Partnership-Related Relatedness: Measuring Partners’ Capital Interests and Profits Interests

Abstract

Section 707(b)(1) provides that two partnerships are related if the same persons own more than 50% of the partnership’s capital interests or profits interests. Even though numerous sections of the Internal Revenue Code rely upon that definition of partnership relatedness, the law does not provide meaningful guidance for measuring capital and profits interests. Measuring such interests in partnerships with distribution-dependent equity structures is particularly challenging because rights to profits can vary from tier-to-tier in distribution waterfalls. Focusing on measuring profits interests in partnerships, this article presents five methods for measuring such interests: (1) the max-out approach, (2) the capital-only liquidation approach, (3) the capital-plus liquidation approach, (4) the current-profits approach, and (5) the projected-profits approach. With no guidance in this area favoring any approach, observers may conclude that any of the approaches could be used to measure profits interests. The article uses an example to test each approach and to demonstrate that the capital-plus liquidation approach, which considers how capital and profits would be distributed in a hypothetical liquidation at the time of measurement, is the soundest of the five approaches and returns reasonable values. The article suggests that the IRS should provide guidance in this area to create certainty for an important section of the Internal Revenue Code.

Keywords: profits interests, related partnership, section 707(b), section 1031, qualified opportunity fund