Carried Interest: What Is It and How Should It Be Taxed?

By Raymond J. Elson and Leonard G. Weld

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The goal of the legislation is to ensure that the lower long-term capital gains tax rate is not inappropriately substituted for the tax rate on wages and earnings. Taxing carried interest as ordinary income would result in increased tax revenues projected between $4 billion and $6 billion annually [New York Times, June 21, 2007, p. C1]. As noted by Senator Sander Levin (D-Mich.), “These investment managers are being paid to provide a service to their limited partners and fairness requires they be taxed at the rates applicable to service income just as any other American worker” [House Committee on Ways and Means press release, June 22, 2007]. The legislation would affect investment partnerships such as venture capital firms, private equity firms, oil and gas concerns, and real estate partnerships. The main target, however, is clearly private equity firms (PEF).

The legislation gained momentum because of the growing influence of PEFs in the marketplace and the large compensation earned by fund management personnel. For instance, the top two officers at the Blackstone Group earned approximately $610 million in compensation in 2006 and were expected to receive approximately $2.5 billion from the partnership’s recent initial public offering (Wall Street Journal, June 12, 2007).

A Typical Transaction

PEFs are popular investment vehicles. A PEF, such as Apollo Management, Texas Pacific Group, or Kolberg, Kravis, Roberts & Co., is structured as a partnership. The PEF identifies investment opportunities and raises capital to create a fund. Some of the fund’s investment capital comes from its limited-partner investors. These investors are often wealthy individuals, charitable foundations with large endowments, pension funds, or large corporations, especially insurance companies and banks. The private equity fund is managed by a PEF. The PEF is the fund’s general partner, and it decides which investments the fund will make. A target company is identified and acquired, often at a premium over its market price. The PEF typically contributes approximately 15% of the purchase price, with the remainder funded by the investors plus loans obtained from banks and other lenders. Once acquired, the public company is then taken private by the PEF.

Taking the company private allows the PEF to manage the acquired business without the continuous scrutiny of quarterly and annual financial reports by public shareholders. A major challenge faced by the newly acquired entity is to service the debt used in its acquisition. One common, if often unpopular, solution is to reduce costs by decreasing the workforce. Sometimes the PEF sells underutilized assets and spins off underperforming divisions. Once the firm is “right sized,” the PEF (owner) sells the new entity for a profit, either to another company or through an initial public offering of stock.

The sale of DoubleClick to Google announced in April 2007 provides an example of a typical private equity transaction—in this case, a return on the capital invested. DoubleClick was purchased in 2005 for $1.1 billion by two PEFs that contributed approximately $320 million of the purchase price. Two years later, the company was sold (pending regulatory approval) to Google by the PEFs for $3.1 billion in cash (www.cnn.money.com, April 13, 2007). The difference between the sale price and the purchase price serves as the basis for determining fund managers’ carried interest. Determining just how carried interest should be classified and thus taxed is at the crux of the current debate.

Carried Interest

Investment fund managers receive two types of compensation. One is a management fee, which is generally 2% of the assets under management. The second is a share of the profits, generally referred to as a performance fee or carried interest. Fund managers often receive 15% to 20% of the total profit of a successful transaction, such as the lucrative sale of DoubleClick to Google.

Carried interest is currently taxed at the favored 15% long-term capital gains rate rather than the tax rate applied to ordinary income (up to 35%). Because partnerships do not pay income taxes, the carried interest passes through to the partners, who pay the taxes on the capital gains. The proposal from Congress would legislate that the compensation received by investment fund managers is received for services provided and thus should be taxed as ordinary income. The capital gains rate should only apply to the extent that the manager’s income is based on a reasonable return of capital that was actually invested in the partnership.

How Should Carried Interest Be Taxed?

Ever since preferential capital gains rates came into existence, taxpayers have tried to classify income as a capital gain. The definition of a capital asset is found in IRC section 1221(a):

[T]he term “capital asset” means property held by the taxpayer (whether or not connected with his trade or business), but does not include:

(1) stock in trade of the taxpayer or other property of a kind which would properly be included in the inventory of the taxpayer if on hand at the close of the taxable year, or property held by the taxpayer primarily for sale to customers in the ordinary course of his trade or business;

(2) property, used in his trade or business, of a character which is subject to the allowance for depreciation provided in section 167, or real property used in his trade or business …

(3) accounts or notes receivable acquired in the ordinary course of trade or business for services rendered or from the sale of property described in paragraph (1)

IRC section 1221 also covers some other special categories of property, such as creations of the taxpayer, certain government publications, and some other items that are not relevant to this discussion.

