A Technical Analysis of Proposed Section 710



I. Introduction

Representative Charles B. Rangel (D-NY), Chairman of the House Committee on Ways and Means, introduced on October 25, 2007, a comprehensive tax reform bill (H.R. 3970) which includes proposed new section 710 of the Internal Revenue Code. This provision also has been included in the Temporary Tax Relief Act of 2007 (H.R. 3996), introduced by Chairman Rangel on October 30, 2007. Proposed section 710 would change the taxation of any “investment services partnership interest” and represents the most recent legislative response to the carried interest debate.[3] That debate, going back at least to 1971[4] in the courts and to 1972 by academics,[5] recently was reignited by Professor Fleischer in the context of managers of hedge funds and private equity.[6]

II. Summary of Conclusions

1. Coordination With Current Law: Proposed section 710 should provide that it is inapplicable to the holder of a an “investment services partnership interest” who has been taxed on that interest under section 83(a).

2. Definition of “Investment Services Partnership Interest” – Ambiguities: The definition of an “investment services partnership interest” should be refined to eliminate the ambiguity in the term “substantial quantity” and to clarify the meaning of “trade or business.”

3. Definition of “Investment Services Partnership Interest” – Assets: The definition of an “investment services partnership interest” should be limited to those partnerships whose assets consist entirely (but for a de minimis amount) of those assets specified in the final flush language of proposed section 710(c)(1).

4. Definition of Invested Capital – Purchased Interest: Proposed section 710 should be amended to provide that the “invested capital” of the purchaser of a partnership interest includes the price paid for the partnership interest in addition to amounts actually contributed to the partnership by the purchaser.

5. Definition of Invested Capital – Accounting for Partnership Distributions: Proposed section 710 should be modified to allow reasonable allocation on the capital contributed by the holder of an “investment services partnership interest” to account for changes in relative capital resulting from distributions made by the partnership.

6. Definition of Invested Capital – Accounting for Undistributed Allocations: Proposed section 710 should be modified to allow reasonable allocation on the capital contributed by the holder of an “investment services partnership interest” to account for changes in relative capital resulting from undistributed allocations of taxable income made by the partnership.

7. Definition of Invested Capital – Accounting for Subordinated Distributions: The definition of a reasonable return on capital in proposed section 710 should be modified to apply in the aggregate rather than year by year.

8. Definition of Invested Capital – Accounting for Riskier Capital: The definition of a reasonable return on capital in proposed section 710 should be modified to provide that all economic aspects of contributed capital should be taken into account including disproportionate loss allocations.

9. Definition of Invested Capital – Allocations That Exceed a “Reasonable” Allocation: Proposed section 710(c)(2)(A) should be modified to make clear that only that portion of an allocation made with respect to “invested capital” which exceeds the allowable maximum is subject to recharacterization as ordinary income for the performance of services.

10. Definition of Invested Capital – Recharacterization of Recourse Loans: Proposed section 710 should only recharacterize nonrecourse loans between partners and between a partner and the partnership and should authorize regulations to extend that rule to the extent deemed necessary.

11. Distributed Property: Proposed section 710 should be modified to provide that the distribution of property to the owner of an “investment services partnership interest” is not treated as a taxable sale but instead that such distributed property becomes an ordinary income asset in the hands of the distributee partner.

12. Coordination With Section 751(b): The rules of section 751(b) should be modified to coordinate with proposed section 710.

13. Certain “Disqualified Interests”: That portion of proposed section 710 which speaks to “disqualified interests” should be eliminated.

14. General Effective Date: The general effective date of proposed section 710 should be specified as referring to taxable years of the partnership ending after November 1, 2007.

15. Distinguishing Compensation from Entrepreneurial Return: Proposed section 710 should not apply to a partnership interest held more than some specified number of years.

III. An Overview of Proposed Section 710

The basic thrust of proposed section 710 is that distributive share of partnership income should be treated as compensation income to the extent it is attributable to the contribution of a “substantial quantity” of investment activity services to the partnership. The crucial term “investment services partnership interest” is defined in proposed section 710(c)(1) to mean a partnership interest if the partner provides to the partnership any of the following services: (1) advising as to the advisability of investing in, purchasing, or selling any “specified asset”; (2) managing, acquiring, or disposing of any “specified asset”; or (3) arranging financing with respect to acquiring “specified assets.”[7] In this context, a “specified asset” includes securities, commodities, and real estate.[8]

Under the general rule of proposed section 710(a)(1), the net income with respect to an “investment services partnership interest” must be treated by the partner as ordinary income without regard to the character of the partnership’s activity. If, for example, the partnership owns an apartment complex, then this rule would have no direct impact on the partner’s distributive share of rental income (because it would be ordinary income even in the absence of proposed section 710) but would convert distributive share from disposition of the real estate into ordinary income from capital gain. Further, even as to the rental income, proposed section 710 would have an impact because proposed section 710 specifically provides that the net income allocated to the owner of an “investment services partnership interest” is treated as compensation for purposes of I.R.C. section 1402(a).

However, proposed section 710 does not recharacterizes as compensation that portion of a partner’s distributive share reasonably allocated by the partnership to the “invested capital” of the partner owning an “investment services partnership interest.”[9] For this purpose an allocation will not be considered as reasonable if it results in an allocation of income to the “invested capital” of a partner providing investment services in excess of the amount that is allocated to the same amount of “invested capital” of any other partner not providing investment service. “Invested capital” includes the amount of cash contributed by a partner as well as the fair market value of other property contributed by the partner (measured as of the date of contribution of the property).[10]

“Invested capital” of a partner owning an “investment services partnership interest” does not include any funds loaned by the partner to the partnership (because it includes only the value of cash and property “contributed” to the partnership).[11] In addition, it does not include any amount contributed by such a partner to the extent “attributable to the proceeds of any loan or other advance made or guaranteed, directly or indirectly, by any partner or [by] the partnership.”[12] Application of this rule does not turn on whether the loan is with or without recourse, whether the owner of the “investment services partnership interest” is credit-worthy, or to whom the creditor will look for repayment. In the most extreme case, funds could be borrowed by a credit-worthy service partner (“G”) on a fully recourse basis and then contributed to the partnership. But if the partnership’s assets are pledged to secure the loan, the loan will not count as “invested capital” of G even though G is fully liable to the lender and, if the partnership’s asset eventually are used to repay some or all of the debt, G is fully liable to the partnership and to the other partners. Further, in computing a “reasonable” allocation on the investment services partner’s “invested capital” as compared with the “invested capital” of partners who have not contributed services to the venture, the loan made or guaranteed by a nonservice partner is treated as “invested capital” of that nonservice partner.[13]

