A carried interest is a type of equity interest in a business taxed under Subchapter K of the Internal Revenue Code, 26 U.S.C. § 701, et seq., which can receive significant federal tax benefits under some circumstances.
The concept of carried interest is attractive to many businesses because it can allow a service provider to receive an interest in the profits of a business taxed under Subchapter K, to effectively transform what would normally be characterized as ordinary income — currently taxed at a maximum marginal rate of 39.6% — into long-term capital gain — currently taxed at a rate of 20%. Needless to say, this can be a significant tax savings.
How Does It Work?
Section 83 of the the Internal Revenue Code, 26 U.S.C. § 83, includes as income the value of equity interests at the time they are granted.
But just how do you value an equity interest when it is granted? What if it has no value because it is largely speculative?
Well, the IRS attempted to answer that question in 1993 via Revenue Procedure 93-27 — and has subsequently issued additional guidance.
Rev. Proc. 93-27 divides interests in the profits of a partnership into two distinct categories: (1) Capital Interests and (2) Profits Interests.
A capital interest is an interest that would give the holder a share of the proceeds if the partnership’s assets were sold at fair market value and then the proceeds were distributed in a complete liquidation of the partnership. This determination generally is made at the time of receipt of the partnership interest.
A profits interest is a partnership interest other than a capital interest.
Carried interests are quite common in businesses that invest in capital assets, like real estate and securities, and that have: (1) managers that are actively involved in the management of the business and (b) investors who aren't active in the management of the business.
In other words, carried interests are very common to hedge funds and private equity and are somewhat common in the case of venture capital firms.
Carried interests are often thought of in the context of distributions at liquidation as opposed to operations, but they can also be used during operations.
An Example
For example, a real estate investment fund holds real property for a minimum of 1 year in order to qualify for long-term capital gain treatment. Upon the sale of property for a profit during the operations of the business, the business can be structured so that the investors are allocated 80% of the long-term capital gain and the managers of the fund are allocated 20% of the long-term capital gain pursuant to IRS Section 704.
In effect, the management has converted what would be considered ordinary income for services into long-term capital gain if their interests in the business were properly structured as profits interests, i.e. they was subject to a substantial risk of forfeiture along with other requirements.
This brief overview of some important considerations associated with carried interests and profits interests is by no means comprehensive. Always seek the advice of a competent professional when making important financial and legal decisions.