Existing Case Law

The classification of income as either ordinary income or gain from the disposition of an asset has a long history. In a 1941 U.S. Supreme Court case (Hort v. Comm’r, 313 U.S. 28), the taxpayer received a lump-sum payment for a lease cancellation. The court did not argue that a lease cannot be considered “property,” but the court did dispute the characterization of the lease cancellation payment as return of capital. The payment received by the taxpayer was classified as ordinary income, simply replacing lost future rent receipts. The court considered it irrelevant that “for some purposes the contract creating the right to such payments may be treated as ‘property’ or ‘capital.’”

In Comm’r v. Gillette Motor Transport, Inc. (364 U.S. 130), the U.S. government assumed possession and control of the taxpayer’s property during the last 10 months of World War II. The taxpayer received a lump-sum settlement for the value of the property plus interest. The taxpayer maintained that the sum represented “an amount received upon an ‘involuntary conversion’ of property used in its trade or business and was therefore taxable as long-term capital gain.”

The U.S. Supreme Court stated that even though the taxpayer had been deprived of his property and rightly compensated, this does not answer the entirely different question of whether that transaction gives rise to a capital gain. The IRC does allow capital gains treatment for the disposal of real or depreciable property used in a trade or business (IRC section 1231), which would include the property in question. The decision also stated, however, that “the purpose of Congress [was] to afford capital-gains treatment only in situations typically involving the realization of appreciation in value accrued over a substantial period of time, and thus to ameliorate the hardship of taxation of the entire gain in one year” (Gillette Motor Transport, Inc.). The court concluded that the payment received by the taxpayer was for the government’s right to use the property, which does not rise to the level of a capital asset. The payment was considered to be akin to rent and therefore ordinary income.

Courts have applied the same reasoning to recent cases when taxpayers have attempted to claim capital gains status for proceeds from the sale of future lottery payments. The typical arguments made in such cases are that the taxpayer has sold a property right for a capital gain, or sold an investment in a $2 lottery ticket for a capital gain. The courts have consistently rejected such arguments from taxpayers. The courts have consistently held that when a lump-sum amount is received instead of a series of future payments that would be ordinary income, this receipt does not become a capital gain.

At the partner level, appellate courts [Diamond v. Comm’r, 492 F.2d 286 (CA-7), Campbell v. Comm’r, 943 F.2d 815 (CA-8)] have not taxed partners when they receive a “profits interest” in activity of the partnership. This profits interest (separate from a capital interest in the partnership) represents the partner’s share of future profits earned by the partnership. Unless this interest has a readily determinable value, receipt of a profits interest does not result in a current tax liability, but is taxed when realized. (It is worth noting, however, that Revenue Procedure 93-27, 1993-2 CB 343, says that gross income includes the profits interest if it is a limited partnership interest in a publicly traded partnership.)

Two Critical Questions

To apply the appropriate tax rate, the first question to answer is whether carried interest is received because of services provided by the fund managers. Compensation for services is clearly included in gross income and is taxed at ordinary income rates. Fund managers generally receive a 2% fee based on the amount of assets under management, a fee charged to an investor for the opportunity to pool money with other investors and participate in the venture. If carried interest is a fee based on asset performance, distinct from a fee based on assets under management, then that fee is also ordinary income and the question has been answered.

Assume that carried interest is not simply a performance-based fee, but instead results from the profitable activities of the partnership. That is, carried interest is paid to a partner from profits earned when the partnership has disposed of a company taken private. If carried interest is not a fee, the second question is, “What is the proper classification of the asset that was sold?”

As stated by the U.S. Supreme Court, the determination that a taxpayer sold property for a gain does not answer the question of how the gain should be taxed. It is not the property itself that gives rise to a capital gain, but the classification of that property. For example, the sale of an automobile out of inventory by a dealership results in ordinary income. If the individual taxpayer who bought the automobile later sells it to a friend, the result is a capital gain/loss. It is the use of the property by the taxpayer that determines the classification of the property as either inventory or a capital asset.

