• Update on Taxation of Carried Interests
  • March 26, 2010 | Author: Joseph T. Gulant
  • Law Firm: Blank Rome LLP - New York Office
  • This alert will discuss the background, current status and outlook for proposals to tax as ordinary income the services partnership interest (SPI)--or the “carried interests”--held by a person who provides services to a partnership, such as a private equity or hedge fund.

    The carried interests tax proposal first emerged in Congress in 2007, but eventually faded due to the onset of the global financial crisis. But, amidst soaring fiscal deficits and wide-scale public hostility over executive compensation, many of the proposal’s supporters believe that the current political climate is ripe for enactment.

    As a result, in December the House included the change in carried interests taxation in the Tax Extenders Act of 2009 (H.R. 4213), a $31 billion bill that extends a variety of expiring tax provisions, including research and development and renewable energy tax credits. That bill passed, by a vote of 241-181, and the carried interests change was included to “pay for” the budgetary impact of the legislation. The bill would, among others, impact partners at private-equity firms, hedge funds, venture-capital firms and real estate investment partnerships. Also included in the bill were some provisions designed to ensure tax collection on offshore profits of international firms.

    On March 10, the Senate passed the bill by a vote of 62-36, but an amendment in the nature of a substitute was made, which did not include the carried interests provision. In addition, the Chairman of the Senate Finance Committee, Sen. Max Baucus (D-MT), has joined Republican opposition--albeit on different grounds--arguing that this issue must be included within a broader tax code overhaul later in the year. Senate Majority Leader Harry M. Reid (D-NV) decided last week not to include the carried interests language in a jobs creation bill currently being debated on the Senate floor. So, for now at least, the carried interests legislation appears to be sidelined.

    A new front in the battle on carried interests was opened in early February when President Obama released his fiscal 2011 budget. That proposed budget included a very broad carried interests taxation proposal--extending well beyond private equity and hedge funds to cover most financial firms and real estate investors. This tracks closely with a proposal floated in 2008 by New York Senator Chuck Schumer (D) who suggested that carried interests taxation should be the same for all sectors of the financial industry. At the time, that proposal was viewed by many as a “poison pill” because it would fire up such significant opposition.

    The Obama proposal limits to some degree the definition of carried interests because if the holder of an SPI contributes “invested capital”--defined as money or other property contributed to the partnership--income attributable to the invested capital would not be considered an SPI. In addition, the portion of any gain recognized on the sale of an SPI that is attributable to the invested capital would be treated as capital gain.

    Additional measures within the proposal include (1) a requirement that service partners pay self-employment taxes on an SPI; and (2) a requirement that any person who performs services for an entity and holds a “disqualified interest”--defined as convertible or contingent debt, an option, or any derivative instrument with respect to the entity (excluding a partnership interest or stock in certain taxable corporations)--in the entity is subject to taxation at ordinary rates on any income or gain received with respect to the interest.

    In total, the Obama administration projects that this proposal would increase government revenue by $24 billion over 10 years. The proposal would be effective for taxable years beginning after December 31, 2010.

    Enthusiasm for this proposal in the Senate is not running high. There appears to be little appetite for a tax increase in the current environment, and the breadth of the Administration’s proposal has lead many to call the proposal a non-starter. The private equity, hedge fund and real estate industries are particularly active and vigilant on this issue. Nevertheless, continued pressure to reduce the deficit and the continued push by the Administration for this change will keep the issue on the table throughout this congressional session.

    The proposed carried interests tax increase on fund managers was not included in the Tax Extenders bill passed on March 10th by the Senate. Sander Levin (D., Mich.), newly appointed Chairman of the House Ways and Means Committee, indicated that he would not require that the carried interests proposal be included in the Extenders legislation, and that the issue needs to be considered more fully.

    While a proposal as broad as the Administration’s will be difficult to advance, a more limited approach would have a better chance of success. In fact, there have been recent rumblings from some Congressional quarters that the issue may be fixable through an administrative rather than a legislative change. Where the line is drawn on carried interests taxation will be a very important question. Those who would be impacted by a change of this nature are well advised to maintain a vigilant posture.