Barely a week after Senate Finance Committee Chairman Max Baucus (D-Mont.) and committee Ranking Member Charles Grassley (R-Iowa) questioned the utility of subjecting the income earned by fund managers through “carried interests” to tax at ordinary (rather than capital gains) rates,1 Rep. Sander M. Levin (D-Mich.) introduced legislation to not only tax this income at ordinary rates but also to accelerate when the tax is due in some cases.
Taxing Carried Interests
We have previously reported on the proposals of Congress to tax partnership income related to a carried interest as ordinary income from the performance of services, and certain proposals by New York State and New York City to subject such income to New York State tax and the New York City unincorporated business tax (see our Tax Alerts for December 31, 2007 and December 23, 2008, available at http://www.pepperlaw.com/publications_update.aspx?ArticleKey=1041 and http://www.pepperlaw.com/publications_update.aspx?ArticleKey=1335, respectively). Rep. Levin’s proposal is similar to these prior federal proposals, but in certain cases goes even further.
Under current law, the character of any income recognized by a fund flows through and retains its character at the partner level. Thus, fund managers who hold carried interests are allocated their share of the capital gain recognized by the fund on its disposition of stock in a portfolio company, and would pay tax at a current rate of 15 percent on their share of the long-term capital gain. Picking up on a line item in President Obama’s proposed budget, H.R. 1935, introduced on April 3, 2009, would convert this gain into ordinary compensation income in the hands of the carry partner, subjecting the carry partner to tax at a current maximum rate of 35 percent, plus self-employment taxes. Accordingly, the proposal, like its predecessors, would significantly increase the tax burden of fund managers by changing the character of the income that flows through to them from the fund.
The proposal applies to “investment services partnership interests.” An investment services partnership interest is any interest in a partnership that is held by any person if it was reasonably expected (at the time that such person acquired such interest) that such person (or any person related to such person) would provide, directly or indirectly, the services typically associated with fund managers. We note the addition of the related-party language since prior versions. Presumably, this was added because of a glitch that might have permitted the avoidance of these rules if the carried interest were gifted to a spouse or other related party who did not provide such services.
Rep. Levin’s press release that accompanied his proposal couched the issue in terms of fairness. The release states: “Real estate agents only make money if they actually sell a house, no matter how hard they work. Authors receive a portion of their book’s profits. Waiters get tips based on the quality of service they provide. All of these people pay ordinary income tax rates on their compensation. Only private equity and other fund managers get to pay capital gains rates on their compensation.”
H.R. 1935 also would change the character and, in certain cases, the timing of the fund manager’s income on the disposition of a carried interest. Although, under current law, a sale of a partnership interest generally results in capital gain, the proposal would convert all of the gain recognized on the sale of a carried interest into ordinary compensation income. Moreover, though the premise of the proposal was “fairness” in determining the character of income from carried interests, the proposal goes further and would require fund managers to recognize as ordinary compensation income the difference between the fair market value of the interest and its adjusted basis upon any disposition of a carried interest, notwithstanding the existence of other, long-standing statutory provisions that would defer or exclude the gain (such as gifts and transfers to controlled corporations). The purpose of this new provision is unclear, except that it is possibly intended to prevent planning transactions. However, given the addition of related-party language that clarifies that the proposal applies to carried interests in cases in which a party related to the holder (and not necessarily the holder) is expected to provided investment management services, this seems like overkill.
Where is the UBTI Provision?
One of the few good things to come out of Congress’ look at the taxation of carry was a provision that would have benefited tax-exempt investors in private equity funds and hedge funds. Under this provision, debt-financed income earned by partnerships in which tax-exempt organizations invested would not be treated as unrelated business taxable income. Unfortunately, the Levin bill does not contain this important provision.
A Bright Side?
Levin’s bill contains a provision that would codify Treasury’s current position that the receipt of a partnership profits interest (including carry) in return for services is not taxable, and that an 83(b) election (i.e., an election to treat an unvested interest as taxable currently, at $0 if it is a true profits interest, rather than when the interest ultimately vests) is deemed made unless the partner elects not to have such provision apply. Notwithstanding the broad and favorable language of the provision, the Treasury may provide otherwise. Accordingly, it would not be surprising if Treasury excludes interests received in anticipation of sales or certain other interests excluded in proposed regulations.
H.R. 1935 is more evidence that the House and the Obama administration are serious about taxing income from carried interests as services income. However, the likelihood of passage in the near term is unclear. The proposal appears to have the President’s support, but key members of the Senate, where past proposals ultimately were rejected, appear to oppose the measure. The effective date of President Obama’s proposal is 2011, whereas the effective dates of H.R. 1935’s provisions are left blank, raising further questions about the likely effective date. H.R. 1935 goes further than previous proposals, and retains the 40 percent penalty that would be applicable solely to underpayments related to the carry legislation. Unfortunately, it provides no comfort or clarity as to how foreign managers will be treated if they receive carry through a partnership with U.S. managers. We will continue to follow this issue closely.
Steven D. Bortnick and Timothy J. LeskaEndnotes
1 At a policy briefing on March 25, 2009, Sen.Baucus said that because of “current market conditions” expected government revenues would likely be less than anticipated, and therefore changing the taxation of carried interests is “less of an issue now.” Similarly, Sen. Grassley said “[a]t this point, with the economy being in such bad shape, nobody wants to do anything that is going to upset Wall Street.” National Journal’s Congress Daily, March 25, 2009, PM Edition.