United States: Taking Advantage Of The "Carried Interest Loophole"

Published in the New Hampshire Bar Association

For the company looking to motivate and reward managers or executives, a profits interest provides a pathway to an economic stake in the company, without requiring upfront capital investment or payment of income tax.

When Mitt Romney's tax returns became public during the 2012 presidential election campaign, the "carried interest" method of compensating executives (or the "carried interest loophole") came to the forefront of the national conversation. Just how does a man as successful as Romney end up with a tax rate of 13.9 percent?

Many of the tax-saving strategies Romney used to achieve that result are beyond the reach of the average taxpayer, but the carried interest strategy can be of use to owners of small businesses, which may include your clients or you.

A carried interest is essentially a type of equity called a "profits interest" in a partnership that is given to a manager or other service provider in exchange for services provided to the partnership. Although many businesses now are taxable as partnerships (including most LLCs), carried interests for managers of other businesses can be designed by adding an entity taxable as a partnership to the business structure. For instance, adding a holding company taxable as a partnership atop an operating business taxable as a corporation can give management access to profits interests.

A profits interest is economically similar to a stock option – in either case, the executive receives equity that may appreciate in value, but loses nothing if the equity declines in value. Neither is taxable on the date of grant. However, a stock option that does not qualify as an "incentive stock option" under IRS rules is taxable at ordinary rates upon exercise, to the extent that the market price of the stock exceeds the strike price. The tax treatment of an incentive stock option is more similar to that of a profits interest (capital gains tax upon sale on the spread between the market and strike price), but this favorable treatment is subject to statutory limits and may not be available to the extent that the service provider is subject to the alternative minimum tax.

A properly structured profits interest falling within the safe harbor (as described below) created by IRS guidance is treated as having no taxable value on the date of grant. For the company looking to motivate and reward managers or executives, a profits interest provides a pathway to an economic stake in the company, without requiring upfront capital investment or payment of income tax. Additionally, the profit interest is subject to capital gains tax rates upon liquidation of the interest.

The recipient of the profits interest reports his share of the partnership's income and gain on his individual tax return. This income and gain has the same character (ordinary or capital) as was recognized by the business. In Romney's case, because the income of the private equity funds he managed was primarily derived from the sale of portfolio companies, nearly all of the income from his profits interest was taxable at 15 percent (then the capital gains rate), instead of at 35 percent (then the highest ordinary rate).

In contrast, the holder of a profits interest in a business that generates primarily ordinary income will receive ordinary income via the profits interest. In such a business, the big reward for the holder of a profits interest is usually realized when the business is sold. Upon the sale of the company taxable as a partnership, a profits interest holder realizes a capital gain.

A "profits interest" is defined in IRS guidance as a partnership interest that has no liquidation value at the time of grant (even if the interest is unvested). So long as the criteria detailed in the IRS's Revenue Procedures 93-27 and 2001-43 are met, the tax treatment described above applies. Among other things, the profits interest must not be an interest in a substantially certain and predictable stream of income from partnership assets, and must not be disposed of within two years of receipt. The service provider also must take into account his share of the partnership's income and other tax items on his own tax return. The tax treatment of a profits interest that does not satisfy these requirements is substantially less certain, because there is no specific IRS guidance on the matter.

Many view the use of a profits interest as a "loophole" and have argued for an end (either by statute or by regulation) to the favorable tax treatment they are afforded. Legislation to increase the tax on carried interest income has been introduced in Congress repeatedly over the past several years and commentators have warned that it appears inevitable that there will be legislation in this area, given the multi-trillion dollar deficit.

That said, the status quo has many well-connected and financed backers, and Congress has not made any progress on the issue, despite its oft-proclaimed concern about the deficit. Even if such legislation does pass, it is probable that it would apply only to profits interests in partnerships in which most of the assets are cash, securities, real estate held for investment, and the like.

Businesses considering issuing profits interests should be aware of potential disadvantages that flow from operating within a tax partnership structure. First, service providers will be taxed on income as it is earned by the partnership, not as cash is distributed to them. Second, partners cannot be treated as employees, so service providers with profits interests may be subject to self-employment taxes and liable for the employer-share of payroll taxes. Moreover, certain tax-advantaged benefit plans will no longer be available to service providers who move from employee status to partner status. Sophisticated structuring and drafting can mitigate some of these concerns.

Despite the potential drawbacks and technical complexity of operating in a partnership structure, for businesses looking to provide equity to executives and managers, profits interests are an attractive compensation strategy. They remain a uniquely tax-efficient form of compensation that is available to businesses of any size.

Catherine Hines is an attorney in the tax department of the McLane Law Firm.

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