Distributive share of net loss allocated to an “investment services partnership interest” is limited to the extent of prior distributive shares of net income,[14] with any excess loss carried forward.[15] This limitation is relaxed for the purchaser of an “investment services partnership interest.”[16] Suspended losses do not reduce the partner’s outside basis.[17]

Gain recognized on the disposition of an “investment services partnership interest” is recharacterized as compensation[18] while loss recognized on such a sale is treated as ordinary only to the extent that the aggregate net income for all prior years allocated to that interest exceeds the aggregate net loss for all prior years.[19] However, this recharacterization does not apply to the extent a reasonable allocation of the gain or loss is made to account for the “invested capital” of the partner.[20] An “investment services partnership interest” is treated as an inventory item when itself held by a partnership.[21]

If appreciated property is distributed to a partner with respect to an “investment services partnership interest,” the property is treated as sold by the partnership.[22] As a result, gain will be recognized to the partnership and allocated among the partners in accordance with the usual rules of I.R.C. sections 704(b) and (c), with that portion of the gain allocated to the owner of an “investment services partnership interest” subject to recharacterization as compensation under proposed section 710(a) to the extent not attributable to the partner’s “invested capital.”

The rules recharacterizing gain as compensation extend beyond “investment services partnership interests” to certain “disqualified interests.”[23] A “disqualified interest” is any interest (other than nonconvertible and noncontingent debt) in any entity other than stock in a domestic C corporation or a foreign corporation subject to a comprehensive foreign income tax.[24] While a “disqualified interest” does not include a partnership interest,[25] it includes an option to acquire a disqualified interest in an entity as well as derivative instruments entered into (directly or indirectly) with an entity or with an investor in an entity. An interest in an entity will only be a “disqualified interest” if the person holding the interest performs investment management services for any entity and the value of the interest is “substantially related to the amount of income or gain (whether or not realized) from the assets with respect to which the investment management services are performed.”[26]

The rules in proposed section 710 do not apply to I.R.C. section 856(c)(2)-(4) by reason of an amendment to I.R.C. section 856(c). Additional civil penalties are provided for failure to comply with the rules of proposed section 710 including, under limited circumstances, an elimination of the reasonable cause exception.

Proposed section 710 includes both a general effective date as well as three more specific effective dates. As currently proposed, the general effective date reads: “Except as otherwise

IV. A Detailed Technical Analysis of Proposed Section 710

A. Coordination with Section 83 and Related Elements of Current Law

The premise underlying proposed section 710 is that a partner who contributes services to an investment partnership in exchange for an interest in the venture should be required to treat the partnership return as compensation for the provided services. An alternative approach is to treat receipt of the partnership interest as taxable compensation. This alternative is consistent with the taxation of receipt of corporate stock in exchange for a contribution of services and is codified in section 83. Under that provision, once the provider of services is taxed on the value of the interest received (that is, on the partnership interest or corporate stock), that interest in the venture is treated as any other interest and can qualify for capital gain treatment when such treatment is otherwise appropriate for the holder of such an asset. No plausible argument can be made that both approaches should apply to a single taxpayer; that is, at most, receipt of the interest is compensation or subsequent returns on the interest are compensation, but not both. Unfortunately, nothing in proposed section 710 coordinates with current law to ensure that the owner of an “investment services partnership interest” is not taxed on receipt of the partnership interest and again under proposed section 710.

The usual form of a carried interest given to a service partner is a “profits” interest. Such an interest includes a share of future profits of the partnership but does not include any portion of the partnership’s capital as of the date of the grant of the interest. In other words, if the partnership were to liquidate immediately after the profits interest were granted, the holder of the profits interest would receive nothing.

The tax principles currently applicable to the receipt of a profits interest in exchange for the contribution of services reflects an accommodation of theory to practical application. Until the Diamond case[27] was decided, all commentators thought that the receipts of a profits interest was a tax-free event.[28] Nonetheless, both the Tax Court and the Seventh Circuit concluded that the service partner is taxable on the fair market value of the interest received, and no court since Diamond has held to the contrary.

However, determining the value of such a profits interest is problematic: because a profits interest is worthless unless the partnership generates profits, placing a precise value on a profits interest requires either a determinable income stream within the partnership or some external measure of value (such as an immediate sale of the profits interest in an arm’s-length transaction). As a result, several courts have been willing to accept a zero or low immediate value for a profits interest in a partnership owning non-readily marketable assets.[29]

Ultimately, the Service determined that this valuation difficulty rendered the Diamond decision inadministrable. In Revenue Procedure 93-27,[30] the Service ruled that receipt of a profits interest is tax-free to the service partner unless (1) “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” or (2) the profits interest is sold or exchanged within two years of receipt.[31]

Proposed regulations[32] have been promulgated that replace the rule of Revenue Procedure 93-27 with a rule requiring immediate taxation (consistent with the Diamond case but technically under the application of I.R.C. ß83) along with a partnership election that restores the tax-free rule of Revenue Procedure 93-27 subject to a pair of similar but slightly different limitations.[33] Thus, under proposed future law as well as under current law, receipt of a profits interest often can be tax-free but also can be taxable to the recipient partner. In addition to a profits interest, a carried interest can include a share of the partnership’s capital as well as a share of future profits. Such an interest has immediate value, and receipt of such a capital interest in exchange for the contribution of services has always been considered a taxable event. As a result, in addition to the limited circumstances listed in Revenue Procedure 93-27 and included in the proposed future administrative guidance (subject to an election by the partnership), the grant of a capital interest represents an additional fact pattern to which the application of proposed section 710 would represent inappropriate double taxation.

Proposed section 710 must be coordinated with the other provisions potentially applicable to receipt of a carried interest. When the valuation difficulty can be overcome, the right result is to tax receipt of the carried interest as a taxable event and then treat the carried interest as if purchased for cash; that is, when the owner of the carried interest is taxed under existing tax provisions, there is no need for proposed section 710.[34] Once the full value of the “investment services partnership interest” is taxable as compensation income, tainting the return on that income under proposed section 710 not only puts partners at a significant disadvantage as compared with service-providing shareholders[35] but also disadvantages partners as compared with non-partner employees who simply are paid a salary and than a portion of that salary is invested in marketable securities, real estate or any other asset. Accordingly, section 710 should provide that it is inapplicable to the holder of a an “investment services partnership interest” who has been taxed on that interest under section 83(a).

