Cash and Carried Interests: Protecting the Investor and Developer in a Real Estate Partnership Howard E. Abrams Of Counsel, Steptoe & Johnson LLP Professor, Emory Law School Copyright 2003 by Howard E. Abrams. All rights reserved

2 The Basics of Economic Effect Capital accounts must be properly maintained. Final capital account balances must determine liquidating distributions. No negative capital accounts without clawback obligation.

3 The Problem of a Carried Interest; Of Taxes and Timing

4 The term “carried interest” is not defined in the Internal Revenue Code. The term is not defined under case law or any IRS authority. Carried interest commonly refers to a partnership interest that is secondary in priority with respect to cash recovery; i.e., it does not get paid first. This does not mean, however, that carried interests necessarily get paid last. What is a “carried interest”?

5 Baseline Situation ID ID $98,000$2,000 BlackacreWhiteacre $50,000

6 Example 1a Facts: ID sells Blackacre for $80,000 and distributes the sale proceeds to the partners. Possible Results: Asset-by-Asset Approach -- $50,000 of the distribution is treated as a return of capital and $30,000 is treated as profit. Aggregate Approach – The entire $80,000 distribution is treated as a return of capital because the partners’ aggregate unreturned investment stands at $100,000.

7 Example 1a; Asset-by Asset Approach _______ I _______ _______ D _______ Capital Basis Capital Basis $ 98,000 $ 98,000 $ 2,000 $ 2,000 Contributions

8 Example 1a; Asset-by Asset Approach _______ I _______ _______ D _______ Capital Basis Capital Basis $ 98,000 $ 98,000 $ 2,000 $ 2,000 23,520 23,520 6,480 6,480 Contributions Allocation of Profit

9 Example 1a; Asset-by Asset Approach _______ I _______ _______ D _______ Capital Basis Capital Basis $ 98,000 $ 98,000 $ 2,000 $ 2,000 23,520 23,520 6,480 6,480 (49,000) (49,000) (1,000) (1,000) Contributions Allocation of Profit Return of Capital

10 Example 1a; Asset-by Asset Approach _______ I _______ _______ D _______ Capital Basis Capital Basis $ 98,000 $ 98,000 $ 2,000 $ 2,000 23,520 23,520 6,480 6,480 (49,000) (49,000) (1,000) (1,000) (23,520) (23,520)(6,480) (6,480) $ 49,000 $ 49,000 $ 1,000 $ 1,000 Contributions Allocation of Profit Return of Capital Profit Total

11 Example 1a; Asset-by Asset Approach (continued) Sale of Whiteacre at a Loss of $10,000 Loss must be charged back in proportion to prior allocation of gain. Loss Share to I = $7,840 Loss Share to D = $2,160

12 Example 1a; Asset-by Asset Approach (continued) _______ I _______ _______ D _______ Capital Basis Capital Basis $ 98,000 $ 98,000 $ 2,000 $ 2,000 23,520 23,520 6,480 6,480 (72,520) (72,520)(7,480) (7,480) $ 49,000 $ 49,000 $ 1,000 $ 1,000 Contributions Allocation of Profit Distributions Totals

13 Example 1a; Asset-by Asset Approach (continued) _______ I _______ _______ D _______ Capital Basis Capital Basis $ 98,000 $ 98,000 $ 2,000 $ 2,000 23,520 23,520 6,480 6,480 (72,520) (72,520)(7,480) (7,480) $ 49,000 $ 49,000 $ 1,000 $ 1,000 (7,840) (7,840) (2,160) (2,160) $ 41,160 41,160 $ (1,160) $ (1,160) Contributions Allocation of Profit Distributions Totals Allocation of Loss New Totals

14 Example 1a; Aggregate Approach _______ I _______ _______ D _______ Capital Basis Capital Basis $ 98,000 $ 98,000 $ 2,000 $ 2,000 Contributions

15 Example 1a; Aggregate Approach _______ I _______ _______ D _______ Capital Basis Capital Basis $ 98,000 $ 98,000 $ 2,000 $ 2,000 29,400 29, Contributions Allocation of Profit

