Taxes on Carried Interests

[PaloAltoCougar]

Would you agree that an LP interest is a security? A GP interest in the same fund? How about the performance allocation?

We can expand this geekfest from carried interests to "what is a security?" Because the definition of a "security" includes the element "depends on the efforts of others", general partnership interests are often not characterized as securities, since the GPs are the ones actually doing the work. Limited partnership interests, on the other hand, and passive LLC members of manager-managed LLCs, are usually treated as securities because they depend on the efforts of others.

BYU Law grads may be interested (okay, you won't be, but please indulge me) to learn that my core knowledge of securities law occurred between the hours of 11 pm and 3 am the night before my Securities final. The excellent Cheryl Preston (the seniormost female law prof at JRCLS) was my study partner. As we were going over our notes and consuming unhealthy amounts of Rusty Nail pizza, she said she was quite confident our final would focus on "what is a security?", in light of the U.S. Supreme Court's decision, handed down only hours earlier, in the Daniel case involving a pension fund and whether interests therein were securities. The Court had addressed the definition of a security in great detail there. So we spent a couple of hours going over it.

When we sat down for the final, Prof. Barber presented us with a single question, and it was based on the facts of the Daniel case. Having read the advance sheets of the case only a few hours earlier, we had a very pleasant finals experience. Of course, Cheryl got the higher grade.

[Viking]

We can expand this geekfest from carried interests to "what is a security?" Because the definition of a "security" includes the element "depends on the efforts of others", general partnership interests are often not characterized as securities, since the GPs are the ones actually doing the work. Limited partnership interests, on the other hand, and passive LLC members of manager-managed LLCs, are usually treated as securities because they depend on the efforts of others.

BYU Law grads may be interested (okay, you won't be, but please indulge me) to learn that my core knowledge of securities law occurred between the hours of 11 pm and 3 am the night before my Securities final. The excellent Cheryl Preston (the seniormost female law prof at JRCLS) was my study partner. As we were going over our notes and consuming unhealthy amounts of Rusty Nail pizza, she said she was quite confident our final would focus on "what is a security?", in light of the U.S. Supreme Court's decision, handed down only hours earlier, in the Daniel case involving a pension fund and whether interests therein were securities. The Court had addressed the definition of a security in great detail there. So we spent a couple of hours going over it.

When we sat down for the final, Prof. Barber presented us with a single question, and it was based on the facts of the Daniel case. Having read the advance sheets of the case only a few hours earlier, we had a very pleasant finals experience. Of course, Cheryl got the higher grade.

So, if a security holder (LP) agrees to allocate a certain portion of partnership interests as a performance allocation to another security holder (GP) and the GP does not liquidate that security, why should the performance allocation be taxed at ordinary rates?

[PaloAltoCougar]

So, if a security holder (LP) agrees to allocate a certain portion of partnership interests as a performance allocation to another security holder (GP) and the GP does not liquidate that security, why should the performance allocation be taxed at ordinary rates?

Because the reason he's making that allocation is to compensate the GP for his managerial efforts. Compensation for one's efforts (as opposed to a return on capital investment) should be taxed at ordinary rates, as it is for all working stiffs.

[Viking]

Because the reason he's making that allocation is to compensate the GP for his managerial efforts. Compensation for one's efforts (as opposed to a return on capital investment) should be taxed at ordinary rates, as it is for all working stiffs.

Do you think ISOs should be taxed at ordinary rates?

[PaloAltoCougar]

Do you think ISOs should be taxed at ordinary rates?

I assume you're referring to the sale of stock received upon exercise of ISOs. I'm okay with the law as it is, which provides that stock received from an ISO exercise will be taxed as a long-term capital gain if the holder doesn't sell the stock until at least one year after exercise, and two years after the date of grant.

But in my experience, the apparent tax benefits of ISOs are usually lost either because (i) the optionee doesn't exercise until shortly before, or at the time of, the company's acquisition by a larger company, in which case the one-year holding period will not have been satisfied, or (ii) the gain from the ISO is nearly wiped out by the alternative minimum tax. My colleagues worked hard back in the early '80s to get Congress to create ISO's, but altmin pretty much gutted them.

[Viking]

I assume you're referring to the sale of stock received upon exercise of ISOs. I'm okay with the law as it is, which provides that stock received from an ISO exercise will be taxed as a long-term capital gain if the holder doesn't sell the stock until at least one year after exercise, and two years after the date of grant.

But in my experience, the apparent tax benefits of ISOs are usually lost either because (i) the optionee doesn't exercise until shortly before, or at the time of, the company's acquisition by a larger company, in which case the one-year holding period will not have been satisfied, or (ii) the gain from the ISO is nearly wiped out by the alternative minimum tax. My colleagues worked hard back in the early '80s to get Congress to create ISO's, but altmin pretty much gutted them.

ISOs are issued on the basis of managerial efforts. Why should an interest in a LP security not divested within one year of receiving its allocation be treated differently from the perspective of tax rate?

[PaloAltoCougar]

ISOs are issued on the basis of managerial efforts. Why should an interest in a LP security not divested within one year of receiving its allocation be treated differently from the perspective of tax rate?

All ISOs must have an exercise price equal to the fair market value of the stock at the time of grant, and the recipient must actually pay that FMV in order to receive the stock.

