Phantom Carry and Carry Points: Taxes, Vesting and the 83(b)

When are carry points taxed: at grant, at vesting or when carry is paid?

Carry points that are a profits interest are generally not taxed when granted or when they vest. You are taxed on the carry as the general partner (GP) allocates it to you on your Schedule K-1, starting from the grant date. That follows from two IRS revenue procedures, Rev. Proc. 93-27 and Rev. Proc. 2001-43 (Internal Revenue Bulletin 2001-34). When the GP later pays the carry in cash, the payment is generally not taxed again, because you already reported the income; only cash beyond your basis in the points is taxed (26 USC 731(a)). Phantom carry, a cash bonus measured by carry, is different: it is wages.

Rev. Proc. 2001-43 says the IRS will not treat the grant, or the later vesting, of a profits interest as a taxable event when three conditions hold:

1. The GP and you treat you as a partner from the grant date, and you report your share of the GP's income, gain, loss and deduction on your own return for the whole time you hold the points, vested or not.
2. Neither the GP nor any partner deducts the value of the points, as wages or otherwise, at grant or at vesting.
3. All other conditions of Rev. Proc. 93-27 are met.

Rev. Proc. 93-27 does not apply, and the grant can be taxable, when any of these is true (Notice 2005-43, which summarizes it):

The revenue procedures cover an interest received for services to or for the benefit of the partnership, in a partner capacity or in anticipation of becoming a partner. Many employees work for the management company, not the GP that grants the points. The revenue procedures do not say directly whether work for the management company counts. Read how the grant letter and the GP agreement describe your services, and have a CPA review them if they name only the management company.

What makes a case not simple: a grant made when the fund already has gains, a missing or late 83(b), a forfeiture, a firm loan, or phantom carry paid in cash. Each is below. Gather the grant letter, the GP or carry vehicle agreement, any 83(b) copy and mailing proof, every K-1 from the GP, and any loan papers. A CPA firm that prepares fund employees' returns can read these together and report each item; see hedge fund and private equity tax.

Do I need an 83(b) election for unvested carry?

Not if Rev. Proc. 2001-43 applies: it says taxpayers it covers "need not file" a section 83(b) election (Rev. Proc. 2001-43, section 3). Firms often ask for a protective election anyway, in case that safe harbor (a rule the IRS promises to follow if you meet its conditions) turns out not to apply. If it does not apply and you made no election, section 83(a) taxes the value of the points, less anything you paid, as pay in the year they vest, measured then, when the fund may have grown. Until vesting you are not treated as the owner, so anything you receive from the points before then is also pay (26 USC 83(a); 26 CFR 1.83-1(a)(1)). For points worth nothing on the grant date, a protective election reports zero income.

The rules for any 83(b) election, protective or not:

The election reports the fair market value of the points on the transfer date, less anything you paid, as pay for the year of the grant. For points that would get nothing in a liquidation, the value entered is often zero. Fair market value and liquidation value are not always the same, and a liquidation-value safe harbor described in Notice 2005-43 was only proposed, so check the value with the GP before you sign.

The fund already has gains when I get points: is the grant taxable?

It can be, in part. Rev. Proc. 93-27 covers only a profits interest: one that would get nothing if the partnership sold all its assets at fair market value and liquidated on the grant date (Rev. Proc. 2001-43, section 2). Points that would share in gains already built up are partly a capital interest, which the revenue procedures do not cover.

GPs usually deal with this by revaluing partners' capital accounts when points are granted: marking the fund's assets to current value and crediting existing gains to the partners who already hold interests, so new points share only in future gains. The regulations allow that revaluation in connection with granting an interest for services (26 CFR 1.704-1(b)(2)(iv)(f)). Ask the GP whether capital accounts were revalued, or whether a hurdle or threshold was set, at your grant date. If neither was done and the fund had gains, the value of any capital interest is a question for a CPA before you file.

I can't find proof my 83(b) was filed: what do I check?

Check, in this order: the firm's copy (you were required to give one), your own signed copy, a certified mail or delivery receipt, and the grant paperwork the firm sent. The 30-day deadline has no extension, so a missing election cannot be filed late.

