You can download a PDF of this article, with footnotes, here: Beyond Two and Twenty.pdf
Victor Fleischer, Associate Professor of Law at the University of Illinois, has written a draft article entitled Two and Twenty: Taxing Partnership Profits in Private Equity Funds, that has received significant attention from Congress, tax practitioners, the trade press and the mainstream media.
Fleischer proposes changing the way in which the “carried interest” received by venture capitalists and other private investment fund managers is currently taxed. He proposes that it be taxed (1) At least in part, before the human capital – the labor – that is intended to create value results in any realizable income or gains and (2) At higher rates than are afforded returns on human or financial capital generated within other forms of business.
Fleischer’s analysis simplifies many of the practical realities confronted by private investment funds that operate within the existing partnership tax rules. More troubling, his article confuses — rather than illuminates — tax policy.
Sifting through the sensationalism (yes, some fund managers are very wealthy) and eliminating concerns that apply to all forms of equity compensation (whether held by partners, sole proprietors or corporate founders), Fleischer’s article deals almost exclusively with a valuation conundrum – that is, how carried interest should be valued upon grant. This issue has been addressed by the courts, by Treasury and by the Internal Revenue Service (“IRS”) for decades. It is not novel, although it is complex. Insightful tax professionals have addressed this problem over those years to devise workable, if imperfect, solutions. And although the solutions have taken varied forms, remarkably they have all achieved a consistent result reflecting sound tax policy. One way or another, a true partnership profits interest received by a service partner, with limited exceptions, should not be taxed upon receipt.
The other points raised by Fleischer are larger questions of tax policy. Should we tax long-term capital gains at preferential rates? How should we tax unrealized human capital, or labor, that is invested into a business entity? Should the owners of the partnership form of business entity be afforded one level of tax when corporate owners face an additional entity-level tax? These are all important and interesting questions. But their careful consideration should be analyzed within the context of our society and tax policy as a whole, rather than applied arbitrarily and inconsistently only to private investment funds.
The following stories illustrate an often overlooked aspect of the venture capital industry – its volatile risk profile – and establish the practical reality of the entrepreneurial risk taken on by a venture capitalist.
Shortly after the internet bubble burst in the early part of this century, the phones started ringing. The calls were from partners in venture capital firms that focused on information technology.
Client A: Client A was a nuclear physicist who had worked for a large corporation for many years, and who had subsequently started his own, very successful company. After he sold that company, Client A started his own venture capital firm with some like-minded colleagues and formed a $200 million fund to invest in other start-up companies focused on similar technologies. Over several years, the fund called $100 million from its investors using a portion, during the pre-bubble era, to invest into about 10 companies, and the rest to pay expenses, including an annual management fee to Client A’s firm equal to 2% of commitments ($4 million per year). The fee was used for the majority of the fund’s operating expenses and all of the expenses to run his firm – including office space, computers, insurance, salaries and payroll taxes for his staff, partners and himself. As was typical, he and his partners would be entitled to 20% of the fund’s cumulative net profits over its 10-year life.
Before the bubble burst, two of the 10 companies went public, resulting in the fund receiving stock worth $200 million. Because the original investment in these two companies was $20 million, this represented a net gain of $180 million, and with expenses to date of another $20 million, a $160 million cumulative net profit for the fund to date. The fund’s limited partners required that the first $100 million of stock be distributed to the investors. Twenty percent of the remaining $100 million of stock was distributed to the venture capitalists, or $20 million (even though the venture capitalists would ultimately be entitled to $32 million – 20% of cumulative net profit of $160 million – if the rest of the portfolio achieved no further gain or loss).
After that big win, the venture capitalists called the remaining capital of $100 million from its investors and used that to invest in companies and pay expenses. Then the bubble burst. It became clear that the rest of the portfolio was going to be a wash out. The companies failed. Ultimately, the entire $160 million of prior net profit was going to be offset by losses and expenses so that – on a cumulative basis – the fund was going to have a zero net profit.
Now, here was the interesting part. The venture capital fund had a cumulative net profit of $0. This meant that – since 20% of $0 = $0 – the venture capitalists were entitled to no carried interest, so they’d have to return the $20 million of stock they had received. But because the venture capitalists were subject to a “lock up”, they had been unable to sell the $20 million of stock and it was now valueless. They were staring down the barrel of a $20 million obligation, but had never received the corresponding benefit. It wasn’t spent on cars, houses or private jets. It wasn’t sitting in the bank. It had vanished with the risk that is the essence of the venture capital industry.
Client B: Client B worked at a larger venture firm that invested in companies across the information technology and life sciences technology industries. Client B’s partners included scientists, engineers, medical doctors and other technologically savvy professionals. When the technology bubble burst, their situation was a little different. Using the same set of figures as above for convenience, Client B’s fund had actually sold securities, rather than distributing them in kind. Client B’s group of venture capitalists had received their carried interest of $20 million in cash. But they had paid tax on $36 million – they had paid $7.2 million in U.S. federal income tax at the then capital gains rate of 20%. Far from deferring taxation, Client B’s venture capitalists actually paid tax on $16 million of income in advance of receiving the associated cash. But that was not Client B’s biggest concern. Rather, Client B’s venture capitalists had an obligation of $20 million, but had only received $12.8 million after taxes. Although not as severe as Client A’s case, Client B and his partners still had to come up with $7.2 million out of thin air.
Client C: Client C had been an MIT whiz kid who had built up the company he founded with venture capital backing. After 11 years, he sold it to a large Washington-based company. In the late 90’s he was courted by a number of venture capital funds to help build other such companies. He had agreed to join a venture capital firm whose most recent fund (Fund X) had been formed two years earlier. Client C was impressed by the performance of that fund’s portfolio of companies. When they brought him on board, Client C was granted 10% of the carried interest of the Fund X general partner. Client C recognized compensation income when he received his share of the carried interest since Client C was treated as having received a capital interest equal to his pro rata share of the unrealized appreciation inherent in the Fund X portfolio of companies. Because the carried interest was subject to vesting, Client C made an election under Code Section 83(b) and paid tax on that value at ordinary income rates. Fund X’s value then plummeted after the bubble burst, and Client C received no distributions of carried interest.
Any person with experience in the venture capital industry could continue with dozens of similar stories of venture capitalists and other entrepreneurs who have invested their time, energy and money into companies only to make no profit, or even to lose money. Although a more technical analysis is set forth below, these stories illustrate certain obvious truths:
• Venture capital is a risky business. Venture capitalists themselves are at real entrepreneurial risk of loss, and their fortunes rise and fall with the companies that they help to build.
• A venture capitalist’s carried interest is not like an option received by the employee of a corporation, and it is nothing like an annual discretionary bonus received by an investment banker. Rather, the venture capitalist’s carried interest very similar to the stock received by the founder of a start-up company or the owner of a sole proprietorship. Each of the venture capitalist, corporate founder and sole proprietor invests time, energy and money in the hopes of building value in his or her business. Corporate founders, sole proprietors and venture capitalists all receive capital gain tax treatment when they sell their businesses.
• It is far too simplistic, bordering on naïve, to assert that a venture capitalist’s carried interest is the “single most tax-efficient form of compensation available without limitation to highly-paid executives.”
• Tax gamesmanship is not the driving force behind the venture capital structure. As partners, venture capitalists are subject to a complex set of partnership tax rules, with a long history of thought behind them. Under these rules, it is inaccurate to say that carried interest is currently subject to tax at 15% or that it is a non-taxable profits interest.
• Most important, it is nearly impossible to ascertain the value of a carried interest at the inception of a venture capital fund, and any non-zero value would, in effect, be a tax on unrealized human labor, which may or may not ultimately result in any carried interest distributions.
Part I of this article will discuss how the partnership tax rules apply specifically in the life cycle of a venture capital fund.
This will provide the basis for explaining, in Part II, (i) why the alternative approaches proposed by Fleischer would represent a monumental shift in fundamental tax policy; (ii) that such alternatives would support a tax policy that would cut across all forms of business enterprise to tax labor – human capital – before the fruits of that labor have been realized; and (iii) that such alternatives, in turn, reflect a tax policy that would support the elimination of the preferential capital gains rate.
