10.2.1.b: Note on the 'Carried Interest'

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Abstract

The award of a carried interest in profits to the general partners of a investment partnership is not deemed by most practitioners to be a taxable event, despite the fact that the holding in a celebrated early case, Sol Diamond,[1] can be read to the contrary. (The award of a free interest in capital would clearly be taxable.) The facts in Sol Diamond were that the "carried" profits interests granted to the taxpayer had immediate value; indeed, the taxpayer realized on the interest by selling it at a gain within weeks after the acquisition. Tax practitioners have interpreted the Sol Diamond holding, and the Internal Revenue Service's subsequent inactivity, as suggesting a "liquidation value" approach to the issue; that is to say, the proper inquiry is whether the profits interest granted on "day one" would be worthless on "day two," assuming the partnership were liquidated on...