This document originally appeared in the May 1, 2013 edition of Tax Notes Today.
The IRS isn't holding its breath for direction from Congress on the taxation of carried interest and is moving forward on a tangential issue -- the treatment of fee waivers -- which it has determined is "fair game," Clifford Warren, special counsel in the IRS Office of Associate Chief Counsel (Passthroughs and Special Industries), said April 30.
"Fee waivers is something that we are in fact studying at this point," Warren said at a Practising Law Institute seminar in Chicago. "There's a spectrum, and we're trying to figure out what's good and what's bad," Warren told Tax Analysts, adding that while some fee waivers might work perfectly well, it's not clear that all of them fall within the safe harbor in Rev. Proc. 93-27, 1993-2 C.B. 343. That safe harbor requires that the recipient act as a partner and not dispose of the interest within two years. "We don't like what we see in all cases," he said.
Management fee waivers allow private equity and hedge fund managers to forgo their fixed management fee (commonly 2 percent) in exchange for a profits interest -- a carried interest -- to take advantage of deferral and preferential capital gains tax rates. Warren said some fee waivers may implicate section 707(a)(2)(A), which would treat the service provider as acting in a non-partner capacity.
Prospects for Carried Interest
At an earlier panel on the final (T.D. 9612) and proposed (REG-106918-08) noncompensatory partnership option regulations, Joy Spies, branch 1 senior technician reviewer, IRS Office of Associate Chief Counsel (Passthroughs and Special Industries), said the Service is waiting to see what happens with proposed carried interest legislation before it resumes work on 2005 proposed regulations (REG-105346-03) concerning the tax treatment of compensatory partnership interests.
Glenn Dance of Ernst & Young LLP said some on Capitol Hill have cited the IRS's administrative policy of not taxing the issuance of a profits interest under Rev. Proc. 93-27 as one of the reasons for the favorable tax treatment of carried interest. He asked Spies for reassurance that the IRS is not reconsidering that policy.
Rev. Proc. 93-27 and Rev. Proc. 2001-43, 2001-2 C.B. 191, continue to represent the IRS's position, Spies said. "They're not being rethought at this point," Spies said, adding that there's no update regarding proposed regulations on equity for services.
At the later panel, Warren said that some believe that if the carried interest legislation is "out there again and again and again, it's going to be enacted." But he said the proposed legislation is complex. "It tries to do something in subchapter K that's unnatural," he said. The complexity is necessary to prevent taxpayers from avoiding the provision by using tiers, borrowing capital from the limited partners, using derivatives, or simply selling the partnership interest before the carry is earned, he added.
As for the prospects that carried interest legislation in some form will be passed soon, Warren said, "It could get lost in major tax reform . . . or it could be the centerpiece of major tax reform. We don't know."
Julie A. Divola of Pillsbury Winthrop Shaw Pittman LLP said the legislative uncertainty concerning carried interest reminds her of similar uncertainty that surrounded the codification of the economic substance doctrine. "People said that's a really bad idea, and yet one day we got it," she said.
Back-End Profits Interest
Bahar A. Schippel of Snell & Wilmer LLP discussed a planning strategy that may enable a partnership to compensate a service provider with a profits interest that entitles him to more than just a flat percentage of future profits. Under the strategy, the service provider receives a profits interest that entitles him to catch up to a pro rata share of existing capital but only to the extent that there are future profits -- without requiring allocations of ordinary income or withholding for those future profits. If the service provider is treated as a partner all along, the back-end payment will be entitled to capital gains treatment and won't trigger tax upfront, she said.
Schippel further explained that under the planning strategy, the service provider takes a profits interest that entitles him to receive, for example, 5 percent of future profits and a catch-up allocation that pays, for example, a share of profits equal to 5 percent of existing capital, but only in a liquidity event. That is done by allocating to the service provider's capital account 100 percent of the interim book-up gain, if any, or profits upon the sale of the business until he is made whole, she said. Warren pointed out that that could mean the service provider may not receive a Schedule K-1 until the partnership is sold.
"There are varying levels of thought as to whether the IRS would buy into that," Schippel said. "I personally believe that given that the employee is actually taking a risk that the business will have to actually grow in value, there's a good position to take that that strategy does work."
Divola said the planning strategy raises two questions: whether the allocation of book-up gain only has substantial economic effect and whether the interest is really a profits interest. "All you're doing is letting it trigger sometime in the future on a revaluation event," she said. "You've deferred your ability to be taxed until the end. It's a timing thing, and I think the issue is whether it has substantial economic effect."
Schippel said she would give the employee, for example, not only 5 percent of the future growth in the business, but also a share of annual operating income that ideally is equivalent to the employee's back-end participation. "But if not, at least something that's more than de minimis," she added. "That makes the person a partner in the meanwhile. You want to become a partner. You don't want to just say, 'Hey, look, there's a sale. We'll give you a bonus.'"
Schippel continued: "There's substantial economic effect, because the day you promised this to the [service provider], it had absolutely zero value, so its liquidation value was in fact zero. There was substantial risk that the value may not actually go up."