Capital accounts at the end of the year are $105 for the LP and $0 for the GP. The perceived risk in this scenario is that IRS may determine that with no capital account, the GP is not a partner in the Fund on day one. If the LP is the only partner, the Fund is instead a single-member disregarded entity (DRE) for tax purposes.

There are several consequences to IRS deeming the Fund a DRE. Because as a DRE, the Fund would not be allowed to file a partnership tax return, all activity would have to be reported on the LP’s tax return. If IRS makes the determination after the Fund already filed several years of tax returns, from an administrative standpoint, it could require numerous amended returns for the LP. From a tax perspective, this reclassification could possibly void certain elections and render some expenses nondeductible, particularly under the tax rules.

There is also a risk that IRS would disagree as to when the GP’s interest vests. There is a principle in partnership law that states that if a partner receives a partnership interest with value in exchange for services, the partner will be taxed on the value of that interest at ordinary rates. The industry practice is that a carried interest has no inherent value until the GP’s interest vests, so there is nothing to tax. Once the GP’s interest vests, the value of the GP’s capital account is based entirely on income allocations from the fund. Those income allocations are taxable on their own under the same rules as a partner with contributed capital, so there is no value deemed granted to the partner in exchange for services.

Based on the partnership agreement, this capital shift should not occur because the GP’s interest would vest immediately upon the capital account becoming a non-zero amount. If profit is $10, the GP receives no allocation of income and therefore has no capital account. If profit is $11, the GP’s interest vests and it receives an allocation of income of 20 cents. The GP’s capital account is only 20 cents, all of which is from an allocation of income, so the GP received no taxable shift of capital.

There is always the possibility, though, that IRS may wrongly determine that the carried interest vests at an arbitrary time. At the end of the first taxable year that the carry vests, for instance, or at the end of a particular transaction that causes the value of the Fund to exceed the preferred return. If the $20 of profit is a single transaction, the GP will argue that their interest vests during the transaction and it should receive $2 of taxable income. IRS, though, may argue that the GP’s interest vests at the close of the transaction. At the close of the transaction the GP’s interest is worth $2, and if the GP doesn’t receive that $2 as an allocation of income, the IRS may argue it’s a taxable shift and the $2 is taxable at ordinary rates as compensation for services rather than as an allocation of profit. Even if the GP would prevail at trial, the cost of litigation may be prohibitive.

The Takeaway

As a protective measure, the partnership agreement should specify that the GP is treated as an owner of a partnership interest for tax and all other purposes as of the date of the grant of the carried interest, irrespective of the presence of a capital interest. The GP should also file a protective Sec. 83(b) election to mitigate the consequences of the IRS imposing an arbitrary time of vesting.

Unless a law firm advises that the GP will be treated for state law purposes as a partner or member on the date of grant, if there is a risk that the GP may not receive any regular distributions or allocation of profits in the first year of a partnership, the GP should consider making a contribution of the lesser of 0.1% of total capital in the fund or $100,000 to obtain an immediate capital interest. This capital interest ensures that the GP is a partner on day one. If the GP is itself a partnership with multiple partners, each partner in the GP entity does not need to separately contribute the lesser of 0.1% of total capital in the fund or $100,000. The GP contribution can be split amongst the partners in the GP, or even borne only by specific partners.