10.1.

11: Carried Interest

The award of a carried interest in profits to the general partners of a investment partnership is not deemed
by most practitioners to be a taxable event, despite the fact that the holding in a celebrated early case, Sol
Diamond,
[1]
can be read to the contrary. (The award of a free interest in capital would clearly be taxable.)
The facts in Sol Diamond were that the "carried" profits interests granted to the taxpayer had immediate
value; indeed, the taxpayer realized on the interest by selling it at a gain within weeks after the
acquisition. Tax practitioners have interpreted the Sol Diamond holding, and the Service's subsequent
inactivity, as suggesting a "liquidation value" approach to the issue; that is to say, the proper inquiry is
whether the profits interest granted on "day one" would be worthless on "day two," assuming the
partnership were liquidated on "day two." What has been troubling practitioners over the years, however,
is the fact that many of the "carried" interests in question, although they would be worth nothing if there
were an immediate liquidation, are indeed "worth" a lot of money when granted. Certainly a carried
interest in an elite investment fund might be purchased for significant cash by an astute investor in the
appropriate circumstances, even though realization depends entirely on a contingency-partnership profits-
and the same will be postponed generally until the partnership is liquidated.
[2]
Writing in 1979, eight years
after Sol Diamond, a leading commentator referred to the "mystery" surrounding the Tax Court decision
and mused:
Perhaps one reason why the Sol Diamond decision has not bothered taxpayers more is that there may
have been a nondeliberate conspiracy to disregard it in cases not involving the same tax abusive
characteristics that were present in that decision.
[3]

The plethora of investment and other funds employing the "carried interest" formula makes it likely as a
political matter that the "conspiracy" to disregard Sol Diamond will continue indefinitely. The issue
becomes sticky, however, if the individual acquiring the "carry" is also an employee of one of the limited
partners, as when a bank or bank holding company organizes an investment partnership in which it is the
sole limited partner and attempts to install one of its officers (who may wish to remain a bank officer to
protect valuable fringe benefits) as a partner with a "free" interest in profits. The risk exists that the
partnership will be disregarded and the partner/employee charged with a tax on the assignment of the
carried interest.
[4]
Some practitioners have recommended that the recipients of a carried interest make
the election under 83(b) of the Code
[5]
to limit their exposure to the date of the initial transfer; it is the
author's experience that most recipients do not do so because they do not want to admit to the possibility
that they have "perform[ed] services in connection with" the transfer.
[6]

The impact of Campbell v. Commissioner
[7]
litigation on the organization of pooled investment vehicles
was, for a time, intense and troubling. The gist of the Campbell decision in the Tax Court entailed a
litigation position by the Internal Revenue Service to the effect that the typical "carried" or "promote"
interest in an investment partnership allocated to the general partner or partners has value for tax
purposes when granted, even though no profits had eventuated as of the date of grant. The Tax Court's
opinion purported to be simply an extension of the holding and a restatement of the 1974 holding in Sol
Page 1 of 4 10.1.11: Carried Interest - Encyclopedia - Library - VC Experts
Diamond,
[8]
but the ripple effect was enormous. The property in question in Campbell, real estate, was not
marked by substantial unrealized appreciation (and was not sold shortly after the partnership was
organized). Therefore, the so-called liquidation test would not indicate any value in the "promote" interest.
Nonetheless, the Tax Court held otherwise; indeed, the "futures" characteristic of the Campbell profits
interest was underscored by the fact that it was a subordinated interest-the cash investors were to receive
a preferred return before any profits were to have accrued to the general partners.
The Campbell decision, however, was reversed by the Eighth Circuit,
[9]
not a surprising result once the
government conceded in its brief on appeal that a true profits interest, allocable to a service partner qua
his status as a partner in the partnership, is not taxable upon receipt. The government did argue that
Campbell still had incurred a tax because he had rendered his services to his employer, a 83(a) taxable
event, which employer had then allocated the carried interest to Campbell as employer/employee
consideration. The court of appeals didn't buy that argument and so held. The court then went on to
expound what the law was, citing 721 and 707(a) to buttress the proposition that an interest in future
profits, allocated for services, is not taxable upon receipt. The court distinguished Sol Diamond
[10]
by
noting that the taxpayer in Diamond "flipped" his partnership interest shortly after receipt. This lines the
court of appeals' opinion up with the practitioner consensus prior to Campbell, focusing on the fact that
Campbell's interest in profits, though it had some value, was nonetheless speculative.
[11]