16 Example 1a; Aggregate Approach _______ I _______ _______ D _______ Capital Basis Capital Basis $ 98,000 $ 98,000 $ 2,000 $ 2,000 29,400 29, (78,400) (78,400)(1,600) (1,600) $ 49,000 $ 49,000 $ 1,000 $ 1,000 Contributions Allocation of Profit Return of Capital Totals

17 Example 1a; Aggregate Approach (continued) Sale of Whiteacre at Cost Now suppose that ID sells Whiteacre for its cost basis of $50,000. There is no book or tax gain to be allocated, so the books remain unchanged.

18 Example 1a; Aggregate Approach _______ I _______ _______ D _______ Capital Basis Capital Basis $ 98,000 $ 98,000 $ 2,000 $ 2,000 29,400 29, (78,400) (78,400)(1,600) (1,600) $ 49,000 $ 49,000 $ 1,000 $ 1,000 Contributions Allocation of Profit Return of Capital Totals

19 Example 1a; Aggregate Approach _______ I _______ _______ D _______ Capital Basis Capital Basis $ 98,000 $ 98,000 $ 2,000 $ 2,000 29,400 29, (78,400) (78,400)(1,600) (1,600) $ 49,000 $ 49,000 $ 1,000 $ 1,000 The partnership has turned a profit of $30,000, But D made only $600! What happened to the carry? Contributions Allocation of Profit Return of Capital Totals

20 Example 1a; Aggregate Approach (continued) Could the partners agree to distribute the final cash other than in accordance with final capital account balances?

21 Example 1a; Aggregate Approach (continued) Could the partners agree to distribute the final cash other than in accordance with final capital account balances? No, because that would violate the requirement of “substantial economic effect.”

22 Example 1a; Aggregate Approach (continued) What if a clawback was imposed on I?

23 Example 1a; Aggregate Approach (continued) That would not work either. If we require that I contribute additional funds to the venture, that contribution will increase I’s capital account. Because final liquidation proceeds must be made in accordance with capital account balances, the clawback cannot operate to shift funds from I to D

24 Example 1a; Aggregate Approach (continued) Then what is the solution?

25 Example 1a; Aggregate Approach (continued) The only way to fix the problem is to anticipate and address the tax allocations from the beginning. We need to allocate the gain in accordance with profits interests even though we will distribute the cash as return of capital. This yields:

26 Example 1a; Aggregate Approach (continued) _______ I _______ _______ D _______ Capital Basis Capital Basis $ 98,000 $ 98,000 $ 2,000 $ 2,000 23,520 23,520 6,480 6,480 (78,400) (78,400)(1,600) (1,600) $ 43,120 $ 43,120 $ 6,880 $ 6,880 Contributions Allocation of Profit Distributions Totals

27 Example 1a; Aggregate Approach (continued) The moral of this story: Even if cash will be distributed on an aggregate basis, profits must be allocated on an asset-by-asset basis.

28 Example 1a; Aggregate Approach (continued) _______ I _______ _______ D _______ Capital Basis Capital Basis $ 98,000 $ 98,000 $ 2,000 $ 2,000 23,520 23,520 6,480 6,480 (78,400) (78,400)(1,600) (1,600) $ 43,120 $ 43,120 $ 6,880 $ 6,880 Contributions Allocation of Profit Distributions Totals

29 Example 1a; Aggregate Approach (continued) _______ I _______ _______ D _______ Capital Basis Capital Basis $ 98,000 $ 98,000 $ 2,000 $ 2,000 23,520 23,520 6,480 6,480 (78,400) (78,400)(1,600) (1,600) $ 43,120 $ 43,120 $ 6,880 $ 6,880 Contributions Allocation of Profit Distributions Totals But now there is a cash flow problem for D.

