Category Archives: Compensatory Property Transfers

When is a Rose Not a Rose? IRS Tries to Plug Carried Interest Loophole by Claiming Roses are Not Flowers

The sweeping tax law passed in December requires partners holding some “carried interests” (partnership interests disproportionately large as compared to the relative capital contributed) to recognize gain at ordinary income tax rates (up to 37%) if their holding periods do not exceed three years, as opposed to the one-year holding period normally required to qualify for 20%-tax-rate long-term capital gain. The idea is that these interests are associated with services — often performed by hedge fund and private equity managers — that don’t carry the investment risk associated with a normal capital asset, and therefore holders of these partnership interests should have to own the interests longer to qualify for a low tax rate.

The statute categorically exempts partnership interests held by “corporations” from the new rules. Without explanation, the IRS announced this week it will take the position that “S corporations” are not “corporations” for the purposes of the carried interest law, even though by definition the opposite is true throughout the Internal Revenue Code. Their interpretation is akin to claiming roses aren’t flowers.

There are common sense reasons why S corporations should not be exempt from the carried interest statute. Because S corporations are pass-through entities, there is no practical difference between an individual owning a carried interest directly, as opposed to owning it through an S corporation. Yet read literally, the statute produces different results in these practically comparable situations.

Still, statutes are supposed to mean what they say. S corporations are corporations, just like roses are flowers. Unless Congress changes the statute, the Internal Revenue Service may have a hard time defending its position in litigation.

See our prior discussion of the new carried interest law:

E. John Wagner, II

Tax Reform Swings a Hand Ax at Carried Interests; What Does it Mean and How Can I Plan Around It?

While tax reform has a long march before becoming law, the amended House of Representatives bill passed yesterday swings an ax at lower-tax-rate-capital-gain-eligible “carried” partnership interests, though it swings a smaller ax—like a hand ax rather than a full-sized ax—than proposals in years past.

This latest proposal focuses on limited industries and allows an escape hatch for interests held more than three years. Here are the details:

How Do I Know if I Have a Carried Interest, and Why are Carried Interests Special?

The phrase “carried interest” applies to a partnership interest granted to a partner for services.  The idea is that the capital-investing partners “carry” the service partner, who does not make a capital contribution in proportion to the service partner’s interest.

Partnerships often structure carried interests to have little or no value at grant, causing the recipient to recognize little or no wage or other compensation income at that time.  Later, if the partnership recognizes long-term capital gain, the partnership allocates part of that gain to the service-providing partner.  This results in the service partner paying tax at a tax rate as little as half the rate on wage or compensation income (approximately 20%, as compared to approximately 40%, depending on the circumstances).

Why Change the Tax Treatment of Carried Interests?

Critics complain that carried interest partnership allocations amount to a bonus that should be taxed at the higher ordinary rates, like wage income and other incentive compensation.  The most vocal criticism focuses on hedge funds, private equity firms, and real estate investment firms, where critics see carried interest allocations as the equivalent of management fees.  Past Congressional proposals would have recharacterized a percentage or all partnership allocations to carried interests as compensation income, without regard to industry.

Carried interest advocates respond that many carried interest holders invest years of effort before receiving an allocation to their partnership interests, and therefore make the equivalent of an investment associated with a capital contribution.

Proposed Changes in the House Bill

The amended House bill takes a middle ground between the current law and prior Congressional proposals to curb the eligibility of carried interests for long-term-capital gain allocations. The bill focuses on carried interests in hedge funds, private equity firms, and real estate investment firms, not traditional operating businesses.

In targeted firms, the bill allows a partnership to allocate long-term capital gain to a carried interest partner who has held his or her partnership interest more than three years. If the partner has held the interest for three years or less, the proposal recharacterizes the allocation as short-term capital gain. In most cases, short-term capital gain characterization results in income taxation at the same rate as wage or other compensation income, but still allows the partner to avoid employment taxes.

It remains uncertain whether this proposal will survive reconciliation with a to-be-passed Senate tax reform bill.