B. The Definition of “Investment Services”

1. Ambiguities

Proposed section 710 defines an “investment services partnership interest” as any interest in a partnership held by any person “if such person provides (directly or indirectly) a substantial quantity of [any of several specified services] with respect to the assets of the partnership in the conduct of the trade or business of providing such services.”[36] This definition raises two significant interpretative difficulties.

First, it is unclear what level of activity will constitute a “substantial quantity” of such services. The term is not taken from an existing provision of the Internal Revenue Code or an existing income tax regulation. As a result, there is no established gloss that can be applied to this crucial phrase.

Perhaps a “substantial quantity” is anything more than a de minimis amount, although it could mean more than, say, one-third or one-half of the partner’s business activity. Should “substantial” be determined in an absolute sense or in comparison to other activities of the taxpayer? To what extent should it be relevant that the taxpayer performs similar services for other partnerships? Unfortunately, the phrase “substantial quantity” offers no help in answering these questions.

Second, the “trade or business” requirement is ambiguous. Must the taxpayer be in the trade or business of providing the specified investment services or rather must the services be rendered in connection with a trade or business of the partnership?[37] If the relevant “trade or business” is that of the taxpayer, can proposed section 710 apply to a taxpayer who does not seek customers beyond affiliated partnerships? Can the provision of services constitute a “trade or business” if the taxpayer provides services for only a single partnership? Should it be relevant whether the taxpayer has provided similar services to other partnerships in the past? Unfortunately, there is no single definition of “trade or business” generally applicable across the Internal Revenue Service.[38]

One way to resolve these ambiguities is for proposed section 710 to incorporate language used in some other provision of the Internal Revenue Code, a provision that has a well-understood meaning. For example, the definition of an “investment services partnership interest” could be defined as a partnership interest held by a partner who “materially participates” in specified investment activities with respect to partnership assets, with “material participation” defined in I.R.C. section 469(h) and the regulations promulgated thereunder. A second way to resolve the ambiguity would be to redraft the definition of an “investment services partnership interest” to apply only to a taxpayer who provides substantially all of his business activity providing specified investment services to partnerships in connection with their investment activities. In any event, the definition of an “investment services partnership interest” should be refined to eliminate the ambiguity in the term “substantial quantity” and to clarify the meaning of “trade or business.”

2. Assets

Proposed section 710 applies to a partner who provides a “substantial quantity” of specified services with respect to any asset of the partnership rendered in connection with a trade or business.[39] The specified services include “[a]dvising as to the advisability of investing in, purchasing, or selling any specified asset, [m]anaging, acquiring, or disposing of any specified asset, [a]rranging financing with respect to acquiring specified assets,” and [a]ny activity in support of any service described [above].”[40] As this quotation makes clear, proposed section 710 can apply even if the investment assets held by the partnership represent a small fraction of the partnership’s total assets. Indeed, as proposed section 710 currently is written, it will apply to every partner who has the authority to invest excess cash, for however short a period of time, in marketable securities or similar investments.

Nothing in the legislative history of proposed section 710 suggests it should be applicable to virtually every partnership. To the contrary, proposed section 710 is intended to apply to that small percentage of partnerships whose activities consist of investing in specified assets. Accordingly, the definition of an “investment services partnership interest” should be limited to those partnerships whose assets consist entirely (but for a de minimis amount) of those assets specified in the final flush language of proposed section 710(c)(1).

C. The Exception for Certain Capital Interests

1. Purchased Interests

Proposed section 710 is careful to recognize that the holder of an “investment services partnership interest” may contribute capital as well as services to the venture and that the harsh rules of proposed section 710 should apply only to that portion of the interest acquired for services. Accordingly, proposed section 710 excepts from its reach “certain capital interests.”[41] Pursuant to proposed section 710(c)(2), the rules applicable to the distributive share of an “investment services partnership interest” do not apply to that portion of the interest “acquired on account of a contribution of invested capital” provided that the partnership “makes a reasonable allocation of partnership items between the portion of the distributive share that is with respect to invested capital and the portion of the distributive share that is not.”[42]

While proposed section 710 includes a few special rules applicable to the purchaser of an “investment services partnership interest,” there is no specific provision speaking to the
purchaser’s share of the partnership’s “invested capital.” It is possible that the purchaser will be credited with the “invested capital” of the selling partner although nothing in proposed section 710 provides such a rule. However, if the partnership’s assets include net unrealized appreciation at the time of acquisition, the purchaser will pay a premium for the interest over the amount of the selling partner’s “invested capital,” and the purchaser’s invested capital should be credited with the full amount paid for the interest. Indeed, it is no different than a purchaser of an outstanding bond paying a premium to reflect a reduction in interest rates since issuance of the bond. In such circumstances, a portion of what would otherwise be classified as ordinary interest income can be recast as a return of capital.[43] Accordingly, proposed section 710 should be amended to provide that the “invested capital” of the purchaser of a partnership interest includes the price paid for the partnership interest in addition to amounts actually contributed to the partnership by the purchaser.

2. Accounting for Contributions and Distributions While proposed section 710 excludes from its reach reasonable allocations made with respect to a partner’s “invested capital,” a ceiling is placed on this allowable reasonable allocation:

An allocation will not be treated as reasonable for purposes of this subparagraph if such allocation would result in the partnership allocating a greater portion of income to invested capital than any other partner not providing services would have been allocated with respect to the same amount of invested capital.[44]

[T]he term “invested capital” means, the fair market value at the time of contribution of any money or other property contributed to the partnership.[45]

These rules can be easily understood in the context of a simple example. Suppose X contributes cash of $96 to a partnership while Y contributes cash of $4 as well as services in exchange for an interest that falls within the definition of an “investment services partnership interest.” An allocation to Y will not be subject to the rules of proposed section 710 to the extent that the partnership expressly makes an allocation attributable to Y’s contributed capital and that allocation does not exceed 4% of the partnership’s net income.[46]

If, in the next taxable year, Y contributes additional cash of $20 to the venture, then the maximum reasonable allocation of net partnership income that can be allocated to Y without recharacterization under proposed section 710 increases to 20% (24 of 124 equals 20%). Such a result makes sense because, had Y contributed $24 initially, Y could have been allocated as much as 20% of the venture’s net income as a return to Y’s contributed capital. There is no reason why the same result should not obtain if the capital is contributed in a subsequent year, and the language of proposed section 710 plainly reaches this proper result.[47]

But what if, rather than Y contributing additional cash in a subsequent year, the partnership instead returns some of X’s capital to X? Suppose, for example, that the partnership ultimately determines that it requires less capital than originally anticipated and so in year 2 distributes cash of $20 to X. Once that distribution is made, Y’s proportionate share of the contributed capital increase from 4% to 5%.[48] But proposed section 710 makes no allowance for adjusting the definition of a “reasonable” allocation on capital for distributions even if this distribution increases Y’s claim on all future distributions.

