Congress Again Targets Carried Interests

May 24, 2010

In recent years, a number of bills have been introduced in Congress to impose ordinary income tax rates on profit derived by partners from “carried interests.” Legislation to change the tax treatment of carried interests passed the House of Representatives in 2008 and 2009, but it never garnered enough support in the Senate. That may change in the next few days.

On May 20, 2010, House Ways and Means Committee Chairman Sander Levin (D-MI) and Senate Finance Committee Chairman Max Baucus (D-MT) jointly released statutory language for H.R. 4213, the American Jobs and Closing Tax Loopholes Act. The bill extends numerous expiring business and individual tax provisions. It also enacts new spending measures, including infrastructure incentives and an extension of unemployment health assistance and COBRA benefits. A “fix” for physician payments from Medicare is also included.

In order to pay for roughly $50 billion in tax extensions and new benefits, the bill requires ordinary income tax treatment for carried interests. The House is expected to vote on the bill on Tuesday, May 25. Assuming House passage, the Senate plans to vote on the bill before the end of this week and the Memorial Day recess. It will likely take 60 votes in the Senate to move to a vote.

A “carried interest” represents a partner’s share of future partnership profits, determined without regard to its share of partnership capital. Private equity funds, real estate developers, hedge funds, and operating companies have often used carried interest as an incentive for maximizing partnership gains and profits. As noted above, Congress has targeted carried interest for several years.

In general, the bill treats income a partner derives from certain types of carried interests in the same manner as wages. To accomplish this goal, the bill adds a new section to the Internal Revenue Code which targets a particular type of carried interest, called an “investment services partnership interest.”

An investment services partnership interest is an interest held by a person that reasonably is expected to provide (directly or indirectly, including through related persons) a substantial quantity of services related to (i) advising on investing, purchasing or selling certain assets; (ii) managing, acquiring, or disposing of certain assets; or (iii) arranging financing for certain assets. The bill defines these certain assets to include securities, rental or investment real estate, interests in partnerships, commodities, options, and derivative contracts.

The Ways and Means Committee and Finance Committee describe the bill as applying to investment fund managers who receive service income. However, it also applies to persons such as developers and property managers who hold interests in real estate rental and investment partnerships. Nevertheless, the bill targets only the defined assets listed above. As such, it does not target all carried interests. For example, it apparently does not affect the tax treatment of carried interests issued by operating partnerships, such as those that manufacture, assemble, and/or distribute products. These carried interests should continue to enjoy capital gain treatment as under prior law.

The bill also carves out an exception from ordinary income tax treatment for income and gains attributable to cash and other property the partner contributes to the capital of the partnership. These contributions will be considered capital interests and the allocable income will remain eligible for capital gains treatment under current law even if the remainder of the partner’s interest is classified as investment services partnership interest subject to the new rules.

Under the bill, a partner must pay ordinary income tax rates on 75% of all income attributable to an investment services partnership interest – including gains from the sale or other disposition of the interest. (For tax years beginning before January 1, 2013, only 50% of the income will be subject to ordinary income tax rates.) In addition, the partner must include the same percentage of income in computing the partner’s self-employment income taxes. With the recent expansion of the Medicare tax, this inclusion also will be significant.

As drafted, the bill will apply to tax years ending after the date of enactment. Thus, if enacted this year, the bill will apply to income recognized on investment services partnership interests during the 2010 calendar tax year. A special rule limits this amount to the post-enactment portion of the tax year. The bill also imposes a 40% penalty for underpayment of tax related to the carried interest.

The bill specifically applies to all income and gain recognized on or with respect to an investment services partnership interest after enactment. Thus, any existing built-in gain recognized upon the disposition of an investment services partnership interest after enactment will be subject to full ordinary income tax rates and self-employment taxes. As explained above, it appears carried interests in certain operating companies are exempt from these new rules, so planning may focus on converting or structuring investment services partnerships interests into or as carried interests in these lower-tier companies.