Steven C. Gustafson
GR Review

Recently there has been a fair degree of speculation in the financial press that Congress will undertake to address the taxation of "profits interests" (sometimes called "carried interests") received by managers of partnership ventures in connection with performing their management duties.  The spotlight on this strategy intensified recently with the going public transaction of the Blackstone Group L.P. and the widely reported windfall to principals which, under current law,  qualifies as income which is taxable at favorable capital gains tax rates.

Profits interests, which represent an interest in the profits of a partnership or limited liability company separate from an interest in the liquidation value or the capital of the entity, are commonly used in private equity partnerships, as well as other industries, including real estate development, venture capital, oil and gas, and small or start-up business ventures.  Under current law, rather than recognizing current ordinary compensation income, holders of profits interests are taxed as partners on their distributive shares of partnership income.  If the partnership generates long term capital gains, for instance, the holders of the profits interests are taxed on their shares of the long term capital gain. 

This practice is particularly common in private equity funds, venture capital funds, hedge funds, and similar investment partnerships, where managers receive fees in exchange for their management services and also receive a share of the upside profits in the form of a carried interest, (often a fund manager will receive a fee, such as 2% on assets under management and a profits interest, often in the range of 20% of the entity's profits; a so-called 2 and 20 arrangement).  While the management fees are taxed as ordinary compensation, the income recognized by the manager on the profits interest tends to take the form of capital gains realized as the underlying fund sells its investment assets.

News reports of recent high profile transactions point out the inherent unfairness of permitting certain industries (such as the financial services industry) to structure the receipt of compensation for personal services in a way that is so at odds with the way the rest of the labor market is taxed for providing personal services.  Whereas most of us pay ordinary tax rates (up to 35%) in connection with our personal efforts (plus related employment tax costs), highly compensated fund managers can, by structuring the major portion of their compensation in the form of profits interests, pay taxes at the much more attractive, 15% capital gains rate.

It is a strategy that just will not go away quietly however, as this type of compensation relationship is prevalent in the real estate industry, and is a common form of incentive compensation in many other start ups and small businesses.  What's more, the tax rules applied to these interests have been consistent throughout the years and proponents of the strategy argue that the risk involved in accepting an equity stake as consideration for services justifies the capital gains treatment.  Finally, there have been indications that Congress is loath to take on only one aspect of perceived inequality in the tax code in the face of so much perceived complexity and unfairness in the system and other competing legislative agenda priorities.

As a result, it seems unlikely that the legislature will be able to address this issue globally this year, although there are indications that Congress would be willing to address the taxability of profits interests in the limited context of publicly traded interests.  As a result, at least for the time being, it seems that private partnership profits interests will continue to enjoy their tax-favored status.

Steve Gustafson is the Chair of Gould & Ratner's Tax and Financial Group.  He may be reached at 312.899.1647 or via email at sgustafson@gouldratner.com.