This omission in the context of carried interests is particularly important because many carried interests receive distributions only after capital is returned to the investing partners. As a result, the relative capital contributed by the general partner may increase year by year. But by ignoring such distributions, proposed section 710 blinds itself to the changing economic relationship of the parties. Accordingly, proposed section 710 should be modified to allow reasonable allocation on the capital contributed by the holder of an “investment services partnership interest” to account for changes in relative capital resulting from distributions made by the partnership.

3. Accounting for Undistributed Prior Allocations

A second significant omission in the definition of a “reasonable” allowance for distributive share attributable to contributed capital is the failure of section 710 to account for undistributed distributive (i.e, allocated) share. For example, again assume that X contributes cash of $96 while cash contributes cash of $4, and assume that Y’s interest in the venture falls within the definition of an “investment services partnership interest.” Assume further that under the partnership agreement, net profit from the venture will be allocated 80% to X and 20% to Y. On these facts and assuming the partnership has a single class of capital,[49] the maximum reasonable allocation on Y’s capital equals 4%, and, if the partnership makes such a specification, the remainder (16%) of the allocation to Y will be captured by proposed section 710.

Assume the partnership earns a taxable profit of $50 in year 1, and that this income is allocated 80% (that is, $40) to X and 20% (that is, $10) to Y. Under the analysis presented above, of the $10 allocated to Y, $2 will be treated as attributable to Y’s capital and $8 will treated as compensation to Y. If the partnership retains its $50 profit, it now has aggregate capital of $150, of which $100 was contributed and $50 was earned.

What is the maximum reasonable allocation that can be made to Y attributable to Y’s capital in the next taxable year. While Y’s contributed capital remains at $4, Y’s share of the venture’s aggregate capital now equals $14, and that is almost 10% of the venture’s aggregate capital ($14 of $150). That is, as the partnership allocates profit to Y in excess of Y’s relative share of contributed capital, Y’s share of the aggregate capital increase. To be sure, if the earned profit is distributed in the same proportion that it is allocated (that is $40 to X and $10 to Y), there will be no change in shares of aggregate capital. But to the extent such amounts remain undistributed, the maximum allowable allocation on Y’s capital should increase to reflect the prior taxable inclusion by Y. Indeed, by distributing the venture’s profits to the partners followed by a recontribution of those profits, the partners can arrive at precisely this result. But surely there is no reason to force such a circular transfer of cash simply to arrive at what should be the correct statutory result. Accordingly, proposed section 710 should be modified to allow reasonable allocation on the capital contributed by the holder of an “investment services partnership interest” to account for changes in relative capital resulting from undistributed allocations of taxable income made by the partnership.

Most holders of carried interests not only do not receive distributions equal to allocations but in fact the investing partners generally receive distributions in excess of allocations: that is, carried interests share in allocations from the start but receive distributions only after capital has been returned to the limited partners.[50] As a result, the relative share of partnership capital properly allocable to the carried interest simultaneously increase in two ways: (1) because the owner of the carried interest sees his distributive share accumulated rather than distributed and (2) because the other partners receive distributions not only of distributive share but also as a return of capital. Thus, in many partnerships the relative share of invested capital (including both contributed capital and retained profits) dramatically shifts toward the holder of the carried interest.

4. Accounting for Subordinated Returns and Riskier Capital

Proposed section 710 sets a maximum reasonable allocation that can be attributed to the capital of the holder of an “investment services partnership interest.” In many partnerships, the return to the general partner is subordinated to a specified return (usually called a “hurdle”) on the capital of the limited partners. As a result, in many taxable years the distributive share of the general partner may be far less than the allowable “reasonable” maximum if that amount is determined based on a pro rata comparison of “invested capital.” Such partnerships often authorize so-called “catch up” allocations in years of significant profit which ensure that the general partner’s aggregate return is not prejudiced by an uneven earning stream of the venture. For example, suppose a general partner holding an “investment services partnership interest” contributes 2% of the capital to a partnership. Suppose further than in the first 3 years of the venture, the partner’s net income is allocated exclusively to the limited partners. Finally, assume that in the fourth year of the venture, the partnership’s income is substantial and the partnership allocates 2% of the venture’s aggregate net income to the general partner, an amount that equals, say 5% of the partnership’s income for the current taxable year. Under proposed section 710 as written, the catch-up 5% allocation may be recharacterized as compensation to the extent of 3% out of the 5% of that allocation. But of course the entire 5% is nothing but a return on capital, albeit delayed. That is, if an amount could be allocated to the owner of “an investment services partnership interest” over multiple years without recharacterization under proposed section 710, then the same amount should be permitted without recharacterization if allocated in one or more subsequent years. Accordingly, the definition of a reasonable return on capital in proposed section 710 should be modified to apply in the aggregate rather than year by year.

