On July 31, 2020, the Internal Revenue Service and the U.S. Treasury Department issued ‎Proposed Treasury Regulations (the “Proposed Regs”) providing guidance under the ‎‎“carried interest” rules of Section 1061 of the Internal Revenue Code of 1986, as amended ‎‎(the “Code”).  Please see our Quick Study “IRS Issues Carried Interest Guidance” for more detail.‎

For those working in the compensation area, and especially in the private equity portfolio world, the Background and Overview section of the Proposed Regulations introduced a brief but interesting discussion of the interaction of “applicable partnership interests” or “APIs” subject to the Proposed Regulations as compared with “profits interests.”

Revenue Procedure 93-27 (1993-2 C.B. 343) defines a “profits interest” and provides a safe harbor under which the IRS will not treat the receipt of a profits interest as a taxable event for the partner or the partnership if certain requirements are met. See also Revenue Procedure 2001-43 (2001-2 C.B. 191), which, among other things, provides a deemed election under Section 83(b) for certain profits interest awards. Section 1061 applies to all partnership interests that meet the definition of an API, regardless of whether the receipt of the interest is treated as a taxable event under Revenue Procedure 93-27. Accordingly, the regulations note that taxpayers should not equate an interest that meets the definition of an API with an interest the receipt of which would not be treated as a taxable event under Revenue Procedure 93-27.  As a result, the following should be noted:

  • Revenue Procedure 93-27 applies to a person who receives a profits interest for the provision of services to or for the benefit of a partnership in a partner capacity or in anticipation of being a partner. Section 1061 applies to partnership interests transferred or held in connection with the performance of substantial services in an applicable trade or business or “ATB” that is subject to Section 1061.
  • The proposed regulations address only the application of section 1061 and should not be interpreted as providing guidance regarding the application of Revenue Procedure 93-27 to transactions in which one party provides services and another party receives a seemingly associated allocation and distribution of partnership income and gain.
  • Although a financial instrument or contract may be treated as an API under section 1061, a financial instrument or contract is not an interest in a partnership for purposes of Revenue Procedure 93-27, unless it is otherwise treated as a partnership interest for Federal tax purposes. The Treasury Department and the IRS note that arrangements that are not partnership interests for Federal tax purposes are not eligible for the safe harbor described in Revenue Procedures 93-27 and 2001-43.

The aforementioned discussion supports the general proposition that “profits interests” granted to management teams of private equity portfolio companies are generally not APIs.  See Proposed Reg. Section 1.1061-2(b)(2), example 6, which should mean that managing the assets of an operating business are not specified services. (A is the manager of a hardware store. Partnership owns the hardware store, including the building in which the hardware business is conducted. In connection with A’s services as the manager of the hardware store, a profits interest in Partnership is transferred to A.  Partnership is not an ATB, and profits interest is not an API.)  In addition, even if the profits interest is held in a holdco limited liability company that owns stock of the operating business (typically an entity taxed as a C corporation), the services are not directed to the operating business but the assets held by the C corporation.