Future Planning

Even if the proposal becomes law, look for motivated taxpayers to form “shelf” entities to begin the running of the three-year holding period while undertaking limited business activity. The taxpayers will then have such partnerships ready to use in the future, when a more substantial opportunity arises. Others will design hybrid debt-equity capital structures such that even service-providing partners’ interests qualify as capital interests rather than carried interests.

Read the carried interest proposal (see Section 3314 of the House amendment to the Tax Cuts and Jobs Act).

E. John Wagner, II

IRS Procures a Document Scanner, Simplifies Section 83(b) Elections

Having procured a document scanner, IRS has eliminated the requirement that taxpayers enclose Internal Revenue Code Section 83(b) elections with their income tax returns. When a taxpayer receives property (such as stock or LLC interests in an employer) in exchange for services, the taxpayer normally recognizes the fair market market value of the property as ordinary (regular tax rate) income in the year the property is transferable or is vested (i.e., not subject to forfeiture). A taxpayer can, however, accelerate recognition of income by filing a Section 83(b) election with IRS within thirty days of receiving the property. By doing so, the taxpayer can recognize the property’s value as ordinary income when first granted (when the value may be low) and start his or her long-term capital gain holding period sooner (so the taxpayer is more likely to recognize lower-tax-rate long-term capital gain on a larger portion of gain when the property is later sold). Previously, a Section 83(b) election was valid only if a copy was enclosed with the taxpayer’s income tax return for the year of the election, in addition to filing the election within thirty days of receiving the property. IRS required this because they could not match originally-filed elections with taxpayer tax returns. The absolute rule unfortunately proved a frequent trap for unorganized taxpayers who forgot to include the elections with their tax returns, even though they timely filed original elections. In recent years, some commercial electronic tax filing services had difficulty creating a means for their customers to include Section 83(b) elections with electronically filed returns. This caused some taxpayers to file paper income tax returns just to make sure their Section 83(b) elections were valid. In response to concerns surrounding this issue, IRS created a document scanning process that enables the agency to better match Section 83(b) elections with taxpayer returns, obviating the need to include the elections with taxpayers’ income tax returns. Document scanning is not a new technology. It is disappointing that common sense did not prevail long ago. The taxpayer “trap” has existed for years, but the “fix” only came about when the process became an administrative hassle for IRS. Nevertheless, the new approach is a positive step in tax administration, and we welcome the change. Here is a link to the Proposed Treasury Regulations, effective January 1, 2015:

E. John Wagner, II

Final Regulations Issued on Compensatory Property Transfers

Treasury recently finalized Regulations under Code Section 83, which governs the taxation of the transfer of property (such as shares of stock, partnership interests, options, or warrants) to persons in exchange for services. Under these rules, the taxable event to the recipient generally occurs upon the earlier of the property being transferrable or when the property is not subject to a substantial risk of forfeiture. The final regulations modify Section 1.83-3(c) to clarify that a substantial risk of forfeiture may be established “only” through a service condition or a condition related to the purpose of the transfer. In determining whether a substantial risk of forfeiture exists, both the likelihood that the forfeiture will occur and the likelihood that the forfeiture will be enforced must be considered. Also, a transfer restriction that provides for the forfeiture or disgorgement of all or a portion of the property in the event of a violation of the restriction generally does not create a substantial risk of forfeiture. Finally, the final regulations incorporate the holding of Revenue Ruling 2005-48 by providing that the only provision of the securities law that would delay taxation under Code section 83 would be if a sale of the property could subject the seller to liability under Section 16(b) of the Securities Exchange Act of 1934 (the “Exchange Act”) (which generally prevents corporate insiders from purchasing and selling corporate securities within 6 months). The final regulations add examples illustrating that a substantial risk of forfeiture is not created solely as a result of potential liability under Rule 10b-5 of the Exchange Act (relating to fraud or insider trading) or as a result of a lock-up agreement.

If you have questions regarding the final regulations or the tax treatment of granting equity interests in corporations or tax partnerships or options to acquire equity interests in exchange for services, please contact:

Michael J. Wilson