Carried Interest Tax Challenges Emerging in H.R. 4213 Provisions

Carried Interest Tax Challenges Emerging in H.R. 4213 Provisions

If enacted, H.R. 4213 (The American Jobs and Closing Tax Loopholes Act of 2010), will likely cause managers in private equity, venture capital, real estate, and hedge funds to be in a significantly deteriorated tax posture as compared to the status quo. Although H.R. 4213 is a compromise in some respects, managers will likely be exposed to effective tax rates of over 30 percent (more than double the current rate), stiff potential penalties and anti-abuse measures.

... [O]n Thursday, May 20, 2010, [the] House and Senate committees agreed on an "extenders" bill that would be offset, in part, by the closure of what bill sponsors have termed the carried interest "loophole." A vote on the bill in both houses is expected soon. The emergence of an agreed-on version of the carried interest provision has created a sense that carried interest legislation may be imminent. However, it remains to be seen whether the bill can garner the required support in the Senate without an exception for managers of venture capital firms. Some Senators have emphatically advocated for such an exception.

Section 412 of the bill... would add Section 710 to Subchapter K of the Code. The scope of Section 710 (hereinafter the "New Provision") is not as broad as some previous variations of the "carried interest," which would have affected all partnership profits interests granted for services. Additionally, the New Provision taxes at ordinary income rates only a percentage of the income attributable to a manager's compensatory interest, which appears to be the hallmark of this new compromise bill. Despite the concessions made by House democrats, the New Provision, if enacted, is a game changer for private equity, venture capital, real estate and, to a lesser extent, hedge fund managers. (Many hedge fund managers will not be significantly affected by these changes, as many hedge funds engage primarily in short-term trading strategies that generate ordinary income).

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Section 710: The New Provision

What is New?

Prior to the May 20th compromise, the most recent version of the "carried interest" legislation (which was essentially Representative Levin's 2009 proposal) was attached to the House Engrossed Tax Extenders Act of 2009 (H.R. 4213), passed by the House on December 9, 2009. The New Provision contains some major (and minor) modifications to that version, including but not limited to:
Data in Image An exception for the disposition of an interest in a publicly traded partnership (PTP) by an individual;
Data in Image An election with respect to certain exchanges of interest held by managers; and
Data in Image A special rule for individuals that limits ordinary income to a portion of 50 percent or 75 percent of the "carried interest."

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... [T]he New Provision subjects only a percentage ("Applicable Percentage") of income derived by individuals from the performance of investment management services to ordinary income tax rates. For taxable years beginning on or after January 1, 2013, that percentage is 75 percent; for taxable years ending after the date of enactment, but before January 2013, the percentage is 50 percent. This Applicable Percentage applies to the various classes of income that fall under the New Provision (i.e. operating income, distributions, and dispositions of the carried interest).

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... [T]he New Provision... imposes a 40 percent penalty on underpayments attributable to the application of the Disqualified Interest rules or the anti-abuse regulations authorized by the New Provision. Importantly, there is no reasonable cause defense to this penalty. In order to avoid this penalty, the taxpayer must:
Data in Image Adequately disclose the relevant facts pertaining to the taxpayer's treatment of the income;
Data in Image Demonstrate that there is, or was, substantial authority for such treatment; and
Data in Image Show that the taxpayer reasonably believed that such treatment was more likely than not the proper treatment.

Conclusion

The enactment of the New Provision, perhaps with slight modifications, is viewed by many as imminent. The effects of the provision are yet to be seen, but if enacted, managers in private equity, venture capital, real estate, and hedge funds would be in a significantly deteriorated tax posture as compared to the status quo. While the provision is indeed a compromise in some respects, its thrust and its bite are nonetheless the same as initially envisioned by its proponents. If adopted, managers will likely be exposed to effective rates of over 30 percent, more than double the effective rate to which they are currently subject.

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To ensure compliance with requirements imposed by the IRS, unless we expressly state otherwise, we inform you that any U.S. federal tax advice contained in this communication (including any attachments) is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein.

This article is published with the permission of Ivan Mitev and Matthew Kaden. Further duplication without the permission of Ivan Mitev and Matthew Kaden is prohibited. All rights reserved.

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