The House and Senate have introduced bills that would dramatically change the income tax treatment of "carried interest" profits earned by fund managers in their capacity as general partners of investment partnerships. Hedge fund managers, private equity fund managers, and real estate operators are the targets for legislation that would eliminate the perceived benefits derived from doing business through partnerships.
House of Representatives Proposal
H.R. 2834, introduced on June 22, 2007, significantly changes the way fund managers are taxed on partnership income that is attributable to the services they perform on behalf of the partnership. This income, commonly referred to as a carried interest, performance allocation, or carve-out, is generally equal to approximately 20% of the partnership income. Under present law, the carried interest profit share retains the same character as the profit share allocable to all partners. Consequently, the carried-interest profit share for the fund manager of a hedge fund would include dividends, interest, short-term and long-term capital gain, and the deductions associated with these activities. The items of income described above are specifically exempted from the tax on self-employment income.
The proposed law changes the income taxation of the carried interest by re-characterizing each of the items of partnership income and deductions as ordinary income or ordinary loss. As a consequence of the re-characterization, the benefits of the reduced tax rate on qualified dividends and long-term capital are eliminated. If the carried interest yields an ordinary loss for tax purposes, the loss is limited to the amount of ordinary income previously recognized. The possibility of incurring ordinary losses on a profit-only carried interest may seem counterintuitive, but this can occur if the partnership has book profits and a taxable loss. Finally, the proposed law treats the carried-interest profit share as self-employment income subject to the self-employment tax. Gain on the sale or redemption of the carried-interest profit share will, as you might expect, be treated as ordinary income.
On a more positive note, the proposed law clarifies that the fund manager's profit and loss share attributable to the fund manager's invested capital account balance will continue to receive the beneficial tax treatment that is available to all other partners. Gain or loss on the sale, or redemption, of the fund manager's invested capital account will also be treated for tax purposes in the same manner as all other partners.
Private equity fund managers and real estate operators will likely absorb the greatest impact should H.R. 2834 become law. The loss of the beneficial 15% tax rate on long-term capital gains is more than significant and could be viewed as almost catastrophic, depending on how you view a 20% increase in tax rates or a 133% increase in income tax. Hedge fund managers of "trader" partnerships (those partnerships whose trading activities rise to the level of a trade or business) will likely feel little impact except for the new self-employment tax liability. Hedge fund managers of trader partnerships electing to mark securities to market will similarly feel little impact. However, hedge fund managers of "investor" partnerships (those partnerships whose less frequent trading activities can only be construed as investing) that realize significant long-term capital gains will be less fortunate.
Should the proposed law be adopted, existing funds will have to carefully review their fund documents with counsel to determine if changes are necessary. The proposed law appears to be well thought out. The drafters were careful not to harm limited partners by re-characterizing the carried-interest profit share as an expense of the partnership that might be subject to the 2% limitation on itemized deductions and the Alternative Minimum Tax (AMT) add back. As fund managers lament the potential loss of the beneficial long-term capital gain tax rate, they should remember that nothing lasts forever and even this benefit will expire in time if not repealed sooner by a Congress hungry for revenue.
The Senate, not to be outdone, has proposed its own rules to repeal the benefits of partnership income tax treatment presently available to publicly-traded partnerships that provide investment advisory and management services. Under present law, a publicly-traded partnership is taxed as a corporation unless the partnership derives 90% or more of its gross income from interest, dividends, real property rents, gains from the disposition of real property (including real property that is held for sale to customers), income and gains from specified oil, gas and mineral activities, and gains from the sale of capital assets (collectively passive-type income). Many publicly-traded partnerships that provide investment advisory and management services can easily meet the 90% test through the carried-interest profit shares that they receive as general partners to the funds they advise and manage.
The proposed law, S. 1624, would eliminate the exception for passive-type income for publicly-traded partnerships that provide investment advisory and management services. These partnerships would be taxed as corporations, and distributions to partners would be taxed as dividends. In effect, the partners would be subject to a double tax on distributed profits. The partners would also lose the more beneficial 15% tax rate on long-term capital gains.
The proposed law is a knee-jerk reaction to the Blackstone transaction and certainly provides publicity for the bill's sponsors. Nonetheless, the Senate bill must be taken seriously, especially in light of the introduction of the House bill. The proposed effective date is June 14, 2007. If a partnership was publicly-traded on June 14, 2007 or a partnership filed a registration statement with the Securities and Exchange Commission on or before June 14, 2007, the present law would continue to apply until taxable years beginning on or after June 14, 2012. So Blackstone and other partnerships publicly-traded on June 14, 2007 that provide investment advisory and management services may have some additional time to figure out the next best structure and approach. Like any other proposed tax legislation, however, the effective dates and transition provisions are moving targets that may change for better or worse.
Both the House and Senate bills reflect an increasing trend to higher income taxation which will not likely stop here. We will provide updates on these bills and report on other legislative initiatives. We will also be reporting on the impact this legislation is likely to have on state and local income taxation for those jurisdictions with the greatest fund activity. The next decade should prove very interesting indeed.
By Maury Cartine, CPA, tax partner with Marcum & Kliegman LLP
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