At a minimum, those alternatives would arbitrarily apply this concept only to the partnership form of business enterprise, thereby undermining an integral form of business that recognizes the benefits of (i) pooling the disparate contributions of labor and capital and (ii) permitting those disparate interest holders the flexibility to share in the profits in a manner designed to reward the entrepreneurial risk taken by each. Further, those alternative tax treatments of carried interest would result in unnecessary complexity, avoidable through other structures.
The article then will demonstrate, in Part III, that existing partnership tax rules actually do prevent any perceived tax gamesmanship in the venture capital industry.
I. Current Partnership Taxation of Carried Interest
A. General VC Fund Structure and Economics
1. Legal Structure
Venture capital funds are organized as limited partnerships or as limited liability companies (LLCs) under state or non-U.S. law. In all cases to which this article applies (and almost all cases in practice), the venture capital fund is classified as a partnership for U.S. federal income tax purposes. The fund qualifies for such treatment either under the default rules for entity classification or as a result of making an affirmative election to be classified as a flow-through entity under those regulations.
2. Formation of Investment Team and Strategy
The venture capital fund formation process starts with the individual venture capitalists. The typical venture capitalist possesses an advanced scientific degree or other technological background. Very often, the venture capitalist also has had operational experience with start-up companies. That background and experience typically gives a venture capitalist unique skills to identify, invest in and grow start-up companies in a specific technical field.
The typical venture capitalist will band together with either (i) a group of other individuals with similar technological backgrounds to form a fund to invest specifically in start-up companies in that technological space or (ii) a group of individuals with other types of technological backgrounds to form a fund to invest in companies across a spectrum of technologies. The majority of venture capitalists invest in information technology or life sciences, although many specialized sub-sets exist within those categories. Some of the industries that have been developed or created by venture-backed companies include biotechnology, medical devices, network security, on-line retailing, web-based services and clean-energy technology.
Once assembled, the team determines how much money to raise based on what it expects to invest. This generally depends on the number of venture capitalists on the team and the approximate amount of funding that is necessary to build a company in their targeted industry. Venture capitalists typically sit on the board of directors of each portfolio company in which they invest, providing strategic counsel regarding financings, sales and marketing, operations, intellectual property rights, recruiting, liquidity, and all other aspects of the company’s business. Most venture capitalists sit on no more than 5 to 10 active boards. Although most venture capitalists invest significant portions of their personal wealth in their portfolio companies, the capital needed by emerging-technology companies outpaces the assets of individuals.
3. Formation of Relationship between Venture Capitalists and Institutional Investors
Venture capitalists typically partner with institutional investors such as public and private pension funds, universities and endowments and private foundations. Other investors include high net worth individuals and corporations, especially those with cash reserves such as insurance companies and banks. Some investors in each of these categories might be non-U.S. persons. These cash-intensive entities generally seek to diversify their investment portfolios with a small percentage of the type of high-risk investments offered by venture capital funds.
Although lengthy negotiations often determine the specific rights and obligations of the venture capitalists (some group of whom own the “general partner” of the fund and the “management company” to the fund) and the investors (the “limited partners” of the fund), certain broad market terms have evolved over the years.
The management company, which is usually formed as an LLC or a C-corporation, typically enters into a non-partner, contractual arrangement with the fund to perform its day-to-day operational activities. In exchange, it receives a guaranteed, annual management fee from the fund, usually at a rate of 2% of fund commitments. This rate often declines after the first four- to six-year period during which all of the fund’s portfolio companies are expected to be identified. The management fee pays for the office space of the venture capitalists, the furniture and computers, insurance costs, salaries and payroll taxes for analysts and staff, as well as the salaries of the venture capitalists themselves. Essentially, the management fee is used to run a business.
The general partner on the other hand, which is usually formed as another limited partnership, makes the investment and divestment decisions for the fund. It typically contributes between 1% and 5% of the capital of the fund and receives 20% of the cumulative net profits of the fund (the “carried interest”), as well as 1% to 5% of the remaining 80% as an investor. The limited partners generally view the carried interest as a necessary incentive to reward the general partner for the entrepreneurial risk it takes regarding whether its efforts will lead to financial success. The carried interest aligns the interests of the parties by focusing the general partner’s attention on building value in the underlying portfolio companies. That is, the venture capitalists will not achieve financial success unless the underlying portfolio companies that they are advising perform well.
4. Venture Capital Fund Operations
The fund typically is closed-end, has a finite term of 10 years, plus one to three one-year extensions, with additional time permitted to liquidate any remaining portfolio companies. Often, the fund lasts between 13-17 years. Investors are not permitted to withdraw or redeem their interests during this time. Transfers of interests are highly restricted.
During the first four to six years, the general partner finds companies and the fund invests in them. During this time and thereafter, the venture capitalists work with company management to build the company and, in many cases, an industry. With a handful of exceptions (most notably the “internet bubble”), this process typically lasts between four to eight years, but can be longer for those life science companies that require significant regulatory processes and approvals.
Ultimately, the venture capitalists spend the last years of the fund guiding portfolio companies to acquisitions or initial public offerings. Because the venture capital industry focuses on high-risk technologies, however, many venture-backed companies fail. As the companies are sold or go public, the fund distributes the proceeds (either in cash or in public company stock) to the partners. After the last portfolio company has been sold, distributed to investors or written off, the fund itself liquidates.
Because gains and losses (and usually expenses, including the management fee) are netted for purposes of determining the cumulative net profits upon which the carried interest is calculated, the amount of carried interest, if any, to which the general partner is entitled cannot be calculated definitively until the fund liquidates. At any time during the term of the fund, the cumulative net profits to date can be determined, but unless the future profit or loss of each of the remaining portfolio companies can be predicted with accuracy, this will only be an interim determination. Moreover, because the partners’ capital is usually called on a “just-in-time” basis as investments are made and expenses incurred, investments made with later-called capital can produce a loss or gain as well.
As a result, the partners negotiate for provisions to safeguard the overall economic deal. In the venture capital industry, this typically means that the general partner is not entitled to receive distributions attributable to its carried interest until all contributed capital has been returned to the limited partners. For practical purposes, this often results in no distributions of carried interest to the general partner within the first six to eight years of the venture capital fund’s term. In almost all cases, the governing documents also provide for a “clawback” mechanism requiring the general partner to return to the limited partners – at the end of the term of the fund – any overdistribution of carried interest as determined after all investments have been liquidated.
B. Taxation of Management Fee.
The management company usually does not become a partner of the fund. Instead, it typically receives the management fee directly from the fund pursuant to a management contract for services. Since the management company is engaged in the trade or business of providing those services, the management fee is ordinary business income when received or accrued by the management company. The expenses of the management company generally constitute ordinary and necessary business expenses, deductible under Code Section 162.
If the management company is formed as a C-corporation, the salaries paid to the venture capitalists, analysts and other staff generally are deductible by the management company as business expenses, to the extent not otherwise disallowed. If the management company is formed as an LLC, the salaries paid to its owners (typically, the core group of VCs) are deductible as “guaranteed payments” under Code Section 707(c). In either case, the salaries or guaranteed payments are included in income by the recipients as ordinary compensation income and are subject to employment taxes and estimated tax payments.
Because of the relatively small size of most venture capital funds, most or all of the management fee typically is used on an annual basis to pay for ongoing operational expenses, salaries and bonuses. Because the carried interest (described below) is speculative, and often is not distributed to the venture capitalists for years (if at all), the management fee is large enough to permit the venture capitalists to run their businesses as well as to provide them sufficient, competitive salaries. According to the Holt Compensation Study, the median salary (before bonus and carry) paid in 2006 to general partners of independent venture capital firms was $400,000 (for regular partners) to $680,000 (for managing general partners). Including bonuses (but not carry), those amounts were $493,000 and $958,500, respectively.
