PROPOSED LEGISLATION WOULD TAX "CARRIED INTEREST" AS ORDINARY INCOME FOR PRIVATE EQUITY AND OTHER PARTNERSHIPS, author Keith W. Kaplan, Tax Alert

Rep. Sander Levin (D – Mich) introduced a bill to tax income earned by investment fund managers from so-called “carried” partnership interests as ordinary income.  The bill was introduced on June 22, 2007 and public hearings are slated for mid-July.  While many press releases have touted the bill as a measure aimed at private equity and hedge fund managers, its broad scope also would include real estate, venture capital and other partnerships.  Proposals are also being floated by other Members of Congress to tax all profits interests, not just those granted to “investment managers”.

Background

Most domestic investment funds are formed as partnerships for federal income tax purposes.  Investors contribute capital to the fund in exchange for limited partnership interests, which the fund invests in securities or real estate with the intent to sell at a profit.  The fund’s investment professional is usually compensated for its services in two ways:  a management fee equal to a specified percentage (e.g., 2%) of capital commitments per annum, and a “carried” interest equal to a certain percentage (e.g., 20%) of realized gains. 

A “carried” interest is generally structured as a profits interest in the partnership.  It represents a right to share in appreciation of the fund investments.  The general partner will typically include income from its “carried” interest as capital gains taxable at favorable capital gains rates to the extent it represents a share of long-term capital gains realized by the partnership.  In the case of individuals, long-term capital gains are generally taxed at a maximum 15% rate under current law, while ordinary income is taxed at a maximum rate of 35%. 

It also is common for real estate developers to receive profits in excess of their percentage interests in capital after investors achieve certain rate of return hurdles.  The proposed legislation would apply equally to all of such interests involving investment management, not just to hedge and private equity funds.  In addition, other Members of Congress are questioning whether all persons who receive profits interests, not just investment advisors, should report ordinary income relating to these interests.

Summary of the Bill

The bill would add new Section 710 to the Internal Revenue Code of 1986, as amended (the “Code”).  Section 710 would treat net income derived from, and gain on the disposition of, an “investment services partnership interest” as ordinary income for the performance of services.  This would not only subject the income and gain to a much higher tax rate, it would also subject the items to self-employment taxes.  Net loss from an investment services partnership interest would be treated as an ordinary loss. 

An “investment services partnership interest” is broadly defined as any partnership interest (capital or profits) held by a person who, in the conduct of an active trade or business, provides a substantial quantity of certain investment management services, including:  (i) advising the partnership as to asset valuation, (ii) advising the partnership as to purchasing or selling assets, (iii) managing, acquiring, or disposing of assets, (iv) arranging financing with respect to asset acquisitions, and (v) any supporting activity related to these services. 

To trigger Section 710, investment management services must relate to certain types of assets.  Again, however, the sweep is broad – these assets include stock, interests in publicly traded partnerships or trusts, debt, various derivatives, commodities and real estate.  Any partner receiving a partnership interests for services and providing the requisite type of investment management services could be affected.

If a fund manager also has capital invested in the investment partnership from which it earns the “carry”, the bill would not affect the tax treatment of the portion of the investment fund manager’s interest that represents invested capital.  Capital gains rate would continue to apply, but only to the extent of the fund manager’s income and gain represented by a reasonable return on invested capital.  A “reasonable allocation” would not include any amount allocated to the service providing partner that exceeds what non-service providing partners are allocated as a return on their invested capital.

The bill includes a special carve-out rule for real estate investment trusts (“REITs”) and should not affect an entity’s ability to qualify as a REIT.  If a REIT receives a “carried” interest from a real estate partnership, the bill would not recharacterize as ordinary income the income from such “carried interest” for purposes of the REIT’s 95% and 75% gross income tests.  Still, that income would flow through to the REIT’s shareholder as REIT dividends taxed as ordinary income. 

There is no effective date provided in the bill.  According to its sponsors, that date will be decided in the legislative process.  

Going Forward

Partnership taxation is quite complex and there are strategies that could defeat the intent of the proposed legislation.  If Congress is to take any action, a large unanswered question involves the complexities it will enact and the “collateral damage” it will inflict in any legislation to tax carried interests.  At general hearings held on July 11, 2007, Senators expressed an understanding of the complexities and disclaimed an intent to stifle economic progress.  Yet, they expressed discomfort with a system that allows individuals to earn over a hundred million dollars a year without paying employment or ordinary income tax.

We will monitor developments and will publish bulletins from time to time.  If you have questions, please call or contact one of our tax partners; Larry Arem, 215.569.4142 or Keith Kaplan, 215.569.4143.

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