Does anyone have knowledge on how carry is structured for an employee from a tax perspective?
For example, when creating an investment entity, say your firm will give you 1% interest in the GP; the GP investment is $100, so you're interest today is $1 - are you taxed for the $1 as income in that year?
Then, lets say the GP makes a return of 25% in the 2nd year when the investment is sold; you will be taxed on your 1% share of the 25% gain at the capital gains tax rate, correct?
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Unfortunately, the answer is that it depends on how your employer structures your carry. What you're describing is probably the most likely, since it's the easier (they're giving you a K1 interest in a given deal). However, things like shadow equity exist, and a couple others ways of structuring these things which might avoid a tax liability for you (the employee) but require a lot more oversight and back office administration on the part of your employer.
Been having some recent conversations with my current employer on shadow equity instead of direct partnership interest (their preference). My general understanding is the shadow equity is more tax inefficient for the employee.
Can you clarify how it would be potentially to the employee's benefit? Do you have any resources you would recommend?
I think the shadow equity is preferential for an employee because you don't actually receive anything. If you're being given an equity grant, that's taxable day 1. Shadow participation, as I've heard it defined (and I'm sure there are a lot of different interpretations!), is that the company keeps an eye on what your piece is worth and when there is cash to distribute, that is when you get taxed.
In other words, you get taxed when you have income to cover it, instead of paying a tax when you get awarded your equity.
No sources, unfortunately, except hearing about how my firm thinks about participation and how colleagues at other places are being given participation.
Ok, I would agree with what you outlined. I wasn't really thinking about the tax on the initial equity grant but good reminder. I think the shadow equity cash flow/distributions are taxed as ordinary income correct? Was trying to see if there is some way to get the carried interest tax treatment here.
I think that is probably correct. I guess if you were to give a true equity interest, then any profits on that (after yr 1 obviously) would be long term gains, but this is definitely one of those places where you should talk to a tax professional and not trust a stranger on the internet. I guess that's really true for all things
So to clarify - the most common way is for the 'carry' to be taxed as income when received, and then the returns taxed as capital gains when the asset is liquidated?
I wouldn't say that's the most common. There are three ways I typically see it done
1) They award you a portion of the GP - you receive a K-1, behaves as if you'd put in the money yourself and is taxed day 1 (not an accountant, so someone correct me if the tax piece here is wrong)
2) You receive a portion of the GP promote entity - what you own is technically worthless day 1 so you pay no taxes until the deal/fund gets into the promote (on funds this can be tricky because of how the promote is valued for tax purposes and you can end up owing taxes before seeing any promote)
3) They make you pay money to invest in the GP but generally provide some sort of cheap financing to allow you to invest a decent amount (if you're at a MF the loan is forgivable a lot of the time, varies in other places).
Have you seen a situation in which a company allows an employee to defer bonuses/commissions and contribute the equivalent dollar amounts directly into a deal, without coming out of pocket?
For example, an employee receiving a commission as % of the acquisition fee electing not to take the commission check but rather have the company invest the equivalent $ amount.
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