,
Anne Marie Konopack 
and
William Levy
Originally published May 25, 2010
Keywords: American Jobs and Closing Tax Loopholes Act, tax carried interest, ordinary income, funds, share of profits, investment partnerships
On May 20, 2010, Senate Finance Committee Chairman Max Baucus and House Ways and Means Committee Chairman Sander Levin released the legislative text of H.R. 4213, the American Jobs and Closing Tax Loopholes Act. If passed, this legislation will subject managers of private equity funds, hedge funds, and other investment partnerships to tax at ordinary income tax rates on most of the share of profits they receive as carried interest.
The proposal to change the tax treatment of carried interest is a revenue-raising measure included as part of broader legislation that Congress is set to consider this week. Supporters of the proposal argue that carried interest is essentially compensation for services and should be taxed as ordinary income, while opponents maintain that such earnings should be treated like any other income of the investment fund.
Background
Private investment funds are typically structured as partnerships that have both general and limited partners. Fund managers, who guide fund strategy and make investment decisions, are general partners, while outside investors such as pension funds, endowments and high-net-worth individuals are limited partners. Fund managers generally take 2 percent of the fund's assets each year as a management fee, and 20 percent of the fund's total profits as carried interest. For US federal income tax purposes, the carried interest is treated as a profits interest in the investment partnership.1
Under current law, the transfer of a profits interest by a partnership to a general partner or other person that performs services for the partnership generally will not lead to income recognition, provided that the profits interest meets the requirements set forth in Revenue Procedure 93-27. Once a general partner, or other person that performs services for a partnership, has been granted a profits interest, the general partner is allocated income and loss from the partnership with respect to the general partner's profits interest. The character of the income allocated to the general partner depends on the character of the underlying income earned by the partnership. Thus, the income allocated to the general partner with respect to its carried interest may be taxed either at long term capital gain rates (currently a maximum rate of 15 percent) or at ordinary income rates (currently up to 35 percent). Furthermore, if the general partner sells its carried interest, part of the gain realized could be taxed at long term capital gain rates.
Finally, individuals are subject to self-employment tax (currently at 15.3 percent) on their net earnings from self employment. A general partner's allocable share of an investment partnership's income and gain, as well as gain recognized by a general partner from the sale of an interest in such a partnership, is generally not subject to self-employment tax under current law.
Proposed Legislation
H.R. 4213 modifies the current treatment of carried interest in a number of ways that could impact the taxation of investment fund managers and other service partners. Although the law regarding the initial receipt of a partnership profits interest in connection with the performance of services would generally be unchanged, the proposal would treat a portion of the income and gain earned by an investment fund manager or other service partner with respect to any "investment services partnership interest" as ordinary income, regardless of the character of the underlying income earned by the partnership.
The proposal, which would add new Section 710 to the Internal Revenue Code of 1986,2 defines an "investment services partnership interest" as a partnership interest held by any person if such person was reasonably expected (at the time such person acquired the partnership interest) to provide a substantial quantity of certain services (e.g., advising, managing, or arranging financing) with respect to the acquisition or disposition of securities, real estate, interests in other partnerships, or certain other property. The definition is broad, but is subject to an important exception for "qualified capital interests" as discussed below.
For individuals, the new provision would treat 75 percent of the net income or loss attributable to an investment services partnership interest as ordinary, regardless of its character to the underlying partnership. The remaining 25 percent would retain its ordinary or capital character. A transitional rule applies through 2012, during which time only 50 percent of such income or loss would be recharacterized as ordinary. For carried interest income that would otherwise be taxed as long term capital gain, the blended rates would result in investment managers being taxed at a rate of approximately 25 percent during 2010, 29.8 percent during 2011 and 2012, and 34.7 percent thereafter (based on current tax rates and rates scheduled to take effect beginning in 2011, but excluding self-employment tax and additional Medicare taxes imposed by the Health Care and Education Reconciliation Act of 2010).
The proposal also applies to dispositions of investment services partnership interests and distributions of partnership property with respect to an investment services partnership interest. However, the blended rates do not apply to taxpayers other than individuals; consequently, 100 percent of the income or loss attributable to an investment services partnership interest is treated as ordinary income for such taxpayers. Thus, for example, income allocated to a real estate investment trust (REIT) with respect to an investment services partnership interest would not support a capital gain dividend by the REIT.