If all of Rev. Proc. 2001-43's conditions are met, a missing protective election may not matter, because that revenue procedure says no election is needed. It matters if the points were partly a capital interest or fall under one of the Rev. Proc. 93-27 exceptions: then the value at vesting can be taxed as pay. A CPA should confirm which applies before you rely on it.

Am I taxed on carry allocated to me while it's unvested?

Yes, if you rely on Rev. Proc. 2001-43. Its first condition is that you report your share of the GP's items for the entire period you hold the points, starting at grant, vested or not (Rev. Proc. 2001-43, section 4.01). A partner may owe tax on a share of partnership income whether or not it is distributed (Partner's Instructions for Schedule K-1).

Whether you get cash to pay that tax depends on the GP agreement. Some agreements make tax distributions; some do not, or pay them only after carry is actually received. If the distribution falls short of your bill, see estimated tax in a big bonus year.

I forfeited unvested carry: can I deduct anything?

Two amounts are involved. The 83(b) loss is limited to what you paid for the points, which is often zero; income you reported but never received is unsettled. With an 83(b) election in effect, a forfeiture is treated as a sale with a loss equal only to what you paid for the points minus what you got back, and that loss is a capital loss if the points were a capital asset (26 CFR 1.83-2(a)). For points you paid nothing for, that is often zero.

Income allocated to you before the forfeiture but never paid out is harder. Proposed regulations issued with Notice 2005-43 would require the partnership to make "forfeiture allocations" in the year of forfeiture to reverse income allocated earlier (Internal Revenue Bulletin 2005-24). Those rules were proposed, never finalized, and the notice says taxpayers may continue to rely on Rev. Procs. 93-27 and 2001-43 until they are. How a GP reverses earlier allocations is therefore unsettled; it depends on the GP agreement and how the GP reports the forfeiture year on your K-1. If the GP does not reverse it, the preamble to the proposed rules says section 83(b)(1) may bar a loss for income you were allocated but never received. Have a CPA review that K-1 before you file.

My firm pays phantom carry in cash: is it taxed like real carry?

No. A cash bonus measured by carry is wages: ordinary income on Form W-2, with no K-1, no capital gain and no three-year rule. Publication 15 says wages include all pay for services and that it does not matter how payments are measured (Publication 15).

The timing usually splits. Social Security and Medicare are generally due when the bonus vests, meaning you no longer lose it by leaving, or later once the amount can be determined (26 CFR 31.3121(v)(2)-1). Income tax is due when paid, if the plan follows section 409A, the federal rules for deferred pay, or pays soon after vesting. If it meets neither, income can be taxed earlier with an added tax (26 USC 409A(a)(1)). The full timing is in deferred bonuses at a fund manager.

My carry is vested and I've left: which K-1s keep coming?

Each GP or carry vehicle you hold points in sends a Schedule K-1 every year you hold the interest, often until the fund winds down. A calendar-year partnership's K-1 is due by March 15, or September 15 with an extension; fund K-1s often arrive late, as late fund tax forms explains. Where the fund invests in several states, the GP may also send state K-1s and file state returns for you; see state returns for fund investors. If the IRS later audits a year you held points, the GP can elect to push the adjustment out to that year's partners, including you after you leave: you then pay the extra tax for that year with your return for the year you receive the statement (26 USC 6226).

Read the GP agreement's departure terms: some let the GP buy back vested points, which ends the K-1s and may be a taxable sale. A buyback within two years of the grant may also take the grant outside Rev. Proc. 93-27 (see the exceptions table above); have a CPA review it. What happens to unvested pay and points when you leave is in leaving a fund with unvested pay and carry.

The firm lent me money to co-invest at a low rate: is that taxable pay?