Unlike other private equity, there are few if any other types of fees or income that are earned by the typical venture capital management company. Because venture capital funds invest in start-up companies and because venture capitalists do not typically provide investment banking services in connection with portfolio company transactions, venture capitalists rarely, if ever, receive transaction, monitoring, breakup or other fees from their portfolio companies. While they sometimes receive fees in their capacities as members of a portfolio company’s board of directors, most such fees are nominal reimbursement amounts. In some cases, however, grants of non-qualified stock options result in greater value. Often, the management fee payable by the fund to the management company is reduced by some amount if the venture capitalists receive such fees. These fees would also be subject to tax at ordinary income tax rates.
C. Taxation of Grant of Carried Interest.
1. Profits Interests/Capital Interests – Taxation
At the inception of a venture capital fund, the general partner’s carried interest generally is viewed as a partnership “profits interest.” The appropriate taxation of a profits interest has aroused much tax angst over the years, in part because a profits interest itself is a slippery concept.
A profits interest is defined by reference to its partnership interest complement – the “capital interest.” A capital interest in a partnership is defined under Treasury Regulations as “an interest in the assets of the partnership, which is distributable to the owner of the capital interest upon his withdrawal from the partnership or upon liquidation of the partnership.” The Treasury Regulations further state, “[t]he mere right to participate in the earnings and profits of a partnership is not a capital interest in the partnership.” Similarly, the IRS has stated in published guidance that 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.” That guidance also states that the “determination generally is made at the time of receipt of the partnership interest” It concludes by stating that a “profits interest is a partnership interest other than a capital interest.”
Under Code Section 83, when property is received in connection with the performance of services, the recipient will recognize taxable compensation income in an amount equal to the excess, if any, of the fair market value of that property over the amount paid for that property. Property includes a partnership interest. The interesting (and slippery) issue is the determination of the fair market value of a partnership interest. As stated above, a capital interest is, by definition, an amount equal to fair market value assuming a liquidation of the partnership at such time. As a result, its fair market value cannot exceed that liquidation value. The profits interest is an interest in the partnership’s future value, if any, above the current liquidation value. As will be discussed below, the receipt of a profits interest in exchange for providing services to a partnership is generally not treated as a taxable event to either the partner or the partnership unless the profits interest relates to a substantially certain and predictable stream of income from partnership assets or if the profits interest is disposed of within two years of receipt. Each of those situations is indicative of a value above and beyond the liquidation value.
2. Carried Interest Granted at Inception of Fund – Only a Profits Interest
At the inception of a venture capital fund, no investments have yet been made. The fund is a “blind pool.” In fact, in most cases, no capital has even been drawn down from investors. Since there are no assets to liquidate, there is no capital interest (or, the capital interest has no value).
Now assume all capital has been drawn down. The general partner’s carried interest would still only be a profits interest. The general partner would also have a capital interest, but that interest would not be attributable to its 20% carried interest. That is, if the general partner contributed $1 million to a $100 million fund and it liquidated immediately thereafter, the general partner would be entitled to $1 million in distributions from the fund (and this would be its capital interest). Since the fund only held cash at that point, there would be no gain or loss to allocate to the general partner. As a result, the carried interest (a 20% share of the fund’s profits) would be only a profits interest.
Further, since the general partner paid $1 million for the capital interest, the general partner, upon receipt of that capital interest, would have no tax liability (since there would be no excess between the fair market value of the capital interest which is defined by reference to its liquidation value and the amount paid for such interest). The capital interest takes into account the actual fair market value of the assets that would be realized if all of the fund’s assets were liquidated – whether that value is realized or unrealized at the time – but it does not take into account value above and beyond that which could be realized if the assets were liquidated currently.
If, however, the carried interest were granted at a time when the fund’s portfolio companies had appreciated value, then a portion of the carried interest received at that time would be a taxable capital interest (see Part I.C.3. below). For example, assume all capital has been drawn down and invested before the general partner was granted its carried interest. Assume further that the investments had appreciated in value from $10 million to $12 million. The general partner’s carried interest would now consist of both a profits interest and a capital interest. If the fund could sell the securities immediately upon granting the general partner its carried interest for $12 million, the general partner would recognize 20% of the $2 million gain or $400,000. That $400,000 would be the capital interest portion of the carried interest and would be subject to tax at ordinary compensatory tax rates. The profits interest portion of the carried interest would be any profits that ultimately could be earned above and beyond the $400,000. The profits interest, therefore, is the portion of the partnership interest that constitutes what could be earned by the partnership in the future – beyond what could be realized if the partnership were to liquidate currently. It is an inchoate value, dependent in part on the partners’ ability to build value in the portfolio companies held by fund in the future.
The $64 million question in partnership tax law is how that inchoate profits interest should be valued upon receipt, or whether it should be taxable at all. When the profits interest relates to a substantially certain and predictable stream of income from partnership assets, such as income from high-quality debt securities or a high-quality net lease, or if the profits interest is disposed of within two years, the IRS has indicated that a current liquidation value approach is not necessarily appropriate. But if the income stream is not substantially certain and the interest is not disposed of within two years, and if the profits interest was received in exchange for the provision of services to the partnership, then the IRS would not treat such receipt as a taxable event. Proposed regulations have affirmed this result, though through a different mechanism, by allowing taxpayers to elect a “liquidation value” safe harbor for purposes of valuing profits interests in these situations, effectively resulting in zero tax.
It is understandable that Congress, the IRS, Treasury and, for the most part, the Courts have opted not to tax a service partner upon receipt of a profits interest. Sound tax policy does not always equate to the highest tax. Congress, the IRS and Treasury historically have understood what it would mean to tax a profits interest that is granted to a service provider partner. They have understood that imposing tax on value that might be generated in the future as the result of services that might be performed in the future would amount to a tax on unrealized human capital. The expectation of the value that might be generated by services that might be performed in the future is what accords value to the profits interest of a service partner. Sound tax policy avoids taxing that expectation. In certain cases, it would result in a form of involuntary servitude, where services continued to be provided in order to recoup the tax cost of the grant. It would be like taxing a teacher upon receiving tenure or a police cadet upon graduation for future services to be performed by such person. Further, the value of the profits interest is unique to the service provider. If the service provider were to transfer the profits interest to an unrelated third party, then it is questionable whether the service provider would have the same incentive or ability to build future value in the partnership.
3. Carried Interest Granted During Term of Fund – Profits Interest/Maybe Capital Interest
If a venture capitalist is granted a portion of the general partner’s carried interest during the term of a venture capital fund, that carried interest likely will comprise both a capital interest and a profits interest, as described above. As a result, if the carried interest is transferred among venture capitalists, or to a new venture capitalist member of the general partner, then a taxable event likely will occur.
During the term of the fund, some portfolio companies may appreciate in value. Even if this value is unrealized and will generate realized profits for the fund in the future, this value does not constitute a profits interest. Rather, because this value would be realized if the fund were to liquidate, these unrealized profits constitute a capital interest. As a result, if that capital interest is transferred in connection with the performance of services (e.g., as the result of a transfer of carried interest when unrealized appreciation exists in the portfolio), the transferee generally will recognize taxable compensation income in an amount equal to the excess, if any, of the fair market value of that capital interest over the amount paid for such interest.
Certainly, such a carried interest will also have a “profits interest” component, and that component will not be subject to tax as described above under current tax law. But it is critical to note that the carried interest can also include a capital interest component with a value that is subject to taxation as compensation income upon receipt.
4. Interaction with Code Section 83
Under Code Section 83, the receipt of property in connection with the performance of services is taxable as compensation income in an amount equal to the amount by which the fair market value of that property at the time of the transfer exceeds the amount paid for the property. If, however, the property is subject to a “substantial risk of forfeiture” such as the vesting restrictions that typically apply to carried interest received by venture capitalists, then the property is not treated as transferred for tax purposes until the risk of forfeiture lapses. In that case, the amount of compensation income (if any) would be based on the then fair market value of the transferred property as of the time that the risk of forfeiture lapses (i.e., when the carried interest vests). The carried interest granted to most venture capitalists is subject to some type of vesting restrictions.
