10.1.

7: Interest in Profits and Losses

The idea of general partner substance cannot, however, be entirely overlooked. Thus, to be considered a
true "partner," versus an employee, the general partner (or general partners taken together) should enjoy
at least a 1% interest in profits and losses of the investor partnership.
[1]
The GPGP's interest in profits is
easy-a "carried" interest (i.e., not paid for) ranging in the area of 20 percent is the norm. Merely allocating
losses to the GPGP (versus allocating profits) has, however, no economic effect if the GPGP has nothing to
lose (i.e., puts up no capital). To be sure, the GPGP could be required to invest I percent of the entire
investor partnership's capital; but, given a $100 million investor partnership, a $1 million requirement
could be beyond the GPGP's means. Hence, the recommended practice is to create a liability but postpone
its potential effect.
[2]
Thus, the partnership instrument may require the GPGP to endure at all times 1
percent of the losses and to restore, upon dissolution and winding up, the deficiency, if any, in the GPGP's
capital account. Such a provision clearly means that the GPGP is at risk to the tune of I percent and is
blessed by an early Revenue Procedure.
[3]

However, that provision may be deemed overly harsh by the GPGP because it is unlimited, at least
potentially, in amount. Accordingly, based on a later IRS pronouncement,
[4]
many practitioners are willing
to support arrangements that provide that the GPGP's capital account will not go into a negative position
[5]
as long as the limited partners have positive capital balances and that the GPGP's exposure is limited, in
the nature of an obligation to restore on termination the lesser of the deficit balance in its capital account
(presumably none) or 1.01 percent of the aggregate end-of-the-day loss. Since most investment
partnerships do not borrow, the two versions of the GPGP's exposure wind up in about the same place.
In many partnerships, the entire issue is moot-the "free ride" system is unacceptable as a business matter
and the investors insist that the GPGP put up cash. If the partnership is a clone of an earlier successful
partnership, for example, it is the norm that the managers expose some of the assets acquired in prior
iterations to risk in the new partnership. Moreover, as initial capital calls are smaller in accordance with
recent custom, see 24.4, the burden on the GPGP is diminished.
[1]
See Rev. Proc. 74-17, 1974-1 C.B. 438.

[2]
Most practitioners insist that all parties purporting to act as general partners put up some cash, if only
to avoid treatment of the carried interest allocation as a transaction between the partnership and a partner
acting "other than in his capacity as a member of such partnership." I.R.C. 707(a)(1), (2). The minimum
capital account balance-the lesser of 1% or $500,000-required by Revenue Procedure 89-12 is usually
ignored. See Burke, Tax Considerations in Forming a Venture Capital Fund, in Venture Capital 1991, at
123, 134 (PLI Course Handbook Series No. 583, 1991).
[3]
Rev. Proc. 74-17, 1974-1 C.B. 438. The "responsibility for losses" issue is different from the question of
unlimited liability discussed in the previous section. Arguably, any solvent general partner is a true partner
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in the liability sense, even though the allocation sections do not state that any losses are chargeable to its
capital account, since the general partner is ultimately responsible for all losses in excess of the
partnership's capital. The 1% issue has to do with whether the general partner is a true partner in the
sense of sharing losses with the other partners, even though there is plenty of capital to pay creditors.
[4]
Rev. Proc. 84-67, 1984-2 C.B. 63 1.

[5]
Some practitioners insist that the GPGP actually contribute 1% "in situations where the general
partners are not required to make up deficit balances in their capital accounts on liquidation" 1 Halloran at
1-38.1. Based on one of the most authoritative commentaries, it does not appear that the 1% interest
must be maintained at all times. McKee, Nelson, & Whitmire, Federal Taxation of Partnerships and
Partners. 3-66 (1977).
Page 2 of 2 10.1.7: Interest in Profits and Losses - Encyclopedia - Library - VC E...