Get Out The Backpacks: Carried Interests Must Be Carried For Longer

On December 22, 2017, a sweeping tax reform bill (the "Tax Reform Act" or the "Act") was signed into law.1 Stroock has already released a Special Bulletin covering the implications of the Act generally.2 This Stroock Special Bulletin focuses on how the Act changes the treatment of a so-called "carried interest" and how these changes may affect the ability of a recipient of a carried interest to recognize long-term capital gain on the disposition of such interest, or a disposition of the assets held by the entity with respect to which the carried interest is issued. Carried interest programs have been the subject of media and legislative attention over the years and, despite multiple congressional efforts to eliminate the carried interest benefit, the Tax Reform Act represents the first meaningful change in the tax law applicable to such arrangements.3 As described in further detail below, the Tax Reform Act changes are unlikely to minimize the traditional use and/or practice of many common carried interest arrangements. Nevertheless, clients and friends of the firm would be wise to consider their existing practices and forward planning carefully in light of these changes, particularly with respect to exit and disposition strategies.

Background: Carried Interest

A carried interest generally is an interest received by a general partner, sponsor, manager, employee or other service provider in the future profits of an entity treated as a partnership for U.S. federal income tax purposes. Carried interest arrangements have traditionally raised some technical issues under the Internal Revenue Code — namely whether they should be treated under the tax rules governing the transfer of property in connection with compensation, or whether they should be treated under the regime governing partnerships. While a detailed discussion of this debate is beyond the scope of this Stroock Special Bulletin, many practitioners have worked with both regimes when dealing with carried interests programs because not all arrangements necessarily "fit" within one or the other neatly or completely.

A starting point for present purposes is relief granted by the Internal Revenue Service (the "Service") addressing the grant of a bare profits interest held for at least two years. Subject to certain conditions, the Service ruled in 1993, as expanded in 2001, that the service provider may receive a profits interest without recognizing U.S. federal income tax at the time of the grant — or later vesting.4 (Many carried interests are subject to either time based or performance based vesting conditions). These Revenue Procedures have been utilized by many practitioners to structure carried interest arrangements to avoid the receipt of a compensatory profits interest resulting in U.S. federal income taxation at the time of the grant — or vesting.5 Following the guidelines outlined by these authorities, many practitioners have concluded that carried interest arrangements could be structured so that the service provider would be treated as a partner of the partnership with respect to its carried interest, as of the date of the grant thereof, and would be allocated and recognize income, gain, losses or deductions with the same character as reported by the partnership.

Of course, not all fact patterns fit squarely within this guidance, and many practitioners continued to treat the grant of such unvested awards as a possible transfer of compensatory property, as to which Section 83 of the Internal Revenue Code of 1986, as amended (the "Code") could be applicable. In such circumstances, many practitioners have advised making prophylactic Section 83(b) elections which permit a taxpayer to include the value of unvested property (in this case, arguably, the "property" being the unvested profits interest) received at the time it is granted. In this way, the recognition event for U.S. federal income tax purpose would occur...