Although vesting provisions have the effect of deferring the tax liability arising from a compensatory transfer until a later date, this deferral is more likely to result in a higher tax liability for the recipient. For example, if the fund’s portfolio companies increased in value over that time, then the carried interest would have a higher liquidation value at that later date and a part of the carried interest would not be a profits interest, but would constitute a taxable capital interest. Taxpayers are entitled, however, to make an election under Code Section 83(b) to have the taxable event for the receipt of unvested property determined as of the date the property is issued, rather than the later vesting date. Although the IRS has stated that a Section 83(b) election need not be made upon a service provider’s receipt of a profits interest, many venture capitalists still make Section 83(b) elections because (1) the guidance is not applicable if the interest is disposed within 2 years (or the other qualifications discussed above regarding the taxation of a profits interest generally) and (2) the proposed regulations would require a Section 83(b) election in order to avoid treating the vesting as a taxable event.
If a Section 83(b) election is made, then the tax treatment of the carried interest upon grant will require the inclusion in income of the difference, if any, between the price paid for the capital and profits interests and the fair market value of those interests at the time of issuance (determined without regard to the vesting restrictions).
As stated above, if the carried interest is granted at the inception of the fund, this is likely to result in no income inclusions. It very well could result in income inclusions if the carried interest is granted after the fund has made investments in portfolio companies.
Consistent with the treatment accorded to profits interests generally (as described above), the proposed regulations provide a “liquidation value” safe harbor for valuing a partnership interest, assuming that the same conditions described above are met. Under this safe harbor, the value of a partnership interest is the amount that would be distributed in respect of that interest if all partnership assets (including goodwill) were sold for fair market value, all liabilities paid, and the remaining amounts distributed in accordance with the terms of the partnership agreement.
D. Taxation of Carried Interest As a Result of Fund Operations
1. All Income, Gains and Losses Must be Allocated Annually
Because a partnership is a flow-through entity for U.S. tax purposes, it is not taxed at the entity level. Instead, each partner of the partnership is taxed on his or her share of each item of income, gain, loss, deduction or credit of the partnership, regardless of whether or not the partnership actually distributes any cash to the partners. The entire amount of income or loss for any taxable year must be allocated to the partners on an annual basis.
2. Flow-through Tax Treatment to Partners
Once it is determined that the general partner is a partner of the fund and that the venture capitalists are partners of the general partner (as described in more detail below) and assuming that the venture capitalists have made Section 83(b) elections if their carried interests are subject to a substantial risk of forfeiture, then the partnership tax rules of subchapter K of the Code apply to determine how the venture capitalists should be taxed. As such, the partnership is treated as the owner of property and the earner of income and gains generated by the fund, and the partners are subject to tax on their “distributive shares” on an annual basis. Under Code Section 702(b), the character of each item of income, gain, loss or expense flows through to the partners. The partners are allocated and pay tax on such items in accordance with the “substantial economic effect” provisions of Code Section 704(b). These rules ensure that each partner’s tax allocations reflect each partner’s economic entitlement from the fund.
3. Overview of Partnership Taxation as Applied to Venture Capital Funds
A venture capital fund’s operations are straightforward. In its early years, the fund makes investments in portfolio companies and pays expenses. It might have some nominal interest income earned on partners’ capital during the short time between the draw down of capital and investment in portfolio companies or payment of expenses. In the first three to five years, however, the fund likely will generate a net loss from expenses, and these cumulative net losses generally will be allocated to all partners in proportion to their capital contributions.
When portfolio companies are sold at a gain, the net profit typically first is allocated in proportion to the partners’ capital contributions to “reverse” the net losses previously allocated to date (though in some cases, the economic arrangement is such that expense allocations are not reversed). Thereafter, the cumulative net profit typically is allocated 20% to the general partner and 80% to all partners in proportion to the partners’ capital contributions.
The allocation provisions included in the governing documents of many venture capital funds comply with the Code Section 704(b) safe harbor for substantial economic effect. They provide for capital accounts to be maintained in accordance with the capital account maintenance rules set forth in Treasury Regulations; they provide for liquidating distributions to be made in accordance with positive capital account balances; and they require deficit capital accounts to be restored and/or the limited partnership agreement includes a “qualified income offset” provision. Other venture capital funds liquidate in accordance with the regular distribution provisions contained therein, and allocate in accordance with each “partner’s interest in the partnership.”
Most venture capital funds invest only in stock and securities of start-up and growth companies for long-term appreciation. These companies generate very little current income such as interest and dividends. Moreover, most of the portfolio companies are formed as C-corporations. As a result, most venture capital funds are viewed as being engaged in “investing” activities, and not as engaged in a trade or business. This results in the expenses of the venture capital fund (including the management fee) being treated as a Code Section 212 expense, limited under Code Sections 67 and 68 and not deductible by taxpayers who are subject to the alternative minimum tax regime.
In short, the vast majority of partnership allocations to venture capitalists consist of long-term capital gain or loss and non-deductible expenses. Because the expenses likely are non-deductible and likely subject venture capitalists to taxation under the alternative minimum tax regime, the venture capitalists’ effective tax rates likely are higher than the long-term capital gain rate.
Furthermore, because of the economic arrangements with their limited partners, most venture capitalists are not entitled to receive distributions of carried interest until long after they have paid tax on it. The venture capitalists must pay tax on 20% of the fund’s cumulative net profit as it is realized, but generally do not receive carried interest distributions until the fund has returned its investors contributed capital. It is unlikely, however, that the fund will return all contributed capital to its investors until late in the fund’s term. That is, before the general partner is entitled to receive carried interest with respect to profitable investments, all contributed capital – including contributed capital used to purchase investments that have not yet been sold – must be returned to investors. In effect, this results in “reverse deferral,” or an acceleration of the venture capitalists’ taxation (as compared to their receipt of cash), requiring them to negotiate for tax distributions from the fund so that they have at least enough cash to pay their taxes.
The partnership structure, unlike the corporate structure, permits this type of flexibility. It allows different types of items of income to be shared in varying ratios, and permits different partners to receive distributions in varying ratios over the term of the fund. This flexible structure is a key component in achieving the appropriate economic incentives to match the entrepreneurial risks taken by the parties.
II. Sound Tax Policy Should Encourage and Reward Entrepreneurial Risk.
A. Compensatory Partnership Interests are Analogous to Other Forms of Equity Compensation
The media has a compelling sound bite. Why do investment fund managers pay tax at 15% on their carried interest when investment bankers and public company CEOs pay tax at 35% on their annual bonuses? Each of those amounts presumably reflects performance-based compensation.
The media poses the wrong analogy. It should compare the venture capitalist to Bill Gates when he pays tax at 15% upon sale of his Microsoft stock; to “Mom and Pop” sole proprietors when they pay tax at 15% upon their retirement sale of the corner drugstore to CVS; and to the founder of a cable communications company formed as an LLC when he pays tax at 15% upon sale of his LLC interest to Comcast (even if, in each case, such business owner’s share of the profits are disproportionate relative to the capital that he and his financial backers contributed). Few are troubled by these transactions – and, in fact, each of these transactions advances important tax policy considerations discussed below.
Bill Gates, for example, is a household name today based as much on his great wealth as on the industry he helped create. At one point, however, he was a struggling entrepreneur who held corporate founder’s stock in a small start-up company Tax policy has been constructed to reward Bill Gates with a preferential tax rate when he sells that stock, in recognition of the entrepreneurial risk that he took in founding that company and in developing an industry that has significantly enhanced our economy and society. Further, no one is troubled by the fact that he can continue to sell that stock and pay tax at that preferential tax rate at a time when he possesses enormous personal wealth. The venture capitalist – whose partnership interest is almost indistinguishable from founder’s stock or a sole proprietor’s interest and whose efforts are as valuable as a corporate founder or sole proprietor – should be taxed in the same manner when the venture capital fund’s portfolio companies are sold.
As will be seen, the only distinction among the forms of ownership involves the manner in which the equity interests are valued upon their receipt. Corporate stock is valued at fair market value which, upon the founding of a company, might be quite indistinguishable from liquidation value; partnership interests are valued at fair market value assuming a current liquidation; and sole proprietorship interests are valued at zero. In the case of both corporate stock and partnership interests, current value received (whether realized or unrealized) is subject to tax. It is only the manner in which the speculative future value of the business – which is dependent, in part, on the services themselves – is determined that distinguishes the current tax treatment of compensatory stock and compensatory partnership interests. If speculative enough, the future value of the corporate entity should be as low as that of a partnership.