Perhaps the final word on the subject, for now at least, was spoken in 1993 when the Internal Revenue
Service published Revenue Procedure 93-27 providing that: "[i]f a person receives a profits interest to the
provision of services to or for the benefit of a partnership in a partner capacity or in anticipation of being a
partner, the Internal Revenue Service will not treat the receipt of such an interest as a taxable event for
the partner or the partnership." Revenue Procedure 93-27 does leave an open point, further stating that:
this revenue procedure does not apply ... [i]f the profits interest relates to a substantially
certain and predictable stream of income from partnership assets, such as income from high-
quality debt securities or a high-quality net lease.
The obvious question provoked by the reserved language is whether a given private investment
partnership, which does not contemplate a preferred return to the cash investors
[12]
and which requires
substantial upfront contributions, is throwing off a "substantially certain and predictable stream of
income"-for example, a partnership in which, contrary to current custom, the investors put up most of
their capital at the outset and the general partners, therefore, are recouping interim profits from what
amounts to a money market fund.
[1]
56 T.C. 530 (1971), aff'd, 492 F.2d 286 (7th Cir. 1974).

[2]
A 1983 U.S. District Court decision, St. John v. United States, 84-1 U.S. Tax Cas. (CCH) 1 9158 (C.D.
Ill. 1983) contains a suggestion that a profits interest is subject to taxation under Internal Revenue Code
83 at the time it is no longer subject to a substantial risk of forfeiture; but the value of the profits interest
on the facts in that case was zero, using the liquidation value approach.
[3]
Willis, Partnership Taxation 49 (Supp. 198 1). The facts of Sol Diamond indicate that, had the
partnership been liquidated on the day the "carried" interest was awarded, the beneficiary of the "carry"
would have realized value based on the built-in value of the assets transferred to the partnership. If, as is
the case in the typical PIV, only cash is contributed on organization, a test which looks at liquidation value
Page 2 of 4 10.1.11: Carried Interest - Encyclopedia - Library - VC Experts
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of the GPGP's interest on "day one" would result in no tax.
[4]
In Gen. Couns. Mem. 36,346 (July 25, 1977), a proposed Revenue Ruling disavowing Sol Diamond was
discussed but the ruling was never published. The dispute over whether the "carried interest" produces
ordinary income (versus capital gain) to the GPGP is, of course, somewhat mooted since the Tax Reform
Act of 1986, but the question remains whether a taxable event occurs when the
[5]
One experienced practitioner has suggested that the 83(b) election be made in light of language in
Kobor v. United States, 88-2 U.S. Tax Cas. (CCH) 9477 (C.D. Cal. 1987). See Levun, Receipt
[6]
See Ch. 5 discussing I.R.C. 83(b)(1). See also I.R.C. 707(a).

[7]
59 T.C.M. (CCH) 236 (Mar. 27, 1990) rev'd, 943 F.2d 815 (8th Cir. 1991).

[8]
56 T.C. 530 (9171), aff'd, 492 F.2d 286 (7th Cir. 1974).

[9]
943 F.2d 815 (8th Cir. 1991).

[10]
56 T.C. 530 (1971), aff'd, 492 F.2d 286 (7th Cir. 1974).

[11]
R. Donald Turlington, who has been associated with the Campbell decision since its inception, believes
the opinion goes well beyond a mere "valuation case." He does not think the court would reverse itself, in
other words, if the next taxpayer were to join a partnership with more promise than Campbell's. Turlington
advises (1) that taxpayers plan to become partners in the partnership concerned before rendering the
services; (2) that the services be rendered to the partnership; (3) that the services are called on to be
continuing over a period of time; (4) that any salary received from an affiliated corporation be full and fair
consideration for the services rendered to the corporation; and (5) that the partner stay in harness as a
partner as long as possible. Oral remarks of R. Donald Turlington at the 1991 PLI Tax Strategies
conference, Tax Strategies for Corporate Acquisitions, Dispositions, Financings, Joint Ventures,
Reorganizations and Restructurings (PLI Course Handbook Series No. 316, 199 1).
[12]
In a real sense, the cash investors, in the situations under consideration, always have a preferred
return in that capital accounts are liquidated upon partnership termination and accounts distributed
accordingly, meaning in turn that the carried interest kicks in only if the partnership has made a profit.
Sub-Topics
10.1.11.a: The Carried Interest Tax Debate
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