• Carried Interest Tax Continuing to Draw Scrutiny in Congress
  • May 28, 2010 | Author: Jonathan B. Breviu
  • Law Firm: Alston & Bird LLP - Atlanta Office
  • Congress is again considering a potential change to the tax rate applied to “carried interests” -- a form of profit earned by managers of private equity firms, as well as buyout firms, hedge funds and venture capital firms. Consequently, professionals in these industries are bracing for a change and examining alternatives to their current fund structure. Summarized below is an introduction to carried interests as well as a summary of the current debate regarding taxation of carried interests.

    In the private equity fund context, “carried interest” is an interest in the fund that entitles the fund manager to receive a specified share, often 20%, of profits earned by the fund upon the sale of its portfolio, without requiring the fund manager to invest any capital of its own. In addition to the carried interest, private equity funds typically also receive an annual management fee, usually around 2% of the amount of capital in the fund (known as the principle of “2 and 20”). Under current tax law, the management fees are treated as ordinary income to the fund manager and taxed federally at 35% (likely to increase soon to 39.6%) in the top tax bracket. By contrast, the income from carried interest is treated as investment income and, to the extent the underlying interest is long-term capital gain, realized gain in the hands of the fund manager is treated as long-term capital gain, taxed at 15%, rather than ordinary income.

    A bill expected to be passed by the House this week would treat a portion of the income from the carried interest as ordinary income, regardless of the character of the underlying income.  Similar proposals have passed the House on a number of other occasions, most recently in Title VI of the Tax Extenders Act of 2009, and the Obama Administration supported the change in its proposed FY 2011 budget .

    The current proposal is contained in the latest version of the 2010 tax extenders bill, HR 4213, now called the “American Jobs and Closing Loopholes Act of 2010.” The House is scheduled to vote on the bill on Tuesday, May 25. The Senate is expected to take up the bill soon as well, but whether they will do so before the Memorial Day recess and whether they will make any changes to the House version is as yet unclear.

    Proponents of a change in the tax treatment of carried interest argue  that the profits received by fund managers should be considered compensation for services provided, which in almost all cases is subject to ordinary income tax treatment. Those in favor of the current tax treatment of carried interest believe that such profits are more accurately akin to a long-term investment that has increased in value and is sold for a profit and whether the investment is one of capital or labor should be irrelevant from a tax perspective. They also argue that a change to the current tax treatment will stifle investment at a time when doing so would be dangerous to the economy.