Fuzzy Math and Carried Interests: Making Two and Twenty Equal 710

Abstract

Proposals to tax the compensatory portion of a service partner's return as ordinary income have gained momentum and enactment of carried interest legislation seems inevitable, driven by concerns about fairness and revenue. A leading legislative proposal (modified and reintroduced as H.R. 4213) would add new 710 to the Code. Proposed 710 is widely portrayed as taxing distributions to a covered service partner at ordinary income rates but the actual operation of the new provision is much more complex. This article argues that a distribution-based tax modeled on section 707(a)(2)(A) offers an alternative method of accomplishing the goal of section 710 -- taxing distributions to service providers as ordinary income -- while addressing the problem of deferring tax until distribution. Under a distribution-based approach, the key to proper taxation of a service partner's deferred compensation is to identify when the parties' differing tax profiles pose a risk of abuse due to undertaxation of the investment return on a service partner's deferred compensation. As long as the investment return on the deferred compensation is fully taxed (either directly or through substitute taxation), deferring ordinary income tax until distribution will not necessarily result in a loss of revenue. Bifurcating the benefits of deferral and conversion reveals that partnership profits interests are often no more advantageous, from a joint tax perspective, than other forms of partnership equity-based compensation.

Keywords: carried interests, 710, H.R. 6275, H.R. 1935, H.R. 4213, deferred compensation, profits interest, compensatory partnership options, 83, 409A, 457A, distributions, hot assets, sales of partnership interests

JEL Classification: K34