Fleischer states that “this quirk in the partnership tax rules [the tax treatment of a partnership profits interest] allows some of the richest workers in the country to pay tax on their labor income at a low effective rate.” He further states that “a profits interest in a partnership is treated more like a financial investment than payment for services rendered” and that “[p]artnership profits are treated as a return on investment capital, not a return on human capital.” These statements imply that partnerships are unique in this regard. This same result, however, occurs with respect to all equity compensation, regardless of whether it takes the form of stock, stock options, a sole proprietorship interest or a partnership interest. The only distinction is valuation.
To refashion the question posed by the media – why is the taxation of equity compensation different from the annual bonus to the public company CEO or the investment banker? A bonus reflects a payment for services performed within the past year and is received in cash – the value from the human capital or labor has been realized. In the case of equity compensation, the service provider “invests” its labor. The service provider agrees to provide services for a lesser guaranteed salary in exchange for value that is contingent upon the value of the business enterprise. A bonus, on the other hand, is not in exchange for a guaranteed salary; it is an additional discretionary amount paid currently in recognition of services performed during the taxable year (and, if based on stock value, is based on a stock value created within the year – over a time period that is less than that required for long-term capital gains treatment). When the business pays a bonus, its assets are depleted; the business enterprise that issues equity compensation receives the services without a reduction in its value. In fact, the service provider will be “compensated” by a third party when the equity interest is disposed, based on the value of the business at that time. This entrepreneurial risk is what distinguishes a bonus from equity compensation, and incentivizing entrepreneurial risk through tax benefits accorded equity compensation is a cornerstone of economic and tax policy.
B. Current Tax Policy of Equity Compensation Avoids the Taxation of Sweat Equity and Allows for a Preferential Capital Gains Rate
The tax policy behind taxing Bill, Mom and Pop and the Cable Guy is based on (1) not taxing human capital or labor (“sweat equity”) upon receipt of an equity interest in a business that society wants to succeed in direct relationship to that effort; (2) taxing the gains from sales of businesses that are held long-term at a preferential tax rate to encourage investment and stimulate the economy; and (3) allowing the pooling of capital and labor in the economically flexible partnership form to achieve the same benefits as in the corporate or sole proprietorship form.
This policy encourages service providers to be risk-takers – to build valuable businesses that will fuel the economy – by incentivizing them with investment of pre-tax dollars, deferral of tax and a preferential tax rate. In exchange, the entrepreneur accepts a contingent benefit; that is, only if the business succeeds will the business owner profit. The guaranteed aspect indicative of a salary is absent in equity compensation.
A different system of taxation – one that would tax a service partner upon receipt of a profits interest (or a sole proprietor or a corporate founder) based on the expected value that might be created by services to be performed in the future – would impose a tax on those services even if no value were ever received in exchange. Such a system of taxation would even result in an accountant, consultant or lawyer being subject to tax upon making partner in that person’s firm. Further, if the service partner were taxed upon receipt of the interest in anticipation of that value, then the service partner would be subject to tax even if that service partner quit providing services so that the value was never realized. Waiting to tax human capital until income is realized is a premise not only of the partnership tax structure (see Part II.B. below), but also applies to equity compensation received in the sole proprietorship and corporate context. The comparisons, of course, between realization in the corporate and partnership contexts need not be perfectly consistent since their owners are taxed under completely different systems.
In the partnership context, assume the profits of a partnership were estimated over the future 10 years, and were discounted back on a net present value basis to the date of grant of a profits interest. That value would be dependent on the services of the service partner over those 10 years. If the service partner were to sell his or her interest, then presumably the interest would have less value (and a buyer would pay less for the interest) because the service partner would no longer be incentivized, or might not be able, to provide those services. In other words, receipt of an interest in the business for which the services are being performed – and which will create the value in that business – reverts back to valuation. If, instead, cash were received by the service partner, the value would be easily determinable.
Fleischer proposes that, although the valuation measurement concerns upon grant of an equity interest are sizable, that should not prevent taxation as the services are performed or as the value accrues. Such a proposal, however, would result in concerns over liquidity (for purposes of paying the associated tax) as well as complexity. Moreover, since values that are unrealized likely will fluctuate over time, taxation on this unrealized basis will exacerbate the liquidity concern and deductibility issue inherent in the current taxation of compensatory capital interests and corporate stock. This could result in equity compensation being less attractive to service providers. Such a proposal also does not make sense from a tax policy perspective if it is limited to carried interest, since Bill, Mom and Pop and the Cable Guy should be taxed similarly.
C. Current Tax Policy Treats Compensatory Profits Interests Consistently with other Forms of Equity Compensation under the Aggregate Theory
A well-settled principle of partnership tax law is that a partner should be taxed as if the partnership’s income, gain, loss or expense had been earned or incurred by an aggregate of individuals, rather than as an entity. Although this “aggregate” theory of partnership taxation exists in conceptual tension with the “entity” theory – since the timing and character of items of partnership income, gain, loss or expense are determined by reference to the timing and character at the partnership level – the ultimate tax results to a partner and a sole proprietor should be consistent. As discussed above, a sole proprietor would not be taxed on the value of his business that is attributable to his labor until the business generates a profit or is sold.
Since 1916, partners have been required to include their shares of partnership income on their individual tax returns, and since 1932, the term “partnership” generally has included a syndicate, group, pool, joint venture, or other unincorporated organization through or by means of which any business, financial operation, or venture is carried on and which is not a corporation or trust or estate. Today, most such unincorporated business entities can “check the box” or elect to be classified as a partnership or corporation for U.S. federal income tax purposes.
Under subchapter K of the Code, partnerships function as the earner and owner of income produced by the pooled capital and services of its partners. Rather than analyzing under common law principles whether there has been an “assignment of income” among the owners, subchapter K provides that partnership income, gain, loss and expense is allocated among the partners according to their distributive shares. Under those rules, the agreement of the partners, rather than the assignment of income doctrine, determines how partnership items are shared among the partners. Subchapter K merely (but importantly) requires that the tax allocations reflect each partner’s economic entitlements as determined by the partners contractually. It further dictates that the tax character of each item allocated to it is determined at the partnership level. This flexibility in economic sharing, and the flow-through tax treatment of partnerships generally, provides a powerful tool for incentivizing and rewarding partners based on their varying contributions to the business entity. To decide now to change the rules that have been in effect since tax partnerships have existed, and to provide for recharacterization of those tax items, should be considered in light of the effect on all partnerships, not just private investment funds. Neither should any such change be effected without considering the potential consequences to the intricately related provisions of subchapter K.
Subchapter K has been constructed to reflect that the partnership does not incur an entity-level tax like a corporation. Similarly, the rules and regulations of Subchapter C have been constructed to reflect the fact of entity-level taxation. While this seems an obvious point, the conclusion follows that there will not be full identity of tax consequences to owners of one form of business and another. Among many other differences (but one that is important for this analysis), a C-corporation does not enjoy a preferential capital gains rate. As a result, while pooling of labor and capital can certainly be accomplished in either partnership or corporate form (and even in sole proprietorship form, through the use of debt), the partnership tax construct, over its complete history, permits those pooling parties to determine the sharing of profits thereon – profits derived from both financial capital and human capital – to be shared as those parties agree reflects their relative contributions and for the timing and character of such profits to be determined at the partnership level.
As shown above, the only real distinction regarding the treatment of compensatory equity interests received in any form of business entity is valuation. Consistent across all of these forms of business entity, however, is an overarching tax policy that human capital that is invested into a business not be taxed until realized, where realization is determined by reference to the tax construct developed under the form of business entity chosen.
D. Alternative Approaches Disregard this Tax Policy and/or Create Unnecessary Complexity
1. Gergen Approach
Although he does not necessarily favor it, Fleischer presents the Gergen Approach as a reform alternative. The Gergen Approach would continue to treat the issuance of a partnership profits interest as a nontaxable event, but it would treat any allocations to a service provider partner as ordinary income.
