Cash and Carried Interests: Protecting the Investor and Developer

in a Real Estate Partnership

Howard E. Abrams

Of Counsel, Steptoe & Johnson LLP

Professor, Emory Law School

www.steptoe.com

Copyright 2003 by Howard E. Abrams. All rights reserved

2

The Basics of Economic Effect

• Capital accounts must be properly maintained.

• Final capital account balances must determine liquidating distributions.

• No negative capital accounts without clawback obligation.

3

The Problem of a Carried Interest; Of Taxes and Timing

4

• The term “carried interest” is not defined in the Internal Revenue Code.

• The term is not defined under case law or any IRS authority.

• Carried interest commonly refers to a partnership interest that is secondary in priority with respect to cash recovery; i.e., it does not get paid first.

• This does not mean, however, that carried interests necessarily get paid last.

What is a “carried interest”?

5

Baseline Situation

I D

ID

$98,000 $2,000

Blackacre Whiteacre

$50,000 $50,000

6

Example 1a

Facts: ID sells Blackacre for $80,000 and distributes the sale proceeds to the partners.

Possible Results:

• Asset-by-Asset Approach -- $50,000 of the distribution is treated as a return of capital and $30,000 is treated as profit.

• Aggregate Approach – The entire $80,000 distribution is treated as a return of capital because the partners’ aggregate unreturned investment stands at $100,000.

7

Example 1a; Asset-by Asset Approach

_______ I _______ _______ D _______

Capital Basis Capital Basis

$ 98,000 $ 98,000 $ 2,000 $ 2,000

Contributions

8

Example 1a; Asset-by Asset Approach

_______ I _______ _______ D _______

Capital Basis Capital Basis

$ 98,000 $ 98,000 $ 2,000 $ 2,000

23,520 23,520 6,480 6,480

Contributions

Allocation of Profit

9

Example 1a; Asset-by Asset Approach

_______ I _______ _______ D _______

Capital Basis Capital Basis

$ 98,000 $ 98,000 $ 2,000 $ 2,000

23,520 23,520 6,480 6,480

(49,000) (49,000) (1,000) (1,000)

Contributions

Allocation of Profit

Return of Capital

10

Example 1a; Asset-by Asset Approach

_______ I _______ _______ D _______

Capital Basis Capital Basis

$ 98,000 $ 98,000 $ 2,000 $ 2,000

23,520 23,520 6,480 6,480

(49,000) (49,000) (1,000) (1,000)

(23,520) (23,520) (6,480) (6,480)

$ 49,000 $ 49,000 $ 1,000 $ 1,000

Contributions

Allocation of Profit

Return of Capital

Profit

Total

11

Example 1a; Asset-by Asset Approach (continued)

Sale of Whiteacre at a Loss of $10,000

Loss must be charged back in proportion to prior allocation of gain.

Loss Share to I = $7,840

Loss Share to D = $2,160

12

Example 1a; Asset-by Asset Approach (continued)

_______ I _______ _______ D _______

Capital Basis Capital Basis

$ 98,000 $ 98,000 $ 2,000 $ 2,000

23,520 23,520 6,480 6,480

(72,520) (72,520) (7,480) (7,480)

$ 49,000 $ 49,000 $ 1,000 $ 1,000

Contributions

Allocation of Profit

Distributions

Totals

13

Example 1a; Asset-by Asset Approach (continued)

_______ I _______ _______ D _______

Capital Basis Capital Basis

$ 98,000 $ 98,000 $ 2,000 $ 2,000

23,520 23,520 6,480 6,480

(72,520) (72,520) (7,480) (7,480)

$ 49,000 $ 49,000 $ 1,000 $ 1,000

(7,840) (7,840) (2,160) (2,160)

$ 41,160 41,160 $ (1,160) $ (1,160)

Contributions

Allocation of Profit

Distributions

Totals

Allocation of Loss

New Totals

14

Example 1a; Aggregate Approach

_______ I _______ _______ D _______

Capital Basis Capital Basis

$ 98,000 $ 98,000 $ 2,000 $ 2,000

Contributions

15

Example 1a; Aggregate Approach

_______ I _______ _______ D _______

Capital Basis Capital Basis

$ 98,000 $ 98,000 $ 2,000 $ 2,000

29,400 29,400 600 600

Contributions

Allocation of Profit

16

Example 1a; Aggregate Approach

_______ I _______ _______ D _______

Capital Basis Capital Basis

$ 98,000 $ 98,000 $ 2,000 $ 2,000

29,400 29,400 600 600

(78,400) (78,400) (1,600) (1,600)

