The past several years have given rise to various forms of partnership incentive compensation, most notably profits interest, often referred to as carried interest. A carried interest is a right to participate in the future profits of a partnership. Carried interest is a common form of compensation in the alternative investment arena, i.e. hedge funds and private equity, but is also used in the health care and real estate industries. In the alternative investment area, carried interest is the performance fee paid to general partners of a PE fund or hedge fund. The typical carried interest rate is 20%. Since carried interest is tied to performance, it is an effective way for employers to recruit and retain employees.
A full discussion of the tax and financial reporting consequences pertaining to carried interest is beyond the scope of this newsletter. However, we will provide an overview of certain key issues with respect to carried interest.
AICPA Practice Aid
In 2009, the American Institute of Certified Public Accountants (AICPA) issued the Technical Practice Aid (TPA), “Allocation of Unrealized Gain (loss), Recognition of Carried Interest, and Clawback Obligations.” The TPA requires the investment fund to account for carried interest as if it was earned, at the reporting date, even if a realization event has not occurred. The AICPA goes on to say in the TPA that, “financial statements should calculate the carried interest as if the investment fund had realized all assets, settled all liabilities at their reported fair value, allocated all gains and losses and distributed the net assets to each class of investor at the reporting date.”
Most funds require the General Partner (GP) to return part or all of its prior 20% carried distributions (clawback obligation) due to the following:
- Limited Partner’s minimum hurdle return is not satisfied due to the passage of time
- Prior 20% carry allocations to GP exceed cumulative net gain because of subsequent losses
- The fund’s financial statements must reflect the clawback obligation of the GP via a reduced or negative GP capital account.
Obtaining an independent, supportable valuation of the carried interest at the time of the grant is critical, especially if the value of the carried interest is later challenged by the IRS. Our valuation professionals generally use a discounted cash flow approach (DCF), or an option pricing model to value carried interest. In using the DCF model, we forecast the fund’s inflows and outflows from the GP perspective. Outflows are capital calls, and inflows are returns of and on capital and carried interest. For the DCF model, the major inputs are as follows:
- Overall fund performance (either expressed as a multiple or an internal rate of return (IRR))
- The pace of investment and capital calls (either contractual or estimated)
- Distribution waterfall (detailed in the fund agreement)
- Discount rate
The overall fund performance and discount rate are critical factors, which can be difficult to support. We generally look at 1) past performance and prior funds of the same family (which gives us an idea of how well the GPs generate a return) and then make adjustments if necessary; or 2) industry data (historical returns on funds with the same target — LBO, early-stage, VC, etc.).
Revenue 93-27 provides guidance for the treatment of profits interest for services provided to or for the benefit of the partnership. According to Rev. Proc. 93-27, the transfer to a service provider of a pure profits interest in a partnership in exchange for services provided to or for the benefit of a partnership is not a taxable event to the partnership or the service provider unless:
- The interest relates to a substantially certain and predictable stream of income from partnership assets;
- The partner disposes of the profits interest within two years of receipt; or
- The interest is limited interest in a publicly-traded partnership under Section 7704(b) of the Internal Revenue Code (IRC).
The taxing of carried interest has become a hotly contested issue in the past few years. Congress is concerned that managers of partnerships are able to receive income for the performance of services taxed at the 15% capital gains rate, rather than the ordinary income tax rate. To address this issue, Representative Sander Levin introduced the H.R. 1935 bill in 2009. Under the proposed legislation, carried interest compensation received by investment fund managers would be treated as ordinary income rather than capital gains. As a result, the managers of investment partnerships who receive carried interest as compensation will pay regular income tax rates rather than capital gains rates on that compensation.
While the Bill was passed by the House of Representatives, it has not been passed by the Senate. If the legislation is eventually passed, it will be a fundamental change in partnership taxation.
The valuation professionals at VRC have experience valuing carried interest. For more information, contact your VRC representative.