30 Example 1a; Aggregate Approach (continued) _______ I _______ _______ D _______ Capital Basis Capital Basis $ 98,000 $ 98,000 $ 2,000 $ 2,000 23,520 23,520 6,480 6, (2,592) (2,592) Contributions Allocation of Profit Tax Distribution

31 Example 1a; Aggregate Approach (continued) _______ I _______ _______ D _______ Capital Basis Capital Basis $ 98,000 $ 98,000 $ 2,000 $ 2,000 23,520 23,520 6,480 6, (2,592) (2,592) (77,408) (77,408) 0 0 $ 44,112 $ 44,112 $ 5,888 $ 5,888 Contributions Allocation of Profit Tax Distribution Return of Capital Totals

32 Hurdles; Guaranteed Payments and Preferred Returns

33 Guaranteed Payments The ID Partnership Agreement may provide that guaranteed payments will be made on contributed capital generally or only on the capital contributed by I. Because guaranteed payments for the use of capital are deductible, the guaranteed payment obligation reduces the Partnership’s net income. This reduces the amount of income derived from D’s carry, as some portion of that amount will be used to satisfy the Partnership’s guaranteed payment obligation.

34 Guaranteed Payments; Example 1a The ID Partnership agreement provides for a cumulative, guaranteed return of 6% (compounded annually) on I’s invested capital The Partnership sells Blackacre at the end of Year 2 for $80,000, which results in a gain of $30,000. However, the Partnership’s income will not be $30,000. Rather, because of the deduction attributable to the cumulative guaranteed payment (of $12,113), the partnership’s income from the sale of Blackacre will be only $17,887. Thus, the books of the partnership will become:

35 Guaranteed Payments; Example 1a (Continued) _______ I _______ _______ D _______ Capital Basis Capital Basis $ 98,000 $ 98,000 $ 2,000 $ 2,000 14,310 14,310 3,577 3,577 ( 5,724) ( 5,724)(1,431) (1,431) (59,517) (59,517) (1,215) (1,215) $ 47,069 $ 47,069 $ 2,931 $ 2,931 Contributions Allocation of Profit Tax Distributions Return of Capital Totals

36 Preferred Returns While preferred returns and guaranteed payments are similar in many ways, there exist two significant differences: (1)If the partnership does not do well, the preferred return will have no impact while a guaranteed payment obligation must be satisfied regardless of the partnership’s performance; and (2)The guaranteed payment is taxed as ordinary income to the recipient and gives rise to an ordinary deduction for the partnership (usually shared between I and D), while the preferred return does not affect the character of the income or loss.

37 Preferred Returns; Example 1a (continued) _______ I _______ _______ D _______ Capital Basis Capital Basis $ 98,000 $ 98,000 $ 2,000 $ 2,000 12,113 12, ,310 14,310 3,577 3,577 12,113 12, ( 5,724) ( 5,724)(1,431) (1,431) (59,517) (59,517) (1,215) (1,215) $ 47,069 $ 47,069 $ 2,931 $ 2,931 Contributions Preferred Return Allocation of Profit Preferred Distribs. Tax Distributions Return of Capital Totals

38 A Vesting Carried Interest

39 A Vesting Carried Interest Compare actual capital account to target capital account.

40 A Vesting Carried Interest Compare actual capital account to target capital account. Gross-up actual capital account by distributions.

41 A Vesting Carried Interest Compare actual capital account to target capital account. Gross-up actual capital account by distributions. No need for regulatory allocation offset provision.

42 Contributions of Property

43 Contributions of Property Prohibit taxable dispositions of contributed property.

44 Contributions of Property Prohibit taxable dispositions of contributed property. Prohibit contributions of contributed property to lower-tier partnerships.

45 Contributions of Property Prohibit taxable dispositions of contributed property. Prohibit contributions of contributed property to lower-tier partnerships. Control the section 704(c)(1)(A) recovery method.

46 Exempt Organization as Partners The Fractions Rule: –Irrelevant if no debt on property –Irrelevant if all partners are “qualified organizations” –Limits book allocations only –Consider distributing appreciated property to the exempt organization.