Fleischer does not analyze why the service partner should be treated differently than the corporate founder or the sole proprietor. In each of those cases, the service provider would be afforded long-term capital gain treatment when his or her equity were sold. But if that equity were held through a partnership, the Gergen Approach would change the character of the income to ordinary compensation income. Given that partnership theory has long held that the character of income is to be determined at the partnership level and taken into income by its partners as if each had recognized such income individually, there does not seem to be a valid tax policy reason for treating service provider partners in a different manner.
Further, the ensuing complexity seems more than unnecessary. For example, if recharacterization occurs, would the recharacterized income be treated as ordinary income like interest income, or as compensatory service income? Would this also create a deductible expense? If so, would allocation to all partners, including the general partner, be permitted? How would the mechanical capital account provisions account for this, and how would these rules interact with Code Section 83? Would allocable expenses from an investment partnership now be treated as deductible business expenses? What if cash distributions exceed basis – are those also recharacterized as ordinary income? What if the fund itself is sold – are those capital gain transactions also recharacterized as ordinary income? If there are losses, presumably those are capital losses? Each of these questions is further complicated if there are non-U.S. members of the general partner.
With any thought, no venture capitalist would agree to this arrangement. At a minimum, the service provider partner would opt to receive a fee from the institutional investors which – if payable at a time similar to carried interest distributions – would be taxed after the associated allocation, resulting in tax deferral beyond that which currently exists for most venture capitalists (since carried interests distributions are generally delayed until investors’ contributed capital has been returned). With a little more thought, new structures would be introduced. For example, partnership options or nonrecourse loans from investors might result in tax efficiency for venture capitalists.
There is no doubt, however, that this would have a stifling effect on entrepreneurial endeavors. Some venture capitalists will move to more stable, less risky enterprises. This will result in a lower supply capital available to start-up companies, and increased costs of capital to them. Some venture capitalists will charge their investors a higher guaranteed management fee, thereby providing less incentive to build value in the underlying businesses. Some venture capitalists will charge a higher carried interest, resulting in lower returns to investors. This, in turn, will result in lower pensions for teachers, fireman, plumbers, and all other workers benefiting from the public and private pension plans that invest in venture capital. It will result in lower returns for universities, resulting in higher tuition and less available financial aid. It will result in lower returns for private foundations and endowments, resulting in less funding for research and the arts. It will result in lower returns for insurance companies, resulting in higher premiums. Some institutional investors, instead of investing in higher-cost investment funds, will invest in lower-cost non-U.S. managed funds. This could cause the U.S. to lose its critical competitive advantage on the world stage of innovation- and knowledge-based industries.
As a matter of tax policy, it appears that the Gergen Approach asserts that sweat equity should not receive the same preferential long-term capital gains rate as financial equity. If that is the case, then all forms of equity compensation should be “reformed,” not just partnership profits interests. Taken to its logical conclusion, this type of tax policy would provide that an entrepreneur who invests real labor, effort and thought into a business would be forced to pay tax at ordinary income rates, but the investor who contributes cash to that business and walks away would enjoy the preferential taxation afforded long-term capital gain.
2. Forced Valuation Approach
After turning the partnership profits puzzle over and over and always returning to the one anomaly that exists – that a partnership interest is valued upon grant by reference to its fair market value assuming liquidation of the partnership – Fleischer spends about a half a page dismissing an alternative that would change this value. For this I give him credit.
Fleischer states, accurately, that to be consistent with corporate equity compensation, partnership interest valuation would need to account for the option value of the interest. He states that “[t]he problem, of course, is that given the speculative nature of the enterprise, an appraisal necessarily resorts to rules of thumb, is easily gamed, and will tend to understate the option value of the interest.” He also states that this difficulty is “especially strong in the context of venture capital and private equity funds, where the underlying investments are illiquid.” Fleischer does not acknowledge that each of these situations already exists in the corporate context, with respect to restricted stock grants. But he does mention that regardless of the technical analysis in the Diamond case, it only resulted in the partnership interest being taxed because a determinable market value was found to exist.
Consider Clients A, B and C discussed at the beginning of this article. The very nature of the venture capital industry is risk and speculation. The carried interest might have no value or it might have great value. It is near impossible to predict upon grant. Further, the partnership tax mechanical complexities would be mind boggling. Would an upfront tax result in additional partnership basis? Would there be an election to adjust the inside basis of the partnership assets to match that additional outside basis as in the case of a sale or transfer of a partnership interest? Presumably, all income, gain, loss and deduction would continue to be allocated to all the partners as is currently done. Would the losses or expenses be characterized as deductible losses or expenses to offset the earlier ordinary income inclusion? Would a positive capital account balance at the end of the partnership term result in an ordinary loss, as opposed to a capital loss?
In the end, Fleischer, like the decades of tax professionals before him – the courts, Congress, Treasury, the IRS and practitioners – realizes that the inseparable capital and profits interest that makes up a partnership interest cannot be valued in a manner that works more optimally (though concededly not perfectly) than fair market value assuming liquidation of the partnership.
3. Cost of Capital Approach. After sensibly dismissing a change to the long tax history of partnership interest valuations, Fleischer backtracks and advocates for partially taxing human (as opposed to financial) capital returns on equity as ordinary income. Moreover, he suggests doing this at a time when the return might still be unrealized. Fleischer bases his position on a flawed assertion that “we would presumably like to tax [the relative value of the returns on human capital] currently as the services are performed.” Rather, as stated above, there is a strong tax policy to avoid taxing human capital until the returns thereon are realized in a market transaction.
Under this approach, Fleischer suggests allocating an annual cost-of-capital charge to the service partner as ordinary income. He asserts that the service partner has received an interest similar to a no-interest, nonrecourse loan – the use of the financial partner’s capital has been shifted to the service partner. Since a market rate of interest is not charged to the service partner, he states that interest should be imputed and treated as cancellation of debt income, resulting in a modified form of accrual taxation. Any other gains or losses of the partnership would retain their character and be allocated to the partners as they otherwise would be allocated. While Leo Schmolka (who Fleischer credits with originating this theory) concludes that the allocations of current income in a partnership achieves this same goal, Fleischer refuses to accept the basic tenet of partnership tax law regarding realization, stating that Schmolka’s argument only “holds up” if the partnership has current income from business operations.
Fleischer asserts that this would “recogniz[e] the compensatory aspects of a partnership profits interest as ordinary income, while still offering a significant entrepreneurial risk subsidy.” Yet he is simply reverting to a system of taxing unrealized human capital. This would be similar to taxing a new partner of an accounting firm, consulting firm or law firm based on an amount lawmakers think he should earn, rather than on the amount he does in fact earn.
Fleischer does not explain why a part of a service partner’s gain from building a business should be taxed as ordinary income while that of corporate founders like Bill Gates or sole proprietors like Mom and Pop should be entitled to be taxed as long-term capital gain. Presumably, he would impose this result on the Cable Guy, just like the venture capitalist, although he provides no explanation for the anomalous treatment. In fact, he concedes that this treatment would be inconsistent with subchapter K principles, stating that it is intended to be consistent with Code Section 83 and 7872, yet fails to acknowledge that it would be inconsistent with the treatment of other forms of equity compensation.
Nor does he address the terrific complexity inherent in his proposal. As with the Gergen Approach and the Forced Valuation Approach discussed above, this proposal raises numerous questions regarding the appropriate interaction of the highly integrated partnership tax structure of subchapter K. For example, would the annual tax result in additional partnership basis? Would there be an election to adjust the inside basis of the partnership assets to match that additional outside basis? Would the regular partnership losses or expenses be characterized as ordinary losses or business expenses to offset the earlier income inclusion? Would a positive capital account balance at the end of the partnership term result in an ordinary loss, as opposed to a capital loss?
He further believes that it would provide “precious few planning or gamesmanship opportunities.” Contrary to that belief, much more thought will go into “gaming” this “reform” than that which exists (if any does) under the current system. While he states that any such plan would likely alter the underlying economic arrangements between the partners (which he presumably believes is an advantage), he does not acknowledge the devastating effect this could have on the entrepreneurial investment culture or on the constituencies that invest in those entrepreneurs.