Under the proposed legislation, net losses attributable to an investment services partnership interest would be disallowed to the extent such net losses exceed net income attributable to such interest after the effective date of the legislation. In other words, net losses allocated to chargeback prior allocations of net income that were made with respect to a carried interest prior to the date of enactment would be disallowed.
The proposed legislation also adds the concept of a "qualified capital interest." Under this rule, allocations of partnership items to a service partner on the capital portion of its interest are not recharacterized as ordinary if (i) they are allocated in the same manner as allocations to non-service partners, and (ii) the allocations made to non-service partners are significant when compared to the allocations made to the service partner's qualified capital interest. In general, a service partner will have a qualified capital interest to the extent that it contributes money or other property to the partnership in exchange for its carried interest. The exception for qualified capital interests also applies in the context of tiered partnerships, such that investment fund managers having a qualified capital interest in an upper-tier partnership that has no non-service partners will not be disqualified from the exception due to the inability to satisfy (i) and (ii) above with respect to the upper-tier partnership.
One exception to the "qualified capital interest" concept is the treatment of certain loans. Specifically, loans made to the service partner by other partners, the partnership, or related parties would not be treatedas qualified capital of the service partner. Thus, to the extent a service partner uses loan proceeds to acquire an interest that would otherwise constitute a "qualified capital interest," the interest would instead be treated as an investment services partnership interest and allocations of partnership items with respect to such interest would be subject to the blended rates described above.
Similar rules would apply to interests in certain entities other than partnerships. In particular, if (i) a person directly or indirectly performs investment management services for any entity, (ii) such person holds a "disqualified interest" with respect to such entity, and (iii) the value of the interest (or payments thereunder) is substantially related to income or gain (whether or not realized) from assets with respect to which the investment management services are performed, any income or gain with respect to such entity would be treated as ordinary income (subject to rules comparable to the exception for qualified capital interests). The proposal broadly defines a "disqualified interest" as including, for example, any interest in the entity (other than debt), convertible or contingent debt of the entity, and certain options and other derivatives.
In addition, the proposed legislation would amend Section 7704 (the "PTP Rules") to address whether income from an investment services partnership interest constitutes qualifying income of a publicly traded partnership. The new provision provides that any item of income or gain treated as ordinary income under proposed Section 710 generally would not constitute qualifying income for purposes of the PTP Rules, unless such income is derived from qualifying activities relating to natural resources. However, this rule would not apply to certain partnerships that are treated as publicly traded partnerships by reason of their partnership interests being convertible into interests in a publicly traded REIT (which is intended to cover the operating partnerships of public REITs), or whose assets consist of interests in partnerships that are traded on an established securities market and substantially all of whose income consists of ordinary income or Section 1231 gain.
The proposed legislation also grants the Treasury Department broad authority to enact regulations necessary to carry out the purposes of new Section 710, including modifications to the application of the new rules to the extent that such modifications are consistent with the purposes of the provision. Moreover, significant penalties would apply for underpayments with respect to investment services partnership interests. Specifically, the penalty provided by Section 6662 is increased from 20 percent to 40 percent for underpayments with respect to the application of new Section 710 or the regulations prescribed thereunder. Although prior versions of the proposal provided that the reasonable cause exception under Section 6664(c) would not apply to such underpayments, the current proposal allows for relief if (i) the taxpayer adequately discloses the relevant facts, (ii) there was substantial authority for the chosen treatment, and (iii) the taxpayer reasonably believed that such treatment was more likely than not the proper treatment.
Finally, the proposed legislation provides that any amount treated as ordinary income under Section 710 must be taken into account in determining net earnings from self-employment for an individual taxpayer. A similar amendment would be made to the Social Security Act, in addition to other conforming amendments.
The legislation would generally be effective for tax years ending after the date of enactment. However, for tax years that include the date of enactment, the amount of net income allocated to a service partner would be treated as the lesser of net income for the entire partnership tax year or net income determined by only taking into account items attributable to the portion of the tax year which is after the date of enactment.
Footnotes
1. A profits interest is an interest in a partnership that entitles the holder to participate in the partnership's future profits, but does not include an interest in the current capital of the partnership. Generally, a profits interest is an interest that would not entitle the holder to any share of the proceeds if, at the time such interest is received, the partnership sold all of its assets at fair market value and distributed the proceeds (less partnership liabilities)to the partners in a complete liquidation of the partnership.
2. All section references are to the Internal Revenue Code of 1986, as amended.
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