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House Passes Legislation Ending Carried Interest; Measure Now in Senate

By Jim Hamilton

The House has passed legislation that would prevent investment fund managers from paying taxes at capital gains rates on investment management services income received as carried interest in an investment fund. To the extent that carried interest reflects a return on invested capital, the American Jobs and Closing Tax Loopholes Act, HR 4213, would continue to tax carried interest at capital gain tax rates. However, to the extent that carried interest does not reflect a return on invested capital, the measure would require investment fund managers to treat seventy-five percent of the remaining carried interest as ordinary income (50% for taxable years beginning before January 1, 2013). The provision will be effective for taxable years ending on or after January 1, 2011. The House passed the measure by a vote of 215 to 204.

The measure is now in the Senate, where it is expected to be modified. This modification would decreases the amount of carried interest that is recharacterized as ordinary income from 75 percent to 65 percent and increases the amount treated as capital gains from 25 percent to 35 percent in taxable years beginning after December 12, 2012. The change further decreases the amount of carried interest that is recharacterized as ordinary income to 55 percent and increases the amount treated as capital gains to 45 percent for gain or loss attributable to the sale of an asset which is held for 7 or more years.

Another Senate modification provides that a non-service individual or widely held-regulated investment company selling an interest (held directly or indirectly through a partnership, S corporation, estate, trust) in an energy-related publicly traded partnership is exempt from recharacterization as ordinary income under Internal Revenue Code section 751(a) that portion of the gain or loss attributable to investment services partnership interests held by the publicly traded partnership.

Hedge and private equity funds are typically structured as partnerships for federal tax purposes. Managers of these funds often receive an asset-based management fee of 2 percent of the fund's committed capital and an interest of 20 percent in the profits of the fund. The 20 percent profits interest is referred to as the carried interest. For managers of private equity funds and hedge funds, the carried interest often represents a substantial portion of their total return from the funds.Upon receipt of the carried interest, the fund manager becomes a partner in the fund and pays tax in the same manner as other partners on his distributive share of the fund's taxable income. The character of the income included in the manager's distributive share is the same as the character of the income recognized by the fund. Thus, if the fund earns ordinary income or short-term or long-term capital gain, each partner's distributive share includes a portion of that income. For example, if the fund sells stock of a portfolio company that it has held for more than a year, the manager's share of the long-term capital gain is taxed at the 15-percent federal long-term capital gain rate.

The House believes that carried interest is money earned on a service provided by fund managers, not money earned on their personal investments.The hedge fund managers will still get capital gains treatment on that portion of the profits representing their own money in the funds they manage. In other words, capital gains tax treatment will still be available to the extent that gain is attributable to the manager's invested capital. But the compensation for services portion of the carried interest would be treated as ordinary income.

In a letter to Congress, the hedge fund industry opposed the legislation for a number of reasons. For example, the extenders legislation would unfairly impact only investment funds holding securities, commodities, derivatives, or real property, with the result that this change in the tax treatment of carried interest would reduce or eliminate the incentives for hedge funds to purchase impaired assets.Also, the fundamental rationale behind carried interest is that it represents the contributions of intellectual and sweat equity of a partner to a business enterprise.

For more than fifty years, the Internal Revenue Code has permitted partners in investment partnerships to pool the capital of investors with the skills of entrepreneurs in joint profit-making enterprises. To align interests and contributions to the partnership, the Code treats a partner's carried interest in the profits on the same terms as the other partners. In the industry's view, legislation changing the fundamental tax treatment of partnerships under the Code would damage the competitiveness of U.S. businesses and capital formation.

While she voted for the House bill, Rep. Eshoo said that she opposed the carried interest provisions as bad policy that could chill the creation of jobs. Jobs are created by risk takers, she noted, adding that venture capitalists launch small businesses and take significant risks. The carried interest provisions of the legislation would, in her view, put this job-creating engine in jeopardy. Cong. Record, May 28, 2010, H4184.

Full post as published by Jim Hamilton's World of Securities Regulation on June 10, 2010 (boomark / email).