What Is the Proper Classification?

There are several ways a transaction can be classified, depending on the structure of the disposition. One common scenario with PEFs is that a company is taken private, some assets are sold, operations are streamlined, and the company is returned to a profitable state over the course of several years. The company is then sold to another entity.

Consider one recent example: In May 2004, the Blackstone Group took Extended Stay America, Inc., private, paying $1.99 billion plus $1.13 billion in debt. In April 2007, the Lightstone Group agreed to buy Extended Stay Hotels from Blackstone for $8 billion. This transaction would appear to be the sale of an asset purchased as an investment. The asset is a “compound” asset in that it contains several parts; that is, Extended Stay owns multiple properties. But, essentially it is no different from the sale of a share in a mutual fund that owns shares in many corporations. The proper classification of carried interest from this transaction should be as a long-term capital gain from the sale of an asset held for investment.

Using exactly the same scenario as above, what if the sale of Extended Stay Hotels had been considered property under IRC section 1221(a)(1)? If Blackstone always intended to sell Extended Stay Hotels, that company could be considered “property held by the taxpayer primarily for sale to customers in the ordinary course of his trade or business.” If this were the appropriate classification, the carried interest results from the sale of inventory and is clearly ordinary income.

A third situation involves the sale of stock. Consider a company that is taken private. A general partner is awarded 100,000 shares for his first year’s work helping to restructure the company. The general partner’s basis in the shares would be the fair market value of the shares received. There is no tax difference between wages paid in cash or in shares, except that it is more difficult to value the shares when they are not publicly traded. Assume the partner’s shares are valued at $200,000, resulting in a basis of $2 per share. The partner pays income tax at 35% on this earned compensation of $200,000. When an IPO takes place, the partner sells his shares for the market price of $20 per share and has a capital gain of $1.8 million [($20 market price – $2 basis) x 100,000 shares] on the sale. If the partner has held his shares more than a year, this is a long-term capital gain, and taxed at the preferential rate of 15%.

The same result would probably apply to any scenario where the partnership owns stock that is sold at a gain. Rather than the individual partner receiving 100,000 shares of stock, the partnership may receive 800,000 shares for the services provided by all the partners. The origin of the gain would be the sale of stock and would most likely be classified as a capital gain. The gain would pass through the partnership to the partners and, assuming shares were held for more than a year, would be taxed at the 15% long-term capital gains rate. So, what is the proper classification of PEF transactions?

Classifying PEF Transactions

PEFs typically make money by purchasing a public company, privatizing and restructuring it, and selling the resulting entity either to another company or through an initial public offering. The PEF partners’ share of the profits from this sale is known as carried interest.

The discussion above delineates three options for how carried interest could be classified and thus taxed:

• A capital gain from the sale of an asset held for investment,
• Ordinary income from the sale of property held for sale as inventory, or
• The sale of stock, which would be a sale of a capital asset and yield a capital gain.

In the authors’ opinion, PEFs effectively treat the companies they acquire as inventory held for sale in the ordinary course of business. Even if, upon acquisition, the eventual date of resale is unknown, potentially extending far into the future and entailing restructuring and spinoffs, the intent of the transaction is clear. For federal tax reporting purposes, the authors believe that these assets should be treated as inventory and the fund managers’ carried interest should be taxed at the ordinary federal income tax rate. This position is supportable under IRC section 1221(a)(1), as discussed above. This argument would also apply when the companies are disposed of through an IPO. The “inventory” is just sold to multiple customers.

As noted earlier, Congress is concerned about fund managers treating carried interest as a long-term capital gain rather than ordinary income. The current rate differential between the highest ordinary federal income tax rate and the appropriate long-term federal capital gains rate is 20 percentage points. The way that PEFs typically operate, however, does not resemble the sale of assets held for investment—and thus a capital gain; the acquired companies are more akin to inventory held for resale.

The authors support the legislation proposed by Congress that would tax the carried interest received by investment fund managers as ordinary income. The recent high profile of PEFs has drawn attention to flaws in the tax code that have led to unintended consequences when it comes to the tax treatment of carried interest. The authors realize that this position taken by Congress may not be popular with some constituents, but they applaud Congressional efforts to address the inconsistencies in the tax treatment of inventory.

©2009 The New York State Society of CPAs. Legal Notices