Converting a Profits (or Carried) Interest Into a Capital Interest Tax-Free, Even if it is a Marketable Security
Posted in Taxing Matters

In CCA 201517006 (dated 10/9/14 and released 4/24/15), the general partner of a publicly traded partnership (PTP) had, in addition to its capital interest, a profits interest in the PTP called “incentive distribution rights” (IDRs). We know the IDRs are a profits interest because they “did not carry any interest in partnership capital [on the date of the issuance of the IDRs] but entitled [the general partner] to share in future partnership profits and quarterly distributions”. What is not clear in the CCA is why the IDRs received the benefits of the Safe Harbor of Revenue Procedures 93-27 and 2001-43, which are never sited in the CCA, when the IDRs (which were evidenced by a form of nonmarketable limited partnership interests in the PTP) were issued by a partnership which is a publicly traded partnership as defined in Section 7704(b) — a fact of disqualification under Revenue Procedure 93-27.

After some time (we don’t know if it was within the two-year “no disposition” period of Revenue Procedure 93-27), the IDRs were well into the money, both with respect to current distributions and share of asset appreciation. At this later time, the general partner of the PTP wanted to exchange its IDRs/profits interest for publicly-traded common units in the PTP plus new IDRs. Like the old IDRs, the new IDRs were profits interests. The new IDRs together with the newly issued publicly-traded common units produced the same distributions to the general partner as the old IDRs produced in the prior quarter.

Looking for a book-up event so that the general partner’s capital account for its newly issued, publicly-traded common units was the same as the capital accounts of the other publicly-traded common units and thus all common units would remain fungible, the general partner’s corporate parent contributed more than a de minimis amount of cash to the PTP in exchange for publicly-traded common units in the PTP in order to trigger a book-up event under Regulation Section 1.704-1(b)(2)(iv)(f)(5)(i). We are not told why the issuance of the new IDRs would not have been sufficient to trigger a book-up event under Regulation Section 1.704-1(b)(2)(iv)(f)(5)(iii); but clearly it was not.

Relying on Sections 706 and 761 which enable contemporaneous partners to retroactively readjust their interests in partnership items and on Revenue Rulings 84-52, 95-37 and 95-55, which make tax-free the conversion from one form of tax partnership into another form of tax partnership based on the tax-free contribution principles of Section 721, the IRS’s Chief Counsel Office concluded that the general partner’s exchange of old IDRs for publicly-traded common units and new IDRs was merely a “readjustment of partnership items among existing partners” and therefore was not a taxable event.

When the dust settled, the general partner traded its nonmarketable profits interest (in the form of the old IDRs) for a publicly-traded full partnership interest (in the form of common units) tax free! As a result, subsequent declines in the value of the PTP assets (think of the recent collapse of oil prices) will not be disproportionately borne by the general partner as it would have been if this restructure did not occur. And subsequent increases in value of the PTP assets will be disproportionately earned by the general partner because of its new IDRs. All in all, not a bad day at the office for the general partner, yet not such a good day for the limited partners holding the common units.

For our clients who hold profits (carried) interests in tax partnerships which are not PTPs, CCA 201517006 supports the conversion of such profits (carried) interests into full capital interests based on increases in enterprise value without the recognition of income, and does so without reliance on the Safe Harbor of Revenue Procedures 93-27 and 2001-43. However, the negotiation of the terms of such conversion between the holder of the profits (carried) interest and the investors is an entirely different and more difficult matter.

Tags: Taxes

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