The Proper Tax Treatment of the Transfer of a Compensatory Partnership Interest

59 Pages Posted: 25 Nov 2009 Last revised: 11 Jan 2010

See all articles by Douglas A. Kahn

Douglas A. Kahn

University of Michigan Law School

Date Written: November 23, 2008

Abstract

A partnership interest that is received as payment for past or future services is sometimes referred to as a "compensatory partnership interest." Partnership interests can be divided into two broad categories - profits interests and capital interests. The tax treatment of a compensatory partnership profits interest has been the topic of considerable commentary recently in connection with the receipt of such interests, often referred to as "carried interests," by managers of private equity funds. It is a controversial question as to whether the current tax treatment of those carried interests in private equity funds is bad and should be changed.

This Article does not address questions concerning private equity funds. Rather, the focus of this Article is on the more general question of how the receipt of a compensatory partnership interest should be taxed. However, the analysis and conclusions of this Article are relevant to the resolution of the questions concerning the taxation of a manager of a private equity fund. Two of the issues concerning compensatory partnership interests are: (1) whether their value should be included in the recipient's gross income, and (2) how they should be valued for tax purposes.

Part III of this Article considers the question of what tax treatment should be applied to the receipt of a compensatory partnership interest. In that connection, the Article describes circumstances in which there is a principled reason not to tax the recipient. Part III also discusses the manner in which a taxable compensatory partnership interest, whether a capital interest or a profits interest, should be valued. Part III discusses the landmark decision of the Second Circuit in McCallister v. Commissioner, and the Third Circuit's recent criticism of that decision in Lattera v. Commissioner. Part IV discusses the question of whether a taxable transfer of a compensatory partnership capital interest causes a constructive sale of part of the partnership's assets. Part V sets forth the Article's conclusions.

Keywords: Partnership, Interest, Compensatory, Capital, Tax, Carried Interest, Hedge Fund, Private Equity

JEL Classification: H20, H25

Suggested Citation

Kahn, Douglas A., The Proper Tax Treatment of the Transfer of a Compensatory Partnership Interest (November 23, 2008). Tax Lawyer, Vol. 62, No. 1, pp. 1-28, Summer 2009, U of Michigan Public Law Working Paper No. 179, Available at SSRN: https://ssrn.com/abstract=1511921

Douglas A. Kahn (Contact Author)

University of Michigan Law School ( email )

625 South State Street
Ann Arbor, MI 48109-1215
United States
734-647-4043 (Phone)

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