A similar issue arises if one partner’s capital absorbs losses disproportionately. For example, it may be the case that losses are allocated first to the partner owning an “investment services partnership interest” or first offset disproportionate prior allocations of income to that partner. In either case, the return of the partner should reflect the greater loss risk just as the owner of a low-rated bond insists on a higher stated return. Proposed section 710 may already account for differences in loss sharing among partner because it does not expressly limit a “reasonable” allocation based purely on relative gross amounts of contributed capital. Rather, it provides that

“[a]n allocation will not be treated as reasonable . . . if such allocation would result in the partnership allocating a greater portion of income to invested capital [of a partner owning an “investment services partnership interest”] than any other partner not providing services would have been allocated with respect to the same amount of invested capital.[51]

This language may support a nuanced analysis of “reasonable” allocations sufficient to account for relative priorities of distributions and loss allocations although it is hard to anticipate how such an analysis can be specified with any certainty. Because of the difficulty in providing details for such a sophisticated analysis, agents who are forced to apply proposed section 710 may fall back on a simpler (and inaccurate) pro rata analysis. To ensure this error is not made, the definition of a “reasonable” allocation on invested capital should be modified to provide read as follows:

“[a]n allocation will not be treated as reasonable . . . if such allocation would result in the partnership allocating a great portion of income to invested capital [of a partner owning an “investment services partnership interest”] than any other partner not providing services would have been allocated with respect to the same amount of invested capital on the same terms.

5. Allocations That Exceed a “Reasonable” Allocation partnership interest” that ultimately is determined to exceed the maximum reasonable amount as provided for in proposed section 710(c)(2)(A). In such circumstances, does the recharacterization rule of proposed section 710(a)(1) apply only to that portion of the allocation that exceeds the allowable “reasonable” maximum or does such a failure taint the entire allocation? While the language of proposed section 710 seems to taint only the excess portion,[52] the language is susceptible to alternative interpretations. Cliff effects rarely make sense in income taxation; in this context the uncertainty in the necessary calculation makes such draconian punishment unconscionable. Accordingly, proposed section 710(c)(2)(A) should be modified to make clear that only that portion of an allocation made with respect to “invested capital” which exceeds the allowable maximum is subject to recharacterization as ordinary income for the performance of services.

6. Treating Debt as Equity

The rule excepting borrowed proceeds from the “invested capital” base of an investment services partner if the lender (or guarantor) is another partner or the partnership will in many circumstances seriously distort the underlying economics of a partnership transaction. For example, when the investment services partner borrows on a fully recourse basis from another partner, the contributed capital should be treated as that of the borrower rather than the lender except in the most egregious circumstances.

The only other statutory provision applying such draconian rules to borrowed debt is I.R.C. ß465(b)(3)(A), a provision that initially was limited to carefully delineated tax shelter activities and then expanded more broadly only if and to the extent that Treasury determined such an expansion was needed. See I.R.C. ß465(c)(3)(D). A similar, carefully balanced approach should be adopted here lest common and legitimate business transactions be captured in too broad a net.

For example, true third-party lenders occasionally acquire small interests in a partnership venture to protect their rights in connection with potential bankruptcy proceedings or workout arrangements. Such de minimis interests by a lender should not taint loans otherwise bona fide when made to partners having significant economic interests in the venture. There is, for example, such an exception for small partnership interests held by a lender in the existing partnership debt-sharing regulations[53] as well as in the existing partnership allocation regulations.[54] Regulations promulgated under proposed section 710 might provide a similar lender exception.

To be sure, existing partnership structures using carried interests can be recast into similar forms using indebtedness.[55] But such restructurings can have greater or lesser changes to the underlying economics and will expose more or less ordinary income. Applying a blanket rule which in effect treats all loan transactions as abusive seems extreme, especially when a more nuanced approach could be promulgated as administrative guidance. Accordingly, proposed section 710 should only recharacterize nonrecourse loans between partners and between a partner and the partnership and should authorize regulations to extend that rule to the extent deemed necessary.[56]

D. Taxation of Distributed Property

Subsection (b)(4) of proposed section 710 provides that upon a distribution of property from the partnership to a partner, “gain shall be recognized by the partnership in the same manner as if the partnership sold such property at fair market value at the time of the distribution.” There is no obvious relevance of this provision to the remainder of proposed section 710 or to the concerns underlying that provision. On the hypothetical sale constructed by this provision, most of any gain recognized will be allocated to the nondistributee partners unless the owner of the “investment services partnership interest” happens to own a majority of the venture. There is no reason why such partners – that is, why the partners who did not contribute services to the partnership -should recognize income on such a transaction.

To be sure, if the distributed property had been contributed within seven years by a partner other than the distributee, any pre-contribution appreciation remaining within the distributed property should be taxed to the contributing partner pursuant to section 704(c)(1)(B). But such gain should not be taxed a second time, yet nothing in proposed section 710 precludes such double taxation. In a similar fashion, proposed section 710 must be coordinated with section 737.

Even if there is no overlap with the partnership mixing bowl provisions, the application of proposed section 710 to distributed property has additional technical difficulties. The hypothetical sale constructed by proposed section 710 creates additional asset basis within the partnership. Should this basis increase attach to the distributed property? Nothing in proposed section 710 provides for such a basis increase to the distributed property or to any other partnership asset. Does the recharacterization continue so the distribution is treated as a distribution of the fictional sale proceeds or is the fictional sale limited to triggering recognition of gain at the partnership level?

Most importantly, nothing in proposed section 710 precludes the distributee partner from selling the distributed property subsequent to the distribution and reporting only capital gain on such a sale. Presumably subsection (b)(4) of proposed section 710 is intended to ensure that the ordinary income treatment mandated by the general rule of subsection (a) cannot be circumvented by distributing partnership property to the owner of an “investment services partnership interest.” In fact, it has no such effect. Accordingly, proposed section 710 should be modified to provide that the distribution of property to the owner of an “investment services partnership interest” is not treated as a taxable sale but instead that such distributed property becomes an ordinary income asset in the hands of the distribuee partner.

E. Coordination with Section 751(b)

Under existing law, a partnership distribution that rearranges the partners’ interest in the partnership’s unrealized receivables and substantially appreciated inventory is recharacterized as a hypothetical distribution followed by a taxable exchange. To determine if a distribution has such an effect and, if so, the magnitude of such an effect, an exchange table must be computed for the partnership. This exchange table includes entries equal to the amount of unrealized ordinary income in each of the partnership’s asset.

Under proposed section 710, the amount of unrealized ordinary income in each partnership asset depends on the allocation of that income by the partnership: otherwise capital gain can be recharacterized as ordinary income if allocated to the owner of an “investment services partnership interest.” Thus, until the unrealized appreciation in an asset is allocated by the partnership, it cannot be determined how much ordinary income there is in the partnership’s assets. Further, if proposed section 710 is modified as suggested above to taint property distributed to the owner of such an interest, then the amount of ordinary income in the partnership’s assets cannot be determined without knowing which assets, if any, will be distributed by the partnership to the owner of an “investment services partnership interest.” As a result, the existing rules of section 751(b) cannot be applied to distributions from a partnership including one or more “investment services partnership interest.” Accordingly, the rules of section 751(b) should be modified to coordinate with proposed section 710.

