November 4-November 17, 2015 —
COLORADO REAL ESTATE JOURNAL
— Page 21
Law & Accounting
T
he term “carried inter-
ests” was coined in the
16th century to describe
a bonus payment to sailing ship
captains, and it seems the IRS
has been trying to figure out
how to tax such arrangements
since. Of course in current par-
lance, the term refers to the pro-
mote received by a manager of
a hedge fund or private equity
deal. In more traditional real
estate deals, the arrangement
can take the form of a grant of
an ownership piece with par-
ticipation in future profits from
the deal, often referred to as
a “sweat equity” arrangement.
The point being is that pure
investors are in the deal as just
that, while the more active part-
ner is working the deal and
contributing with its personal
efforts to earn some part of the
upside from the venture. There
is quite a bit of variety in how
deals are arranged so it is dan-
gerous to generalize too much,
but that paints the broad pic-
ture.
The issue is and has been,
what is the character of the
income earned? The IRS has
long tried to suggest that the
income is ordinary and, further,
has wanted to accelerate the tim-
ing of reporting the income to
the date the interest is received,
not when profits are paid out.
Now it seems every politician
in the world is trying to at least
get the income characterized as
ordinary earned income rather
than the more beneficial capital
gain. As noted, the typical real
estate deal may have an arrange-
ment that varies quite a bit from
the Wall Street setup, but likely
any rule changes intended to
go after the highly publicized
carried interest arrangements
will bring many Main Street
real estate sweat equity arrange-
ments under their coverage as
well.
The basic idea out there is if
you make personal efforts in a
business transaction (not a pas-
sive investor) and you receive
some form of payment, direct
or through a participation in
profits, then that should be tax-
able to you as ordinary earned
income. It is worth noting that
the IRS has gone after such
transactions for many years and
has generally only been success-
ful in making its case in the most
egregious of arrangements.
Of course, it is not unusual
for a partner to be paid directly
for services
and
have
the transac-
tion reported
similar to a
payment for
services to a
nonpartner,
as
earned
income (sal-
ary or fee
for services).
The issue is
regarding the
part of pay-
ment that is
styled as a share of partnership
profits. Currently, the rules sup-
port treating the profit share
just as it would be for a passive
investor, retaining the character
of the income as determined at
the partnership level. The stat-
ute does provide that the IRS
can recast a transaction that is
more appropriately styled as
payment for services, “not in
the capacity as a partner.” This
is not new, but, as noted, is only
applied successfully in unusual
situations.
The IRS recently issued pro-
posed regulations in support
of the referenced provision of
the statute that generally pro-
vide that an arrangement will
be recharacterized if the per-
son receiving the payment lacks
business risk in terms of the pay-
ment. Since the new regulations
are only proposed, you might
take a “wait and see” approach
since often proposed regulations
take years before they are made
final and, in many instances, are
never issued in final form at all.
However, in the preamble to the
regulations, the IRS states that
it believes the proposed regula-
tions reflect the intent of Con-
gress, suggesting that it would
intend to apply the principles
therein immediately.
The regulations as written
have a fairly generous defini-
tion of the type of transaction
that might run afoul of the
rules, with the primary factor
revolving around whether the
arrangement, “lacks significant
entrepreneurial risk.” That is, if
the so-called partner is assured
of payment, no matter the suc-
cess or failure of the venture, the
arrangement would be judged
as compensation for services
(ordinary income) by the IRS.
I would say that any payment
that is dependent upon achiev-
ing a profit from business opera-
tions or the increase in value of
partnership assets would have
the requisite business risk to
avoid recharacterization. If a
partner has certainty in the pay-
ment being made and is pro-
viding services to the partner-
ship, then it starts to get into
the territory where the income
could be restated by the IRS. It
is worth reviewing your exist-
ing arrangement to see if you
may run the risk of being recast
under the regulations. I think it
would be fairly simple to revise
the arrangement to avoid the
application of the regulations,
however.
This is another example of
the IRS trying to accomplish
through regulations what really
should be done through legisla-
tion. On that front, politicians
have been touting a rule change
in this area for so long that per-
haps it will get traction (that is if
any tax legislation can survive
the current political environ-
ment). The takeaway is that a
review of your current arrange-
ments is certainly in order to
avoid potential problems down
the road (or immediately if the
IRS is of a mind to apply the
principles in the proposed reg-
ulations before the regulations
are final) and to verify you don’t
have an issue now. Also, there
are often unintended business
consequences to sweat equity
arrangements, so a review with
that in mind can be useful as
well.
s
Zane Dennis, CPA
Tax partner and real
estate practice leader,
Richey May & Co. LLP,
Englewood
Now it
seems every
politician in
the world is
trying to at least
get the income
characterized as
ordinary earned
income rather
than the more
beneficial
capital gain.
