Funds (such as private equity funds, venture capital funds, real estate funds, and hedge funds) are managed by one or more fund managers (whether one or more, the “Manager”), who are responsible for managing the fund’s investments and activities in accordance with the fund’s investors’ goals. One important aspect of setting up a fund is deciding how to structure the Manager’s compensation. There is a delicate balance in offering competitive compensation to attract and retain talent, while remaining cost-effective and attractive to investors. Analyzing the tax treatment of each type of compensation can help make this decision.
Carried Interest
Carried interest, also known as profits interest, is a structure that allows the Manager to share in a portion of the profits earned by the fund (generally represented by a percentage, such as 20%). Typically, the Manager will only realize financial benefits from the carried interest if the fund surpasses a minimum return for investors or achieves a hurdle rate. Conversely, the Manager may realize little or no financial benefits from the interest if the fund underperforms. Issuing the Manager a carried interest is generally structured to be tax-free for income tax purposes. See Rev. Proc. 93-27, 1993-2 C.B. 343; Rev. Proc. 2001-43, 2001-2 CB 191.
Revenue Procedure 93-27 provides that it is not a taxable event when a service provider (e.g., the Manager) receives a carried interest in a partnership (e.g., the fund) as consideration for services provided to that partnership. However, this treatment does not apply if: (1) the carried interest “relates to a substantially certain and predictable stream of income from partnership assets”, (2) the partner disposes of the carried interest within 2 years of receipt, or (3) the carried interest is a limited partnership interest in a publicly traded partnership. Rev. Proc. 93-27. Whether an interest is a carried interest is determined when the interest is granted, even if it is substantially nonvested, meaning it is subject to a risk of forfeiture. Rev. Proc. 2001-43.
If the Manager is issued a carried interest subject to vesting, then the Manager is considered a partner upon receipt and is generally not subject to income tax at that time or when the carried interest vests, if certain requirements are met. Id. However, the fund may have assets that are outside of the safe harbors provided by the Revenue Procedures (e.g., fixed-income assets or real estate subject to a lease that could result in substantially certain and predictable income). Therefore, when compensating the Manager with a carried interest, it is important to structure it to conform with the safe harbors. This can be accomplished by aggregating fixed-income assets with riskier assets or excluding them from the carried interest portion of the fund. The Manager will be generally taxed at the preferential capital gains tax rate, provided that the carried interest and the fund’s assets were held for more than 3 years, but will also have to pay the 3.8% net investment income tax. I.R.C. sections 1061(a) and 1411(a).
Stock-Based Compensation
Another type of compensation is stock-based compensation. Funds that are taxed as a C corporation may grant the Manager stock. Restricted stock is stock of the fund, but with restrictions on alienability that lapse upon a specific event or achievement, or over a vesting period. The Manager will be taxed on the restricted stock upon the stock vesting—not upon the initial grant—unless the Manager elects to recognize taxable income as of the date of granting. I.R.C. section 83(b).
If stock is issued for services and a section 83(b) election is made, then the recipient will be currently taxed on the fair market value of the stock award.
Restricted stock units (RSUs) represent the right to receive a specified number of shares, cash, or cash equivalents after specified vesting conditions are met. If the Manager receives RSUs, the Manager will not be treated as a shareholder until stock is actually issued. Because RSUs are not stock when granted, no section 83(b) election to tax upon the granting date may be filed. Unlike with restricted stock, RSUs must comply with or be structured and paid so as to be exempt from section 409A (i.e., paid when vested or distributed upon a permissible event, such as death or pursuant to a schedule). Failure to comply with section 409A may result in accelerating income recognition for deferred amounts that are no longer subject to a substantial risk of forfeiture and the imposition of additional tax and penalties. I.R.C. section 409A(a)(1)(A)(i).
Generally, stock options are granted with a specified vesting period and give the Manager the right to buy stock at a specified price. If it qualifies as an incentive stock option (ISO), then it is only taxed when the Manager sells the shares acquired through exercising the option. If the Manager held the shares for at least two years from the date of receiving the option and one year from the transfer of the shares, then any gain is taxed at long-term capital rates. I.R.C. section 422(a)(1). To qualify as an ISO, careful compliance with section 422 is required. For example, only employees are eligible to receive ISOs and there is a $100,000 per year, per employee limitation. I.R.C. section 422(a), (d)(1). Stock options that do not qualify as ISOs are non-qualified stock options and do not have the strict compliance requirements, but do not qualify for favorable capital gains tax rates. Instead, they are taxed at ordinary rates upon exercising the option.
Phantom stock is a hypothetical (i.e., phantom) award of shares, which is essentially a promise to pay a service provider the value of the fund’s stock at a certain point in time or upon the happening of a certain event. It is not taxable upon grant, but the Manager will be taxed at ordinary income rates when the phantom stock is cashed out. Similar to RSUs, because phantom stock is a commitment to pay cash in the future, it is important to design the phantom stock award to be exempt from or comply with section 409A (e.g., paying the phantom stock award when it vests or upon a section 409A permissible event).
Recent Developments
In recent months, lawmakers and the current administration have discussed potential legislation that would remove a supposed “tax loophole” with respect to carried interests. As mentioned above, fund Managers who receive a carried interest are generally taxed at long-term capital gains rates if the interest is held for more than three years. Thus, the highest earners would pay 20% capital gains plus the 3.8% net investment income tax for a total of 23.8% (whereas the current highest tax rate for regular income is 37%). Critics have argued that Managers should instead be taxed at regular income rates on any carried interest.
Takeaway
Balancing investors’ goal of maximizing returns on investment with the need to obtain and retain top talent is a delicate balance, which is only made more complicated with the addition of tax benefits and tax consequences. These competing goals are evident in tax regimes such as Revenue Procedure 93-27’s requirements to have carried interest not be a taxable event and section 409A’s vesting requirements to prevent acceleration of income recognition. Yet another complication are the recent discussions by policymakers surrounding fund Managers and their compensation – it will be vital over the next few months and even years to see if any actual changes are brought about.
Fund managers interested in learning more about their options and the most suitable form of compensation for their fund should consult with a tax professional to tailor the most efficient plan and ensure compliance with the tax statutes and regulations.