$ 49,000 $ 49,000 $ 1,000 $ 1,000

Contributions

Allocation of Profit

Return of Capital

Totals

17

Example 1a; Aggregate Approach (continued)

Sale of Whiteacre at Cost

Now suppose that ID sells Whiteacre for its cost basis of $50,000.

There is no book or tax gain to be allocated, so the books remain unchanged.

18

Example 1a; Aggregate Approach

_______ I _______ _______ D _______

Capital Basis Capital Basis

$ 98,000 $ 98,000 $ 2,000 $ 2,000

29,400 29,400 600 600

(78,400) (78,400) (1,600) (1,600)

$ 49,000 $ 49,000 $ 1,000 $ 1,000

Contributions

Allocation of Profit

Return of Capital

Totals

19

Example 1a; Aggregate Approach

_______ I _______ _______ D _______

Capital Basis Capital Basis

$ 98,000 $ 98,000 $ 2,000 $ 2,000

29,400 29,400 600 600

(78,400) (78,400) (1,600) (1,600)

$ 49,000 $ 49,000 $ 1,000 $ 1,000

The partnership has turned a profit of $30,000,

But D made only $600! What happened to

the carry?

Contributions

Allocation of Profit

Return of Capital

Totals

20

Example 1a; Aggregate Approach (continued)

Could the partners agree to distribute the final cash other than in accordance with final capital account balances?

21

Example 1a; Aggregate Approach (continued)

Could the partners agree to distribute the final cash other than in accordance with final capital account balances?

No, because that would violate the requirement of “substantial economic effect.”

22

Example 1a; Aggregate Approach (continued)

What if a clawback was imposed on I?

23

Example 1a; Aggregate Approach (continued)

That would not work either. If we require that I contribute additional funds to the venture, that contribution will increase I’s capital account. Because final liquidation proceeds must be made in accordance with capital account balances, the clawback cannot operate to shift funds from I to D

24

Example 1a; Aggregate Approach (continued)

Then what is the solution?

25

Example 1a; Aggregate Approach (continued)

The only way to fix the problem is to anticipate and address the tax allocations from the beginning.

We need to allocate the gain in accordance with profits interests even though we will distribute the cash as return of capital. This yields:

26

Example 1a; Aggregate Approach (continued)

_______ I _______ _______ D _______

Capital Basis Capital Basis

$ 98,000 $ 98,000 $ 2,000 $ 2,000

23,520 23,520 6,480 6,480

(78,400) (78,400) (1,600) (1,600)

$ 43,120 $ 43,120 $ 6,880 $ 6,880

Contributions

Allocation of Profit

Distributions

Totals

27

Example 1a; Aggregate Approach (continued)

The moral of this story:

Even if cash will be distributed on an aggregate basis, profits must be

allocated on an asset-by-asset basis.

28

Example 1a; Aggregate Approach (continued)

_______ I _______ _______ D _______

Capital Basis Capital Basis

$ 98,000 $ 98,000 $ 2,000 $ 2,000

23,520 23,520 6,480 6,480

(78,400) (78,400) (1,600) (1,600)

$ 43,120 $ 43,120 $ 6,880 $ 6,880

Contributions

Allocation of Profit

Distributions

Totals

29

Example 1a; Aggregate Approach (continued)

_______ I _______ _______ D _______

Capital Basis Capital Basis

$ 98,000 $ 98,000 $ 2,000 $ 2,000

23,520 23,520 6,480 6,480

(78,400) (78,400) (1,600) (1,600)

$ 43,120 $ 43,120 $ 6,880 $ 6,880

Contributions

Allocation of Profit

Distributions

Totals

But now there is a cash flow problem for D.

