Limited liability companies and other entities taxed as partnerships are able to create a special type of interest known as a "profits interest." A profits interest is often given to an employee or other service provider as a form of compensation. The holder of a profits interest is entitled to receive a share of all future profits and gains generated by the entity. From that perspective, a profits interest will perform much like a stock appreciation right that might be issued in a corporate setting.
Under current law, receipt of a profits interest is typically not a taxable event. Instead, the holder includes in income an allocable share of the partnership's income in the future when the partnership generates the income. The character of that future income is determined at the partnership level.
Sponsors of hedge funds, venture funds and other investment funds have long taken advantage of these rules. The sponsors directly or indirectly receive a profits interest in their funds as a form of incentive compensation. In the industry, this profits interest is often referred to as a "carried interest," perhaps because no cash is paid for the interest. The receipt of a carried interest is not subject to tax. When the fund does generate income, that income is often capital gain, some of which is then allocated to the sponsors.
While there have been several legislative proposals to modify these rules, so far nothing has been enacted. This may be changing, however.
Profits Interest Targeted for Reform
Congress will be searching for ways to work on the budget deficit and pay for health care reform. The Obama budget released earlier this year contained only a few domestic tax changes, but one of these targets profits interest reform as a way to generate in excess of $23 billion of revenue over a ten-year period.
The Obama budget contains only a brief summary of proposed legislation without any statutory language. The budget proposal would be far broader than the House version discussed below and would apply to virtually any profits interest awarded to a service provider, not just those in the investment fund industry.
The Senate has never formally considered a proposal to deal with profits interests.
House Bill Characterizes Profits Interest Gains as Ordinary Income
The first significant bill aimed at profits interest reform was introduced in the House in 2007. Iterations of that bill have continued to be considered since that time, including a version introduced earlier this year. All are basically the same. They generally target investment funds and continue to treat the receipt of a profits interest as a nontaxable event. However, the important change is that all income and gains held by holders of profits interests in applicable funds would be recharacterized as ordinary income and would be subject to self-employment taxes.
Specific provisions of the House bill are evolving as people focus on the details. The current version contains exemptions for investments held by real estate investment trusts and publicly traded partnerships that apparently would be caught within the new legislation.
The latest version also contains an anti-abuse provision that targets other financial instruments that mirror the economic performance of a profits interest but would not technically be a profits interest subject to the new rules. Interestingly, there is also a strict liability 40 percent penalty for taxpayers who hold an instrument subject to the anti-abuse rules but who do not treat all payments attributable to the instrument as ordinary income and subject to self-employment taxes.
Departing From Existing Tax Treatment Could Add Complexity
Speculating about pending legislation is always risky, but it would not be surprising for some form of legislation to be enacted later this year. The taxation of carried interests sparked congressional hearings in mid-2008 and was a key campaign issue. While some of the interest over the issue has died down in part because of the decline in the economy and the corresponding decline in the value of carried interests, the underlying tax issue remains.
The problem with any such proposal will lie in the details. The existing tax treatment of profits interests flows from a very straightforward application of partnership tax principles. Departing from these basic principles will require very carefully crafted legislation, but any such provision could add material complexity to the tax law.
Taxpayers May Wish to Take Action Before Bill Is Passed
Given the state of the law, it is premature to begin speculating about issues such as effective dates and grandfathering relief. The House bill contains blanks for the effective date, and the Obama budget proposal suggests a December 31, 2010, effective date. Neither makes any mention of grandfathering relief.
Because of the fluid status of the statutory language, it is far too early to focus on alternate structures that might be utilized to avoid the application of the new law, especially if the 40 percent strict liability penalty is part of what finally gets enacted.
If taxpayers are considering selling an investment, however, they might want to do so before any new proposals start developing traction—and thereby take advantage of whatever effective date ultimately applies.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
