IRS Proposes New Profits Interest Regulations

Originally published June 22, 2005

Under the U.S. tax laws, the receipt of an interest in partnership profits is generally not taxable to the recipient, and allocations of partnership tax items (such as capital gains) to the recipient are characterized in the recipient’s hands based on how such items are characterized by the partnership. These rules allow fund sponsors to grant carried interests in their funds to managers and other service providers on a tax-free basis, and any subsequent profit allocations to those recipients are often characterized as mostly capital gain. Likewise, an operating LLC can achieve similar results by granting profits interests to key executives and employees.