F. Taxation of Disqualified Interests

Proposed section 710 treats as ordinary income any income or gain from a specified “disqualified interest” held by any person who performs investment management services.[57] For this purpose, a “disqualified interest” includes an interest “substantially related” to the assets with respect to which the investment management services are rendered, but excluding a partnership interest, stock in a taxable C corporation, and nonconvertible, noncontingent debt.[58] Frankly, it is hard to know what this provision is intended to capture or what interests the language reaches. Indeed, this part of proposed section 710 seemingly does not require that the “disqualified interest” be in an entity that actually holds a partnership interest of any kind! It presumably will cover stock of an S corporation held by a person who performs investment management services for a partnership if the S corporation holds an interest in the partnership, and it seems to capture many contractual arrangements such as phantom stock of a C corporation or of an S corporation as well as similar arrangements with a partnership. But its potential reach is far greater than these simple examples. Even more remarkably, proposed section 710 imposes a new, strict liability penalty on taxpayers who are captured by this “disqualified interest” provision even though application of this provision is extraordinarily problematic.

At least in the context of stock of an S corporation, it is hard to justify this provision. Suppose, for example, that a taxpayer agrees to contribute services to an S corporation in exchange for stock, and those services ultimately are performed on behalf of a partnership in which the S corporation is a partner.[59] The law is clear that the contribution of services to a corporation is taxable in accordance with the rules of I.R.C. section 83,[60] so the fair value of the services rendered will be immediately taxed to the service provider as ordinary income without the need for proposed section 710 and its extension to “disqualified interests.” Indeed, as discussed above, the failure of proposed section 710 to coordinate with the existing rules of I.R.C. section 83 creates the very real possibility for substantial over-taxation of a taxpayer who contributes investment management services to a partnership or for a “disqualified interest.” Abusive circumventions of proposed section 710 can be addressed by appropriate administrative guidance, Service enforcement, and judicial supervision. The language in proposed section 710 relating to “disqualified interests” is extraordinarily broad and uncertain in scope. Accordingly, that portion of proposed section 710 which speaks to “disqualified interests” should be eliminated.

G. Ambiguity in General Effective Date

The general effective date provision of section 710 refers to taxable years ending after November 1, 2007, but it fails to specify whether it refers to the taxable year of the partnership or of the partner owning an “investment services partnership interest.” This ambiguity should be resolved. Accordingly, the general effective date of proposed section 710 should be specified as referring to taxable years of the partnership ending after November 1, 2007.

V. The Focus of Proposed Section 710 Should Be Narrowed

Why proposed section 710? The law is clear that a partner’s distributive share should take its character from the character of the partnership’s activities. However, the law is equally clear that compensation received for services provided should be taxed as ordinary income. If a partner contributes investment management services to a partnership in addition to cash or other property, is the partner’s distributive share fairly treated as compensation? In part, probably yes, although it is hard to determine the precise contours of that part. Under current law the initial fair market value of the partnership interest – more accurately, the fair market value of that portion received in exchange for the contributed services – should be immediately taxable as compensation. Having won that battle on theoretical grounds, the Treasury ultimately agreed that receipt of a profits interest in exchange for services (or for a contribution of property and services) should be tax-free because there is no administrable way to determine value of the ordinary income component, at least in most cases.

Proposed section 710 bypasses this valuation difficulty by eschewing immediate taxation of the ordinary income component in favor of treating as compensation the subsequent returns on that ordinary income component. However, the valuation difficulty is only partially avoided: if the partner contributes both services and capital, an allocation between the two components of the partnership interest must be made. And if the partnership includes preferential distributions or loss allocations, making that allocation may become extraordinarily complex.

There are two ways to address such complexity: either the complexity can be removed by changing the statutory language or the reach of the statute can be reduced so that only the taxpayers who can bear the cost of the complexity are burdened by it. Currently, the law applicable to partnership carried interests has followed the first approach: Treasury has promulgated two revenue procedures that together simplify the taxation of receipt of a carried interest at the cost of some under-taxation. If section 710 is to follow the alternate approach, it must reduce its reach.

Proposed section 710 and similar provisions recently offered to change the taxation of carried interests are described as targeting the very highly compensated managers of hedge funds and private equity investments.[61] Such taxpayers easily can afford to hire the expertise needed to parse the complexity of proposed section 710. But proposed section 710 applies not only to the roughly 200,000 financial investment partnerships but also to the roughly 1.2 million real estate partnerships.[62] Put another way, if the target of proposed section 710 is the financial services industry operated in partnership form, then proposed section 710 misses the target about 85% of the time.

The reach of proposed section 710 can be limited in various ways. Most directly, the definition of an “investment management services interest” can be limited to apply to partnerships investing in financial instruments by eliminating the reference to real estate in the definition of an “investment services partnership interest.”[63]. Alternatively, proposed section 710 can be limited to partnerships having assets greater than a certain minimum threshold, just as full cost accounting is limited to taxpayers having annual receipts in excess of $10 million[64] and imputation of interest on installment obligations is limited to taxpayers owning such obligations in excess of $5,000,000.[65]

But even if the complexity can be ameliorated, the premise underlying proposed section 710 remains: should all of the return on the contribution of investment services? The answer, I believe, is no.

As a conceptual matter, the carried interest return is composed of three distinct elements: (1) the initial (and hard to value) fair market value of the services provided; (2) an interest element reflecting deferred payment on the initial value of the services provided; and (3) a risk premium reflecting the willingness of the service partner to invest his return on the continued success of the venture.

This third element is less properly characterized as compensation and better described at an entrepreneurial return properly treated as capital gain. Consider the case of Jeffrey Larson, the former senior vice president for international equity managing about $3 billion of the Harvard Corporation’s $20 billion dollar endowment. In his last year at Harvard (2004), Mr. Larson was reported to have earned as much at $17 million in annual compensation.[66] This was true compensation that Mr. Larson pocketed and kept regardless of the eventual success of the funds under management.

