Just as the telecom industry measures progress in the amount of data that can be shoved through narrower and narrower data pipelines, income and estate planners pride themselves on schemes that shove larger and larger portions of their clients’ property through the income, estate and gift tax gauntlet without triggering a tax. While Congress, with the 2001 Tax Act, has widened the road on which income and accumulated wealth can pass with minimal or no tax burden, the pressure to package ownership, control and income stream efficiently does not abate. There is always that last, or rather, that first tax dollar to avoid, and there is always the possibility that politics, the deficit — or the election to the presidency of a governor from a small state — will lead to a reversal of the trend toward less taxation. The device used to do the packaging is the conceit that there is a meaningful distinction between ownership of “capital,” on the one hand, and ownership of an interest in “profits,” on the other.
If you own everything, or a percentage of everything, in a deal, then you own both the capital and the profits interest. Tax planners charged with engineering a least-tax cost means of getting from point A to point B pry that undifferentiated everything into those two parts — capital and profits.
Considering the interests
To own a capital interest is to have a right to receive all (or at least, your share of all) the proceeds of liquidation of that venture if it were sold today. If a business could fetch $1 million today, and you, as stockholder, partner or member, are entitled to any portion of that $1 million, then you own an interest in capital. If, on the other hand, your right to a payoff of any kind is dependent on future events, either future operating results or future appreciation, then you own a profits interest.
Tax planners reserve the capital interest, the “frozen” interest, to the current owner of the venture and steer the low-value, high-upside profits interest to the desired transferee — the heir, the employee, the broker, the investor.
Where’s the tax angle in a profits interest?
Under the right facts, you get to give away a right that is subjectively valued on the high side, even though you report the transfer to the IRS at a much lower, objectively derived value. A profits interest can look pretty thin from a traditional financial analysis because you discount likely cash flow over the life of the investment using a discount rate appropriate to the risk. The IRS can’t force you to report a value based on your gut feeling about a piece of real estate or a hot tech venture. In other words, the real world value of the profits interest may be far greater than indicated by the discounted cash flow methodology used to report taxes.
When it comes to income taxes, the heavy traffic in profits interests occurs when an employee, consultant or broker wants to get paid for his or her immeasurably vital advice or brokerage services but doesn’t want to pay taxes on it. Hey, no problem. Take a profits interest. Even the IRS is in on the secret.
Case in point
The seminal case on this issue involved a mortgage banker, Sol Diamond, who, in exchange for financing a real estate deal, received a percent of the profits from the venture. Immediately upon receipt of the profits interest, he sold it for cash. The IRS argued that the receipt of the profits interest constituted compensation for his brokerage services. Diamond argued that the receipt of the profits interest was not taxable, because its value, dependent as it was on unpredictable profits, was essentially zero.
The problem with Diamond’s argument, however, was that Diamond sold the profits interest the moment he received it. Consequently, his Richard Pryor defense (as in: “Who ya gonna believe, me or your own lyin’ eyes?”) fell flat, and the court ruled that the grant of the profits interest constituted compensation.
Although Diamond’s itchy fingers cost him in taxes, the issue of valuation was joined, and planners were off to the races. Real estate developers handed out profits interests in deals to brokers and tenants, and entrepreneurs issued profits interests to employees and investors. (In fact, they had been doing it for years; now they had a court case to back up the practice.)
After Diamond and a later case in which the court ruled that a profits interest has no value, the IRS threw in the towel. It ruled that it would not attempt to tax the issuance of a profits interest in a venture, provided there were no indicia of abuse. Indicia of abuse include selling the interest too quickly, or granting an interest in no-risk property, such as Treasury bills.
And that’s where the law stands on profits interests used to compensate an employee or other service provider.
Following the trend
Along a parallel track, the law evolved in the area of estate planning to allow wealthy business people to peel off the “upside” in a business or property. They would reserve for themselves an annuity-like fixed payout based on the existing value of the venture and give away the speculative, difficult-to-value profits interests to the next generation. Elaborate rules, commonly referred to by the somewhat sinister-sounding moniker “Chapter 14 rules,” have grown up around this estate freeze technique, but the technique lives on nonetheless.
With the arrival of the ever-flexible limited liability company as a business entity of choice for both estate planning and compensation planning, there is a trend toward using multiple entities in structuring new ventures. It is common, even for straightforward deals, to have S-corporations owning interests in LLCs, single-member LLCs owning S-corps., trusts owning a piece of everything, and on and on. Consequently, the opportunity for shoving ever more low -or no-tax cost interests in ventures through the gauntlet of the Internal Revenue Code arises often. The use of a profits interests to minimize taxes of all kinds has overflowed its banks.
In the late ‘90s, Forbes Magazine pointed out that there was far more fiber optic cable planned for installation than the world could ever possibly use. Telecom promoters, however, continued to hype fiber optic to investors, and investors continued to buy the sunshine. Telecom then crashed, and a lot of profits interests came to naught.
Many of the telecom highflyers are wounded or gone, but there is a lot of fiber optic in the ground, and someone is bound to make money on it someday. Not all profits interests pay off, of course, but the quest to engineer a financial score at little or no tax cost endures.
© Maryland Gazette. Reprinted with permission.