III. Existing Partnership Tax Provisions Prevent Perceived Tax Gamesmanship
Part of the debate surrounding the taxation of carried interest seems to arise because the private investment funds industry, including the venture capital industry, is just that – private. This privacy exists because venture capital funds largely have been exempt from securities regulation and because they are sold only to highly sophisticated qualified investors that are required to make very large investments – there is no reason for the average person to cross paths with them. Privacy, however, has resulted in a lack of understanding of how venture capital funds operate and, in some cases, in an implication that tax gamesmanship activities are being hidden. As discussed in Part I, however, the venture capital fund economic and tax structure is relatively simple.
There are also perceived concerns that run along the lines of “Aren’t the venture capitalists just service providers?” “A venture capitalist’s compensation looks pretty stable and guaranteed.” “What about the “conversion” of management fees into carried interest?” “Aren’t games being played with carried interest when value does actually exist?”
These are all good questions, and they are questions that have been addressed over many years by Congress, Treasury and the IRS, and through the implementation of numerous partnership tax rules. The partnership tax rules provide a construct that the private investment funds must operate within. As complex and burdensome as it may be, the construct has permitted our technology and knowledge-based economy to be successful in creating companies and industries. To add unnecessary complexity to this in a manner that would disregard that tax policy and that would tax, contrary to most areas of U.S. tax law, unrealized human capital would be unwise.
The following sections provide a glimpse of the partnership tax construct within which venture capital funds operate, preventing perceived tax gamesmanship concerns.
A. “Partner” Classification Guidance
The partnership tax rules providing flow-through treatment of the timing, character and amount of partnership income, gain, loss or expense are predicated on such amounts being allocated to the partnership’s “partners” in their capacities as such. To the extent that the parties exist in a different relationship to one another, partnership treatment is not permitted. If, for example, the relationship reflects that of a debtor and creditor or a service recipient and service provider, the rules of Subchapter K will not apply. The courts, Congress, Treasury and the IRS have considered this to be a valid way of preventing compensatory relationships from receiving more preferential treatment in a partnership form.
The partnership tax rules governing classification of parties as “partners” allows for varying interpretations, but under any of those, general partners and venture capitalists should be viewed as being in a partner relationship with their investors. First, under Code Section 704(e)(1), “a person shall be recognized as a partner for income tax purposes if he owns a capital interest in a partnership in which capital is a material income-producing factor, whether or not such interest was derived by purchase or gift from any other person.” Furthermore, under the associated legislative history, “however the owner of a partnership interest may have acquired such interest, the income is taxable to the owner, if he is the real owner. If the ownership is real, it does not matter what motivated the transfer to him or whether the business benefited from the entrance of the new partner.”
Although Code Section 704(e) originally was intended to address family limited partnerships, there is no indication (regardless of the heading under which it falls) that the current version is limited in any way to any particular type of partnership. As a result, for a partnership, like a venture capital fund, in which capital is a material income-producing factor, one must determine whether the purported owner has a capital interest. While debate can take place over how much of a capital interest is required, if a general partner contributes 1% to 5% of the capital of a fund, this should be sufficient.
If Code Section 704(e) does not apply – for example, in the case of service partnerships or owners of a capital-intensive partnership who do not hold a capital interest – partner status is determined under case law. Under the leading cases, the courts look to “whether the parties really and truly intended to join together for the purpose of carrying on business and dividing the profits or losses or both.” The factors considered include whether the purported partner possesses a proprietary profit share, shares in venture losses, has a capital interest, has the right to participate in management, provides substantial services and is held out as a partner to third parties, in partnership agreements or on partnership tax returns.
Because of the entrepreneurial risk that general partners of venture capital funds encounter, the sharing of profits and losses, and their management of the funds, partner status should be accorded them. If, however, a general partner arranged its affairs with its investors so as to eliminate its entrepreneurial risk within the venture capital fund enterprise, then the IRS would have a solid basis for challenging the general partner’s carried interest as a partner interest, and treating it instead as generating compensatory service income.
B. Capital Shift Rules.
As discussed in some detail above, if a capital interest is transferred to a service partner, that service partner is taxed on the fair market value of that interest. This places a significant restraint on the ability of the venture capitalists to replicate a discretionary compensatory structure in place of the partner structure.
For example, assume that of the 20 “points” of carried interest received by the general partner, the four venture capitalists (who are partners of the general partner) want to hold 5 points, or 25%, each. Now assume that, in year 5, the four venture capitalists would like to rearrange the carried interest sharing percentages in order to reward one of the partners, Partner X, who provided greater services to the partnership over those years. If each of three partners transferred 1 of their 5 points to Partner X, they will now hold 4 points, or 20%, each and Partner X will hold 8 points, or 40%. If, however, the venture fund has appreciated in value (so that the additional 4 points transferred to Partner X has a current liquidation value at the time of transfer), Partner X will be subject to tax on this “compensatory” capital shift.
Partner X could avoid this tax by paying the other partners for this value, or by providing for the assets of the venture capital fund to be “marked to market” so that any current unrealized value accrues in the earlier percentages. In that case, Partner X will only have received a true profits interest, not a capital interest.
This mechanism achieves certain tax policy goals. First, it supports the desire not to tax unrealized human capital by acknowledging that such a shift reflects a realization event for the increasing partner. That is, because the shifted interest has a determinable value that was granted in recognition of prior services, it has been realized in the same manner as the initial receipt of a capital interest is taxable to the service recipient partner. Second, it encourages the long-term equity holding by service providers, or at least acknowledges that shifts will risk the loss of long-term capital gains. Third, it supports the partner categorization of the partners by preventing discretionary changes to the profit-sharing ratios that reflect a compensatory relationship.
C. Section 707(a) Payments for Services by Partners.
Payments made to a partner in exchange for services to the partnership generally are treated in one of three ways under the Code currently. If the payments are made without regard to the income of the partnership, then they are treated as “guaranteed payments” under Code Section 707(c). If the payments are made with regard to the income of the partnership, but are made to a partner other than in his capacity as a member of the partnership, then they are governed by Code Section 707(a). Finally, if the payments are made with regard to the income of the partnership and in respect of such person’s partner capacity, then they are governed by Code Section 704 (along with Code Section 731).
If the payments are guaranteed payments or Code Section 707(a) payments, the partner recipient generally must include such amounts in income as ordinary compensation income. While the partnership will have an expense to allocate to its partners, the recipient partner might or might not be allocated this expense item. Further any such item might be limited in its deductibility. This could result in the partner recipient being taxed on services that partner provides to him or herself.
As a result, it is generally more beneficial for a partner to receive a payment that is not dependent on income of the partnership and that is made in a partner capacity. This will ensure that the partner is allocated its distributive share of partnership income under Code Section 704, but the actual payment is not separately taxed nor treated as an item of expense or deduction. Furthermore, if the items of income allocated by the partnership include long-term capital, then the partner will likely also be taxed, at least in part, at a lower tax rate.
Code Section 707(a)(2)(A), however, provides that “disguised partners” will not be afforded distributive share treatment under Code Section 704. The legislative history of Code Section 707(a)(2)(A) lists five factors to distinguish distributive shares from disguised non-partner service (Code Section 707(a)) payments. The most significant factor is whether the payment is subject to an appreciable entrepreneurial risk as to amount and probability of payment. Gross income allocations, because they are far more certain to be satisfied, should be heavily scrutinized according to the legislative history. Capped allocations are also suspect, although net income allocations generally are viewed as implicating entrepreneurial risk. The risk profile of the business in which the partnership engages is also relevant. Under these criteria the carried interest would be viewed as being subject to appreciable entrepreneurial risk, based on the high-risk nature of the investments made by a venture capital fund as well as the netting of gains and losses.
Other factors that are indicative of a Code Section 707(a) payment include (i) transitory partner status; (ii) allocations that are close in time to the performance of services; (iii) indication that the recipient became a partner primarily to obtain tax benefits for himself or the partnership; and (iv) the value of the recipient’s interest in general and continuing partnership profits is small in relation to the allocation in question. All of these factors support distributive share treatment under Code Section 704 with respect to a venture capital fund general partner’s carried interest.
