On April 2, 2009, Congressman Sander Levin (D-Mich.) introduced H.R. 1935, the latest proposal to tax capital gains allocated to a fund manager holding a partnership “carried interest” as ordinary income. The bill would generally apply to carried interests in private equity, venture capital, real estate, LBO, mezzanine, distressed, and hedge funds. Most such funds have a general partner (the fund manager) that receives a management fee (e.g., 2%) and a carried interest equal to a percentage (e.g., 20%) of the profits including realized capital gains.
The Levin bill provides an opportunity to consider Congress’ latest thinking on this matter. While it is not clear that this version of the bill will be enacted, it appears increasingly likely that some sort of “carried interest” legislation will become law. In its recently released “Green Book,” the Obama administration indicated that it will push for carried interest legislation to be effective in 2011. But, of course, Congress may have other plans, particularly in the fall if it addresses estate tax reform. Former Congressman Thomas M. Reynolds, who recently joined Nixon Peabody LLP to lead its Government Relations and Public Policy practice, takes Congressman Levin’s sponsorship seriously and believes there needs to be an immediate effort to educate House members about the bill’s potential adverse impact.
Under current law, when the partnership sells a long-term investment at a capital gain, the portion of the gain allocated to the fund manager’s carried interest is taxed at the favorable capital gains rate, currently 15%. By contrast, compensation income for services is taxed at ordinary income rates, currently, a maximum rate of 35%, and is subject to social security and other payroll taxes. In the Green Book, the Obama administration proposes to allow the maximum rates for capital gains to increase to 20% and for ordinary income to rise to 39.6%.
The Levin Bill’s Impact on Carried Interests
The Levin bill would treat allocations with respect to an “investment services partnership interest” made to a partner who directly or indirectly provides a “substantial quantity” of services concerning “specified assets” (generally, securities, real estate held for rental or investment, interests in partnerships, commodities, and options or derivatives relating to the foregoing) of the partnership as ordinary income received for the performance of services by the partner. Any such income would be treated as self-employment income, subject to Medicaid and social security taxes. The services covered are advising as to the advisability of investing in any specified asset; managing, acquiring, or disposing of any specified asset; arranging financing with respect to any specified asset; and any activity in support of the foregoing. Accordingly, the Levin bill would generally apply to carried interests in private equity, venture capital, real estate, LBO, mezzanine, distressed, and hedge funds.
The Levin bill would not change the tax treatment of capital gain allocated to a “capital interest” in an investment services partnership—i.e., an interest received in exchange for a capital contribution. In general, allocations of income and gain are exempt from the ordinary income rule if (1) they are allocated in the same manner to an investor partner who is not related to the fund manager, and (2) the allocations to the investor partner are significant when compared with allocations made to the fund manager’s capital interest.
Other Impacts
The Levin bill would add two new taxpayer-favorable rules. The first would codify the current IRS treatment of a properly-structured profits interest as tax-free. The second would treat the recipient of a profits interest as having made an election under Section 83(b) of the Internal Revenue Code to be taxed immediately unless he or she elects not to have Section 83(b) apply. This would reverse the rule under proposed regulations, which would require the recipient of a profits interest to affirmatively make the Section 83(b) election. Since virtually all service providing partners seek to make the election, the new default rule would eliminate the risk of partners inadvertently missing the Section 83(b) election deadline.
The bill would also likely have an impact for state and local tax purposes. For example, as a planning technique to minimize the impact of the New York City unincorporated business tax, fund managers typically cause two management entities to be formed: one to receive the annual management fee (subject to the NYC unincorporated business tax) and one to hold the carried interests (not subject to this NYC tax, due to an exclusion for income from investment activities). In this second entity, if income allocated to carried interests is treated as compensation for services income for federal income tax purposes, NYC might try to treat such income as subject to the NYC unincorporated business tax.
Conclusion
In negotiating recent limited partnership agreements, general partners typically want to insert a provision providing them with flexibility to restructure fund arrangements in order to minimize the impact of any carried interest legislation. Limited partners tend to be wary of such provisions, unless they are conditioned on the new arrangements not adversely affecting their economic interests.
The Levin bill does not yet contain any effective dates, but there is not likely to be any grandfathering for carried interests issued prior to the effective date. We will continue to keep you updated on the progress of this bill.