Carry complexity

IRS rules regarding the allocation of carried interest create complexity in a transient private equity market.

Three trends coincided in 2005 that bode well for tax lawyers, but will surely create headaches for GPs. First, the good news – the year just passed saw the generation of an enviable pile of carried interest. As private equity firms refinanced and exited portfolio companies, partners who were due carry looked forward to a prosperous future.

Second, major distributions drove investor enthusiasm for private equity, which in turn led to a fundraising bonanza, which in turn led to an unprecedented wave of spin-outs as junior GPs sought to launch private equity franchises of their own.

Finally, as the private equity market has institutionalized, private equity firms have (slowly, many would argue) adopted structures whereby carry is shared with a broader cast of professionals than just the founding partners.

These three trends have come to the fore just as the treatment of carry for tax purposes may be becoming more complex. Tax experts who advise private equity firms caution clients to be mindful of the consequences of new partners, departing partners, the expanding roster of partners who receive carry, as well as the structures of new funds, because failure to do so could mean unexpected and unnecessary tax payments or, just as frightening, inter-partner squabbles over the fruits of their collective labors.

Vesting at zero
Over the life of a private equity fund, things change. A fund begins with a certain number of partners, defined in this case not in the hierarchical designation most common to the private equity industry but as anyone who receives carry. As the 10- to 12-year life of a fund unfolds, some partners may leave and others join. In addition, in a culture that rewards profits based in part on merit, many firms seek to allocate carry based on the varying degrees of partners' participation in successful deals. ?At the start of a fund, you may not know what the relative contributions of all the partners will be,? says Neal Sandford, a partner in the Boston office of law firm Goodwin Procter.

This means that ?points? of ownership in a partnership may be reallocated several years into a fund's life. All these potential changes have tax consequences, and now more than ever.

Until May of last year, the US tax rules governing the granting and vesting of partnership interests was governed more by lore than law, says David Schnabel, a partner in the New York office of law firm Debevoise & Plimpton LLP. Tax experts typically advised their private equity clients to file for a Section 83(b) election, which allows a partner to ?vest? at the creation of a fund for tax purposes.

Rules proposed in May by the IRS would make it almost essential that partners file a Section 83(b) election when a fund is formed. This ensures that when carry is finally paid down the road, it is treated as a capital gain instead of income, the former having a much lower tax rate.

A Section 83(b) election requires that those who receive a share of a fund be taxed based on the difference between the fair market value of the interest and the value at which it was transferred. Of course, a new fund has no assets, and if liquidated, the owner of a share in the partnership would receive nothing. As such, partnership interests are traditionally valued at zero when they are initially granted for the purposes of Section 83(b).

However, some private equity firms do assign a value to new fund interests based on goodwill and the value of a ?going concern.? The chief financial officer of a major US private equity firm says his firm does assign a value to new partnership interests, but simplifies the process by making the value equal to the value of the capital contribution made by the partner in question. The option value of the partnership interest, however, remains zero.

When carry is (hopefully) finally paid in cash to partners several years down the road, the partners who made 83(b) election will be allocated gain that is typically eligible for the 15 percent tax rate (rather than the 35 percent tax rate applicable to compensation income).

Not every partner to a private equity fund joins at inception. When partners come on board after some value has already been built in the partnership, something of a fiscal Catch-22 emerges.

Under the newly proposed IRS rules, the intended recipient of carry is not considered a ?partner? eligible for capital gain flow through unless he or she files Section 83(b). Of course, such a filing in a more mature partnership often means substantial value is being granted to the new partner and, unless structured around, income taxes may be due on this transfer of value. This is so even if the new partner in question hasn't received a dime in cash carry.

Such a tax penalty for becoming a partner in a successful private equity fund may tempt the new professional to not file Section 83(b), and thereby not recognize an immediate vesting of interest in a partnership. This too can have negative consequences. First, any income generated by the partnership would generally not be allocated to the non-83(b) professional, but instead to the other full ?partners? in the fund. In addition, when the blessed moment of cash carry arrives, any distribution made to the non-83(b) interest holder would be treated not as capital gains but income, which carries the bigger tax burden. To make matters worse, the professional might have to pay income tax without actually having received any of the income in cash.

The CFO of the major private equity firm says his firm's policy for dealing with interim partner hirings is based on a structure of never assigning carry from a deal to partners who were not present at the time the deal was entered into. ?You only get carry in deals done after the day you join,? the CFO says.

Schnabel confirms, ?If you give built-in gain to a new partner, the IRS clearly thinks that's a taxable event and most funds either don't do it or structure around it.?

Schnabel adds that in order to structure around the problem many firms have instituted carry arrangements whereby new partners receive their interest in the partnership, but craft their economic deals such that the new partner will receive carry only out of future appreciation in the value of portfolio investments. Accordingly, if the partnership and the underlying portfolio companies were liquidated the day after a new partner joined the firm, that partner would receive nothing, and therefore receiving the interest in the partnership is not considered a taxable event. Sometimes ?catch-up? allocations are made to the new partner (solely out of future profits) so that in the end the partner may effectively receive a fixed share of all of the carry from the investment.

In most funds, the carried interest is computed on a cumulative basis in which the GP receives 20 percent of the net profits on all portfolio investments over the life of the fund, with gains effectively being offset by other losses. By contrast, the carried interest is often shared at the GP level on a deal-by-deal basis, with some partners receiving a large portion of the carry on certain deals and a reduced or zero share of the carry on other deals.

Schnabel notes that the deal-by-deal nature of these GP arrangements is somewhat at odds with the cumulative nature of how the carried interest is computed at the fund level. Complications can arise, for example, since a loss on one deal will be recouped at the fund level by the next winning deal. Thus, if a new partner is in one of two winning deals that are to be sold after the fund has realized a loss, the impact on the partner of the prior loss will depend entirely on which of the two winning deals is sold first. In order to address this ?unfairness,? many GPs use a complicated ?memo account? structure which forces losses from a given deal to be borne only by those partner who were allocated carry in that deal. Schnabel notes that while this structure is more fair to all of the partners, it requires additional tracking of each portfolio investment and can create considerable complexity.

Take this carry and shove it
Each partner's share of the carried interest is typically subject to vesting, meaning if the partner leaves before certain dates he will forfeit all or a portion of the interest. With some private equity firms now paying carry to almost everyone in the firm, this can mean that the ?forfeiture? of interests in the partnership is a rather common occurrence. If one partner is forfeiting an interest, then another partner is receiving an interest and the receipt of such an interest can raise some of the same issues that apply when a new partner is admitted. Schnabel notes, however, that most people do not treat the receipt of such an interest as a taxable event, even if interest carries with it ?baked-in appreciation,? so long as it is reallocated to a person who was a partner at the time the appreciation was generated.

Points of carry are also frequently allocated over time to partners based on performance.

According to Schnabel, many GPs create a ?point pool? of, for example, 10 percent of the carried interest for a particular investment. The pool is initially allocated to the partnership in general, but no one partner in particular. As the contributions of the various partners become evident over time, the point pool is allocated accordingly.

Schnabel notes that point pool allocations are not typically treated as triggering a taxable event, but he admits: ?It's not entirely clear under the tax rules how you should treat this and some law firms are less comfortable than others in dealing with point reallocations.?