[Viking]

All ISOs must have an exercise price equal to the fair market value of the stock at the time of grant, and the recipient must actually pay that FMV in order to receive the stock.

FMV can be a red herring argument in this case, PAC. Take my family member who received ISOs with a FMV of $10 and exercised well over $200/share. Further, his exercise was completely cashless.

Did he think more about the effective tax savings, or the less than 5% of exercise price "leakage" vis-a-vis a recipient of carried interest he incurred? (there in fact is no "leakage" vs. a carried interest recipient who has a high watermark).

More significantly, most investment managers incorporate the concept of high watermarks in their performance allocation calculations. Meaning, if investment dollars at day 0 are $100, they are never entitled to a performance allocation unless total investment dollars (call it "NAV") are at least $100. If NAV grows to $110, then the new high watermark is $110 and no subsequent performance allocations are allowed unless or until NAV is $110.

Hence, in effect, FMV of the security, as is the case with an ISO issued to an employee, is marked to market at each year end (the de facto issuance period for an investment manager) and serves as the new basis. Is it the same as "paying" the FMV as in an ISO.

The investment manager has to live with a higher FMV as the basis of his performance allocation calculation every year, which is no different whatsoever than an employee who receives an ISO with a FMV of $10 in one year, and $15 the next, in the case of the manager who begins with $100 in NAV in one year, grows assets via capital gains to $150 the next.

I can make the "sweat equity", dividend, and a variety of other arguments here, as well.

[Viking]

Brother #2 receives ISOs every year and the annual variation of the FMV of his reference stock has absolutely no bearing on his ISO issuance.

Compare that with an investment manager who can only receive a performance allocation if his fund's NAV is higher on Dec 31 of year T-0 than it was on Dec 31 of year T-1.

Of course, you will say, the exercise price of the ISO must be about strike price for it to have any value ergo the concept of high watermark exists de facto, at least as it relates to value realization. That is true but the point is that the ISO recipient, for equal managerial efforts, can go on collecting "chits" in the form of new ISOs each year even in the face of a declining stock price, thus negative exercise value, for several years.

The investment manager who sees consistent declining NAV over several years not only does not receive new "chits", he or she likely losing significant assets. 3 years or more, and you're likely out of business.

Meanwhile, brother #2 can blissfully receive new ISOs each Dec 31 based on his performance. He may have to wait for his exercise price to increase above FMV for several years, but at least he would have a job. I, on the other hand, would be out of business.

[PaloAltoCougar]

FMV can be a red herring argument in this case, PAC. Take my family member who received ISOs with a FMV of $10 and exercised well over $200/share. Further, his exercise was completely cashless.

Did he think more about the effective tax savings, or the less than 5% of exercise price "leakage" vis-a-vis a recipient of carried interest he incurred? (there in fact is no "leakage" vs. a carried interest recipient who has a high watermark).

More significantly, most investment managers incorporate the concept of high watermarks in their performance allocation calculations. Meaning, if investment dollars at day 0 are $100, they are never entitled to a performance allocation unless total investment dollars (call it "NAV") are at least $100. If NAV grows to $110, then the new high watermark is $110 and no subsequent performance allocations are allowed unless or until NAV is $110.

Hence, in effect, FMV of the security, as is the case with an ISO issued to an employee, is marked to market at each year end (the de facto issuance period for an investment manager) and serves as the new basis. Is it the same as "paying" the FMV as in an ISO.

The investment manager has to live with a higher FMV as the basis of his performance allocation calculation every year, which is no different whatsoever than an employee who receives an ISO with a FMV of $10 in one year, and $15 the next, in the case of the manager who begins with $100 in NAV in one year, grows assets via capital gains to $150 the next.

I can make the "sweat equity", dividend, and a variety of other arguments here, as well.

Viking, I'm having a hard time following what you're saying here and in the subsequent post (my fault, not yours), but let me address just the bolded line above. If the FMV value of your bro's company was $10 at the time of the ISO grant, and was $200 at the time of exercise, then bless him, as he's among the Facebook/Google type of winners that options are intended to create. That said, he'd still need to hang on to his stock for another year before he could reap capital gain treatment on the money he invested when he purchased his options.

And you know this, but let explain for others (yeah, right, like there are others at this point) what a cashless exercise is. In your brother's example, with an exercise price of $10 and a current FMV of $200, he could exercise one share of his options, pay his $10, turn around and sell it for $200, and use the $200 to exercise his option to buy 20 more shares (still at the $10 price). He could then sell the 20 shares for $4000, and use that money to buy 400 more shares. This process could go on until he had bought all of his optioned shares, and he would only have spent, net, $10 with his original share purchase. This cashless exercise is also called "pyramiding." BUT..... the value of all the shares that he sold immediately to buy more shares would be ordinary income, not capital gains, because he hadn't satisfied the one-year holding period requirement.

For employees, I'm fine if they get capital gain treatment on their cash investment in the company if they satisfy the requisite holding periods, but it ought to be ordinary income if they don't, or if they're simply given their equity stake in the company without paying anything for it.

Because we've lost everyone else at this point, I propose we continue this discussion, if at all, over dinner if ever our paths cross in NYC or SF. I'll buy, and write it off as an entertainment expense in the course of dispensing worthless tax advice.