Mr. Larson left Harvard to start Sowood Capital Management LP, a hedge fund with capitalization of approximately $3 billion. While its investment strategy initially proved successful, by July of 2007 it was out of business having lost half of its investors money. While we do not know precisely how much of Mr. Larson’s carried interest remained within the fund until the end, professional hedge fund managers traditionally report that they keep substantial profits reinvested because their third-party investors demand that the managers keep significant “skin in the game.” Mr. Larson traded in his compensation for a potentially greater entrepreneurial return; like all such entrepreneurial returns, he faced a risk of loss. Whatever carried interest Mr. Larson left within the firm became worthless.

Indeed, a Wall Street Journal article of October 29 reports that Mr. Britt Harris, a fund manager at the California Public Employees Retirement System, will receive roughly $1 million in annual compensation.[67] While such compensation is enormous by any reasonable standard, it pales in comparison to what private fund managers bring home in good times. Surely some of the difference in compensation rates is that the $1 million paid to Mr. Harris is received and retained; Mr. Harris has no skin in the game (except perhaps as a potential retiree).

There is no precise way to distinguish the third, entrepreneurial component from the two compensation components, but various suggestions have been made that offer reasonable approximations. For example, Professor Fleischer proposes that an interest charge could be imputed on the phantom capital underlying the carried interest.[68] That is, if a general partner contributes 1% of the $10 million capital to a partnership venture but is allocated 10% of the venture’s profit, then the GP is receiving the equivalent of a return on an extra 9% of the contributed capital, or $900,000. Professor Fleischer then argues in favor of imputing a cost-of-capital charge on the implicit borrowing of $900,000, using the rules of I.R.C. section 7872 to compute the dollar amount of this interest charge. Perhaps the greatest difficulty with this suggestion is that it fails to account for multiple classes of partnership capital; in particular, if there are preferred distributions or disproportionate loss allocations, there is no easy way to calculate the proper phantom capital loaned to the general partner. Still, it is an approximation that could be used.

An alternative is to recognize that in the early years of the venture, the value of the compensation component likely will dominate while over time the entrepreneurial component will grow in significance. Thus, it might make sense to apply something like proposed section 710 in the early years of the venture but to eliminate its application as the investment ages. This approach works nicely with those carried interests most difficult to value, namely carried interests whose returns are deferred until the end of the venture. Such interests will be rewarded, if ever, only after the partnership’s activities mature. In such cases the carried interest return largely is entrepreneurial in character and properly is regarded as investment return rather than compensation for services rendered. Accordingly, proposed section 710 should not apply to a partnership interest held more than some specified number of years. Two years, the basis of the strong presumption in the disguised sales anti-abuse provision of I.R.C. section 707(a)(2)(B), could be used.[69] Four years, the safe-harbor boundary for REITs and prohibited transactions in I.R.C. section 857(b)(6)(C), also comes to mind. Perhaps a compromise of three years is best.[70] But in all events some statutory outer limit should be set.

[1] Copyright 2007 by Howard E. Abrams. This article previously appeared as Special Report: A Close Look at Rangel’s Carried Interest Legislation, 117 TAX NOTES 961 (December 3, 2007).

[2] I wish to thank the Real Estate Roundtable for its support of this project. Any errors are my own.

[3] See also H.R. 2834, introduced June 22, 2997, by Rep. Sander Levin (D-MI); H.R. 2785, introduced June 20, 2007, by Rep. Peter Welch (D-VT); and S. 1624, introduced 15, 2007, by Senator Max Baucus (D-MT).

[4] Diamond v. Commissioner, 56 T.C. 530, affíd, 492 F.2d 286 (7th Cir.1974); see also St. John v. United States, 84-1 USTC ∂9158 (C.D. Ill. 1983); Kilroy, Inc. v. Commissioner, 47 TCM1749 (1984); National Oil Company v. Commissioner, 52 TCM 1223 (1986); Campbell v. Commissioner, 59 TCM 236 (1990), revíd on valuation, 943 F.2d 815 (8th Cir. 1991).

[5] Martin B. Cowan, Receipt of an Interest in Partnership Profits in Consideration for Services: The Diamond Case, 27 Tax L. Rev. 161 (1972); see also Victor Fleischer, Two and Twenty: Taxing PartnershipProfits in Private Equity Funds, University of Colorado Legal Studies Research Paper Series (Mar. 2006, rev. Mar. 11, 2007), forthcoming in NYU L. Rev. (2008); Howard E. Abrams, Taxation of Carried Interests, 116 Tax Notes 183 (July 16, 2007), reprinted in 23 Tax Mgmt. Real Estate J. 199 (2007); New York State Bar Association Tax Section, Report on the Proposed Regulations and Revenue Procedure Relating to Partnership Equity Transferred in Connection with the Performance of Services, Doc 2005-22612, 2005 TNT 214-19; Mark P. Gergen, Reforming Subchapter K: Compensating Service Partners, 48 Tax. L. Rev. 68 (1992); Leo Schmolka, Taxing Partnership Interests Exchanged for Services: Let Diamond/Campbell Quietly Die, 47 Tax L. Rev. 287 (1991); Laura Cunningham, Taxing Partnership Interests Exchanged for Services, 7 Tax L. Rev. 247, 252 (1991); Mark Gergen, Pooling or Exchange:The Taxation of Joint Ventures Between Labor and Capital, 44 Tax L. Rev. 519 (1989); Barksdale Hortenstine & Nicholas E. Ford, Receipt of aPartnership Interest for Services: A Controversy That Will Not Die, 65 Taxes 880 (1987); Sheldon Banoff, Conversions of Services Into Property Interests: Choice of Form of Business,61 Taxes 844 (1983).

[6] Fleischer, supra note 5.

[7] It also includes “[a]ny activity in support of any service described in” (1) through (3). Proposed section 710(c)(1)(D).

[8] It also includes options and derivative contracts with respect to such assets. Prop. ß710(c)(1) (final flush language).

[9] Proposed section 710(c)(2)(A).

[10] Proposed section 710(c)(2)(C).

[11] Id. 12 Proposed section 710(c)(2)(D)(i).

[13] Proposed section 710(c)(2)(D)(ii).

[14] Proposed section 710(a)(2)(A).

[15] Proposed section 710(a)(2)(B).

[16] Proposed section 710(a)(2)(D).

[17] Proposed section 710(a)(2)(C).

[18] Proposed section 710(b)(1).

[19] Proposed section 710(b)(2).

[20] Proposed section 710(c)(2)(B).

[21] Proposed section 710(b)(5).