30

Example 1a; Aggregate Approach (continued)

_______ I _______ _______ D _______

Capital Basis Capital Basis

$ 98,000 $ 98,000 $ 2,000 $ 2,000

23,520 23,520 6,480 6,480

0 0 (2,592) (2,592)

Contributions

Allocation of Profit

Tax Distribution

31

Example 1a; Aggregate Approach (continued)

_______ I _______ _______ D _______

Capital Basis Capital Basis

$ 98,000 $ 98,000 $ 2,000 $ 2,000

23,520 23,520 6,480 6,480

0 0 (2,592) (2,592)

(77,408) (77,408) 0 0

$ 44,112 $ 44,112 $ 5,888 $ 5,888

Contributions

Allocation of Profit

Tax Distribution

Return of Capital

Totals

32

Hurdles; Guaranteed Payments and Preferred Returns

33

Guaranteed Payments

The ID Partnership Agreement may provide that guaranteed payments will be made on contributed capital generally or only on the capital contributed by I.

Because guaranteed payments for the use of capital are deductible, the guaranteed payment obligation reduces the Partnership’s net income.

This reduces the amount of income derived from D’s carry, as some portion of that amount will be used to satisfy the Partnership’s guaranteed payment obligation.

34

Guaranteed Payments; Example 1a

The ID Partnership agreement provides for a cumulative, guaranteed return of 6% (compounded annually) on I’s invested capital

The Partnership sells Blackacre at the end of Year 2 for $80,000, which results in a gain of $30,000.

However, the Partnership’s income will not be $30,000. Rather, because of the deduction attributable to the cumulative guaranteed payment (of $12,113), the partnership’s income from the sale of Blackacre will be only $17,887.

Thus, the books of the partnership will become:

35

Guaranteed Payments; Example 1a (Continued)

_______ I _______ _______ D _______

Capital Basis Capital Basis

$ 98,000 $ 98,000 $ 2,000 $ 2,000

14,310 14,310 3,577 3,577

( 5,724) ( 5,724) (1,431) (1,431)

(59,517) (59,517) (1,215) (1,215)

$ 47,069 $ 47,069 $ 2,931 $ 2,931

Contributions

Allocation of Profit

Tax Distributions

Return of Capital

Totals

36

Preferred Returns

While preferred returns and guaranteed payments are similar in many ways, there exist two significant differences:

(1) If the partnership does not do well, the preferred return will have no impact while a guaranteed payment obligation must be satisfied regardless of the partnership’s performance; and

(2) The guaranteed payment is taxed as ordinary income to the recipient and gives rise to an ordinary deduction for the partnership (usually shared between I and D), while the preferred return does not affect the character of the income or loss.

37

Preferred Returns; Example 1a (continued)

_______ I _______ _______ D _______

Capital Basis Capital Basis

$ 98,000 $ 98,000 $ 2,000 $ 2,000

12,113 12,113 0 0

14,310 14,310 3,577 3,577

12,113 12,113 0 0

( 5,724) ( 5,724) (1,431) (1,431)

(59,517) (59,517) (1,215) (1,215)

$ 47,069 $ 47,069 $ 2,931 $ 2,931

Contributions

Preferred Return

Allocation of Profit

Preferred Distribs.

Tax Distributions

Return of Capital

Totals

38

A Vesting Carried Interest

39

A Vesting Carried Interest

• Compare actual capital account to target capital account.

40

A Vesting Carried Interest

• Compare actual capital account to target capital account.

• Gross-up actual capital account by distributions.

41

A Vesting Carried Interest

• Compare actual capital account to target capital account.

• Gross-up actual capital account by distributions.

• No need for regulatory allocation offset provision.

42

Contributions of Property

43

Contributions of Property

• Prohibit taxable dispositions of contributed property.

44

Contributions of Property

• Prohibit taxable dispositions of contributed property.

• Prohibit contributions of contributed property to lower-tier partnerships.

45

Contributions of Property

• Prohibit taxable dispositions of contributed property.

• Prohibit contributions of contributed property to lower-tier partnerships.

• Control the section 704(c)(1)(A) recovery method.

46

Exempt Organization as Partners

• The Fractions Rule:– Irrelevant if no debt on property– Irrelevant if all partners are “qualified

organizations”– Limits book allocations only– Consider distributing appreciated property to

the exempt organization.