D. Section 704(b) Substantial Economic Effect Allocation Rules.
Many of the investors in venture capital funds are tax-exempt or non-U.S. investors. This has raised concerns that the tax-exempt nature of the investors will be used to optimize the taxation of all of the partners.
Treasury regulations promulgated under Code Section 704(b), providing that all allocations of income, gain, loss or deduction have substantial economic effect, are quite effective at preventing this result. First, to the extent there is an economic benefit or economic burden that corresponds to an allocation, the partner to whom the allocation is made must receive such economic benefit or bear such economic burden. This is either accomplished by the partnership satisfying the three safe harbor requirements (capital account maintenance, liquidation per capital accounts, and capital account deficit restoration or qualified income offset) or by allocating in accordance with each “partner’s interest in the partnership.” Then, for that economic effect to be substantial, there must be a reasonable possibility that the allocations will affect substantially the dollar amounts to be received by the partners from the partnership, independent of tax consequences. Further, the economic effect of an allocation is not substantial if, at the time the allocation becomes part of the partnership agreement, (1) the after-tax economic consequences of at least one partner may, in present value terms, be enhanced compared to such consequences if the allocation were not contained in the partnership agreement, and (2) there is a strong likelihood that the after-tax economic consequences of no partner will, in present value terms, be substantially diminished compared to such consequences if the allocation were not contained in the partnership agreement. Significantly, “[i]n determining the after-tax economic benefit or detriment to a partner, tax consequences that result from the interaction of the allocation with such partner’s tax attributes that are unrelated to the partnership will be taken into account.”
The regulations then go on to discuss two types of allocation provisions that will not be treated as substantial – shifting allocations and transitory allocations. Shifting allocations result if there is a strong likelihood that (1) the net increases and decreases that will be recorded in the partners’ respective capital accounts for such taxable year will not differ substantially from the net increases and decreases that would be recorded if the allocations were not contained in the agreement and (2) the total tax liability of the partners will be less than if the allocations were not contained in the partnership agreement (taking into account tax consequences that result from the interaction of the allocation with partner tax attributes that are unrelated to the partnership).
Transitory allocations result from the possibility that one or more allocations (“original allocations”) will be largely offset by one more other allocations (“offsetting allocations”) – generally within five years and other than from offsetting allocations attributable to gain or loss from the disposition of partnership property – if there is a strong likelihood that the consequences described in (1) and (2) above will result.
The substantial economic effect regulations provide the IRS with a powerful tool for challenging allocations in partnerships whose partners have differing tax attributes. They require that any tax allocation reflect an actual economic entitlement. For this reason, the regulations also provide a strong incentive to venture capitalists to avoid spending time, money and effort on tax-gaming structures. Institutional investors, especially those not subject to tax, are not amenable to receiving a less determinate economic deal in order to achieve an optimal tax result for the taxable venture capitalists.
E. Partnership Anti-Abuse Rules
The partnership anti-abuse rules are the bazooka in the IRS’s arsenal. They are broad and far-reaching. Because the typical venture capital fund structure and economic arrangements are so straightforward, most venture capital funds (and their tax advisors) do not pay these rules much attention. But they play a significant role in deterring tax professionals from getting too fancy.
Under these rules, if a partnership is formed or availed of in connection with a transaction a principal purpose of which is to reduce substantially the present value of the partners’ aggregate federal tax liability in a manner that is inconsistent with the intent of subchapter K, the IRS can recast the transaction as appropriate to achieve tax results that are consistent. The anti-abuse regulations encompass concepts such as substance over form, the step transaction doctrine, business purpose, clear reflection of income and economic substance to give the IRS the power to challenge technical implementation of the partnership tax rules.
The regulations specifically provide that subchapter K is intended to permit taxpayers to conduct joint business (including investment) activities through a flexible economic arrangement without incurring an entity-level tax. Implicit in the intent of subchapter K are the following requirements: (1) the partnership must be bona fide and each partnership transaction or series of related transactions (individually or collectively, the transaction) must be entered into for a substantial business purpose; (2) the form of each partnership transaction must be respected under substance over form principles; and (3) generally, the tax consequences under subchapter K to each partner of partnership operations and of transactions between the partner and partnership must accurately reflect the partners’ economic agreement and clearly reflect the partner’s income.
Even though the transaction may fall within the literal words of a particular statutory or regulatory provision, it can be determined, based on the particular facts and circumstances, that to achieve tax results that are consistent with the intent of subchapter K, (1) the purported partnership should be disregarded in whole or in part, and the partnership’s assets and activities should be considered, in whole or in part, to be owned and conducted, respectively by one or more of its purported partners; (2) one or more of the purported partners of the partnership should not be treated as a partner; (3) the methods of accounting used by the partnership or a partner should be adjusted to reflect clearly the partnership’s or the partner’s income; (4) the partnership’s items of income, gain, loss, deduction, or credit should be reallocated; or (5) the claimed tax treatment should otherwise be adjusted or modified.
The facts and circumstances that are considered include: (1) the present value of the partners’ aggregate federal tax liability is substantially less than had the partners owned the partnership’s assets and conducted the partnership’s activities directly; (2) the present value of the partners’ aggregate federal tax liability is substantially less than would be the case if purportedly separate transactions that are designed to achieve a particular end result are integrated and treated as steps in a single transaction; (3) one or more partners who are necessary to achieve the claimed tax results either have a nominal interest in the partnership, are substantially protected from any risk of loss from the partnership’s activities (through distribution preferences, indemnity or loss guaranty agreements, or other arrangements) or have little or no participation in the profits from the partnership’s activities other than a preferred return that is in the nature of a payment for the use of capital; (4) substantially all of the partners (measured by number or interests in the partnership) are related (directly or indirectly) to one another; (5) partnership items are allocated in compliance with the literal language of Treasury Regulations Section 1.704-1 and -2 but with results that are inconsistent with the purpose of Code Section 704(b) and those regulations. In this regard, particular scrutiny will be paid to partnerships in which income or gain is specially allocated to one or more partners that may be legally or effectively exempt from federal taxation; (6) the benefits and burdens of ownership of property nominally contributed to the partnership are in substantial part retained (directly or indirectly) by the contributing partner (or a related party); and (7) the benefits and burdens of ownership of partnership property are in substantial part shifted (directly or indirectly) to the distributee partners before or after the property is actually distributed to the distributee partner (or a related party).
Based on the broad powers afforded the IRS in determining the relationships among the partners under these rules, there is little incentive or ability for venture capitalists to employ structures in attempts to game the partnership tax system.
The current tax system – as well as the economic reality faced by the venture capital industry – have resulted in a straightforward venture capital fund structure, and the legitimate tax policy incentives encouraged by that system have assisted in creating an enviably strong U.S. entrepreneurial economy. The current partnership tax rules provide the government with many weapons to attack any perceived tax gamesmanship in the venture capital industry – if tax gamesmanship is a concern, more draconian measures need not be implemented by Congress.
This existing tax policy, moreover, is the same tax policy that has recognized the importance of providing incentives to invest in U.S. businesses. Further, this tax policy has not differentiated between investment of financial capital and investment of human capital – returns on both are permitted to be taxed at the long-term capital gain rate. To deny this treatment to human capital, or sweat equity, would encourage workers to strip profits out of their businesses in the form of guaranteed non-profit-based salaries rather than building value in those same companies. More troublesome, it would also result in the taxation of human capital before the product of the associated labors were realized. This type of a change could have far-reaching consequences to all workers. A change to the long-term capital gain rate or the partnership flow-through taxation generally would affect even more people. Any such change should not be implemented within the isolated context of the private investment funds industry.
The only real issue left on the table, therefore, is valuation of a partnership profits interest. While it might appear attractive to value on a uniform basis all forms of equity compensation – corporate stock, sole proprietor interests and partnership profits interests – each is part of a unique tax construct. Consistency does not necessarily exist in other areas of taxation across these forms of business entities. Congress, the courts, Treasury and the IRS have expended enormous effort to date in effecting an imperfect, but optimal, solution for valuing partnership interests by reference to current liquidation value. Walking away from that is sure only to create needless complexity.