It can be. A demand loan is below-market if it charges less than the applicable federal rate, which the IRS publishes monthly; a term loan is below-market if its payments, discounted at that rate, are worth less than the amount lent (26 USC 7872(e)(1)). A loan at least at that rate has no imputed pay. A below-market loan between an employer and an employee is a compensation-related loan under 26 USC 7872(c)(1)(B). The law treats the interest you did not pay as pay to you, and then as interest you paid back. How and when depends on the loan type:

A loan whose interest benefit cannot be transferred and depends on your continuing to work for the firm is treated as a demand loan, except that the interest rate is set as for a term loan (7872(f)(5)). A temporary regulation also exempts a loan if you can show its interest terms have no significant effect on your or the lender's federal tax, judged on all the facts, such as whether the deemed pay and deemed interest offset each other (26 CFR 1.7872-5T(b)(14), (c)(3)). Whether you can deduct the interest treated as paid back depends on what the loan funded; see becoming a partner at a fund manager.

If the firm forgives the loan because you work there, the forgiven amount is pay for your services (26 CFR 1.61-12(a)). A capital call the firm pays for you as a bonus is also pay (Publication 15). When your employer forgave the loan or paid the call, it belongs on your Form W-2 as wages; if the GP did, ask how it will be reported before you file.

Do I owe self-employment tax or the net investment income tax on carry?

Self-employment tax: carry that the K-1 shows as capital gain is generally excluded from self-employment earnings, but other GP income may not be; see limited partner self-employment tax for fund managers.

Net investment income tax: the IRS lists capital gains as investment income, so carry reported as capital gain can be subject to the 3.8% tax once your modified adjusted gross income passes $200,000 for a single filer or $250,000 for a joint return (IRS questions and answers). Phantom carry is wages, so it is not net investment income, but wages above $200,000 ($250,000 on a joint return) carry the 0.9% Additional Medicare Tax (Publication 15). Whether carry is long-term or short-term is in carried interest and the three-year rule.

Example

All figures are in US dollars and illustrative only.

A VP's points with a protective 83(b)

A VP receives 2 points in the GP of Fund III, vesting over four years. The GP revalued capital accounts on the grant date, so the points would get $0 in a liquidation that day. The firm asks for a protective 83(b). The VP mails Form 15620 showing a value of $0 and $0 paid on day 12, by certified mail, and gives the firm a copy. No income is reported for the grant. In year two the GP allocates the VP $40,000 of capital gain on the K-1; the VP reports it, though nothing has vested and no cash was distributed.

The same VP forfeits

In year three the VP leaves before the points vest and forfeits them. The VP paid $0, so the 83(b) forfeiture loss is $0. The $40,000 reported in year two was never paid out. If the K-1 does not reverse it, a loss for it may not be allowed. Whether the GP's year-three K-1 reverses any of it depends on the GP agreement, because the forfeiture allocation rules were never finalized. The VP's CPA reads that K-1 against the agreement.

A co-invest demand loan

The firm lends a principal $200,000 at no interest, payable on demand, to fund a co-invest. If the federal short-term rate were 4% for the whole year, compounded twice a year as the law requires, the forgone interest would be $8,080. On December 31 the law treats $8,080 as pay to the principal and $8,080 as interest paid back to the firm. Had total loans from the firm been $10,000 or less, nothing would apply, unless avoiding tax was a main purpose.

Different for you?

• You are an independent sponsor with a promote: see independent sponsor fees and promote.
• Your carry is a promote in a real estate deal: different documents and timing; see hedge fund and private equity tax.
• You moved states before your carry or phantom carry was paid: see state tax on deferred pay after a move and moving to Florida or Texas as a fund manager.
• You are not a US citizen or resident, or moved abroad and still hold points: different withholding and filing rules can apply; see foreign partners and withholding.
• Your grant may be partly a capital interest, your 83(b) is missing, or you forfeited points: these need the grant, the GP agreement and your K-1s read together; see hedge fund and private equity tax.
• You are being made a partner and buying in: see becoming a partner at a fund manager.
• You are leaving with unvested pay and points: see leaving a fund with unvested pay and carry.
• You must give back carry you were already taxed on: see repaying a bonus you were taxed on.
• You are granting points in your own LLC, not receiving them: see splitting ownership between LLC partners.
• The IRS is auditing the fund's partnership return: see IRS audit of a fund partnership return.