[22] Proposed section 710(b)(4).

[23] Proposed section 710(d)(1).

[24] Proposed section 710(d)(2).

[25] Proposed section 710(d)(2)(A) (final flush language).

[26] Proposed section 710(d)(1).

[27] Diamond v. Commissioner, 56 T.C. 530, affíd, 492 F.2d 286 (7th Cir.1974).

[28] See Diamond v. Commissioner, 492 F.2d at 289.

[29] E.g., Campbell v. Commissioner, 943 F.2d 815 (8th Cir. 1991); St. John v. United States, 84-1 USTC ∂9158 (C.D. Ill. 1983).

[30] 1993-2 C.B. 343.

[31] The tax-free receipt rule of Revenue Procedure 93-27 also does not apply to the grant of a profits interest in a “publicly-traded partnership,” an entity that while formed as a partnership must be taxed as a corporation pursuant to I.R.C. ß7704(b) unless 90% or more of the venture’s income is “qualifying income” as defined in I.R.C. ß7704(d). In Revenue Procedure 2001-43, 2001-2 C.B. 191, the Service amplified Revenue Procedure 93-27, making clear that the rule announced in Revenue Procedure 93-27 applied to both vested and unvested partnership interests.

[32] Prop. Reg. ß1.721-1(b) (May 24, 2005).

[33] Notice 2005-43, 2005-1 C.B. 1221. The election cannot be made if either the profits interest is “related 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” or the profits interest was “transferred in anticipation of a subsequent disposition.” In addition, the election cannot be made if the entity is a “publicly-traded partnership” as defined in I.R.C. ß7704.

[34] See, e.g., Fleischer, supra note 5, at 37. 35 I.R.C. ß83, applicable to receipt of stock in connection with the performance of services, treats the service provider as the owner of the stock once inclusion is proper under ß83(a) or (b). See Reg. ßß1.83-1(a), 1.83-2(a).

[36] Proposed section 710(c)(1).

[37] Note that the definition of “investment management services” in proposed section 710(d)(2)(C), applicable only to “disqualified interests,” does not resolve this ambiguity.

[38] Groetzinger v. Commissioner, 480 U.S. 23, 27 (1987).

[39] Proposed section 710(c)(1).

[40] Id (emphasis added).

[41] Proposed section 710(c)(2). 42 Proposed section 710(c)(2)(A). 43 See I.R.C. ß1272(a)(7) (treatment of acquisition premium). 44 Proposed section 710(c)(2)(A) (final flush language).

[45] Proposed section 710(c)(2)(C).

[46] This example assumes that all capital shares equally in distributions. If there are multiple classes of capital, the analysis becomes more complicated. Multiple classes of capital are discussed below in the discussion entitled “Accounting for Subordinated Returns and Riskier Capital.”

[47] The general rule recharacterizing distributive share as compensation explicitly is applied on a year-by-year basis, see proposed section 710(a)(1)(A)-(B), while the definition of “invested capital” includes the value of all contributions (valued at the time of contribution), proposed section 710(c)(2)(C).

[48] Following the distribution X’s contributed capital equals $76 while Y’s remains at $4, and $4 out of $80 equals 5%.

[49] This assumption is relaxed in the discussion below entitled “Accounting for Subordinated Returns and Riskier Capital.” 50 See generally Howard E. Abrams, Cash and Carried Interests, 31 Real Estate Tax’n 52 (1st Quarter 2004), reprinted, 20 Tax Mgmt. Real Estate J. 329 (2004).

[51] Proposed section 710(c)(2)(A) (final flush language).

[52] See the “to the portion” language in proposed section 710(c)(2)(A) immediately following subsection (ii).

[53] See Reg. ß1.752-1(a)(2) (ignoring 10% or smaller creditor interest).

[54] See Reg. ß1.704-2(b)(3) incorporating the definition of “nonrecourse” from Reg. ß1.752-1(a)(2).

[55] See, e.g., Howard E. Abrams, Taxation of Carried Interests, 116 Tax Notes 183 (July 16, 2007).

[56] In particular, “qualified nonrecourse financing” within the meanining of I.R.C. ß465(b)(6) should not be treated as the invested capital of any of the partners but rather should be treated as bona fide loan proceeds.

[57] Proposed section 710(d)(2).

[58] Proposed section 710(d)(2)(A)-(B).

[59] Stock of the S corporation might fall within the definition of a “disqualified interest” even if the S Corporation manages real estate that it does not own directly or indirectly. For example, if the S corporation is a real estate management company that receives a percentage of gross rental receipts from unrelated third parties whose properties it manages, then arguably the value of the S corporation’s stock is “substantially related to the amount of income or gain . . . from the assets with respect to which the investment management services are performed.” If so, then gain from the sale of such stock will, among other things, be subject under proposed section 710 to the Self Employment Contributions Act tax.

[60] I.R.C. ß351(d)(1).

[61] Chairman Rangel’s op-ed in the Wall Street Journal on October 30 described the rationale for proposed section 710 this way: “There is no justification for fund managers to continue receiving a lower, 15% tax rate on “carried interest,” which is essentially compensation paid for the services they provide. By adjusting the top rates and reducing windfalls paid out to some of the wealthiest individuals in the nation, we can help restore a sense of equity and fairness that is critical to the success of our voluntary tax system.”

[62] All figures taken from the Report of Dr. John Rutledge available at www.carriedinterest.org.

[63] Proposed section 710(c)(1) (final flush language).

[64] I.R.C. 263A(b)(2)(B). 65 I.R.C. ß453A(c)(4)(A). 66 Gregory Zuckerman & Craig Karmin, Sowood’s Short, Hot Summer, Wall Street Journal at B1 (October 27-28, 2007).

[65] I.R.C. ß453A(c)(4)(A).

[66] Gregory Zuckerman & Craig Karmin, Sowood’s Short, Hot Summer, Wall Street Journal at B1 (October 27-28, 2007).

[67] Craig Karmin, Scaling Up the Pay for Public Service, Wall Street Journal at C1 (October 29, 2007).

[68] See Fleischer, supra note 5.

[69] See Reg. ßß1.707-3(c)(1), -3(d).

[70] See also ßß704(c)(1)(B) (7-year rule),727(b) (5-year rule), 735(a)(2) (5-year rule), and 737(b)(1) (7-year rule)

Previously published by the Emory Law School