Fund Managers Not Yet Taxed on Carried Interest, But Tax Man May Be Coming Soon

Fund managers may be in good shape for 2010 ... although nothing is certain. On March 18, 2010, President Obama signed into law the Hiring Incentives to Restore Employment (HIRE) Act which, aside from providing businesses tax incentives to hire and keep workers on the books, expands the types of entities that must comply with IRS reporting rules on foreign accounts. However, the HIRE Act does not provide for taxation of the carried interest. On March 21, the House of Representatives approved the health reform package approved by the Senate in December 2009 (H.R. 3590, the Patient Protection and Affordability Act). On March 23, the President signed this bill into law. On March 25, Congress passed H.R. 4872, the Health Care and Education Reconciliation Act of 2010 and on March 30 it was signed into law by President Barack Obama (Reconciliation Act). The Reconciliation Act modifies the Patient Protection and Affordable Care Act and includes several revenue raisers including codifying the economic substance doctrine and eliminating the tax credit for "black liquor."1 However, the Reconciliation Act does not include a tax on carried interest.

Commentators have maintained that the "tax man is coming," notwithstanding that in 2007, 2008 and 2009 private equity and hedge fund managers have escaped the carried interest tax. We are now approaching the end of the first quarter of 2010 and the two bills that have passed Congress this year have no carried interest provision. Managers may yet again dodge the bullet in 2010. Congress has just returned from their spring recess. There will soon be long lapses between sessions over the summer, and once Congress is back in session in the fall the focus will likely be on elections. There is a possibility that as part of the election antics the carried interest legislation will be used to portray those who stand in its way as "the bad guy." There is also the possibility that the carried interest tax is included in whatever extenders act is passed this summer as a means to pay for the extensions of credits and rates. This possibility is highlighted by the request by the IRS for the ABA to update its comments on the carried interest legislation. However, many still contend that due to the resistance in the Senate, the carried interest tax will not be a 2010 item and instead the fight over health care reform will likely continue through the summer and new fights will begin, such as the tax rate on dividends. Accordingly, there is a fair chance that the carried interest will again escape the ordinary income tax for 2010. If it does not go through this year, fund managers may begin to think of the legislation proposals as a false threat.

The proposal to tax carried interest has been on the table for years. Legislation introduced by Sen. John Kerry (D-Mass.) and Rep. Rahm Emanuel (D-Ill.) on October 18, 2007 caused a stir in the private-equity and hedge-fund shops. A modified version of this bill was introduced by Rep. Sander M. Levin (D-Mich.) on June 22, 2008. A line item on taxing carried interest at ordinary income rates was included in the Obama administration's 2008 Budget Blueprint. Thereafter, Rep. Levin introduced legislation on April 2, 2009, to not only tax this income at ordinary rates but also to accelerate when the tax is due in some cases. The Obama administration included the carried interest proposal in its 2010 budget. Under the Levin bill, investment partnerships such as private equity funds, hedge funds, venture capital funds and certain real estate partnerships would be subject to the new carried interest rules. However, the President's proposal appears to apply the rules broadly to carried interests received in exchange for the performance of services in all types of partnerships. Accordingly, under the President's proposals, it appears that a manager of an operating business, such as a portfolio company of a private equity fund, would be subject to the new carried interest rules. One area that may avoid the carried interest tax under all legislation proposed thus far is the carry received by the manager of an SBIC fund. This will depend upon whether the proposed temporary 100 percent exclusion from capital gains taxes for qualified small business investments makes its way into a bill that is passed. The proposal eliminates gain on the sale of small business investments held for a four-year period and thus, may eliminate gain which would be recharacterized under the proposed legislation.

A carried interest is a type of equity interest generally received by managers of funds or their affiliates in exchange for providing management services. A carried interest, also called a promote, is an industry term for a profits interest received by managers of a fund. It is an equity interest issued in a fund taxed as a partnership in exchange for services. As long as certain requirements are satisfied, the recipient of a carried interest has no income upon receipt because the recipient is not entitled to anything at the time the carried interest is issued. A carried interest entitles the recipient only to a percentage of future profit or future appreciation in the fund's assets. Because it constitutes an equity interest in a partnership, the character of income passing through with respect to the carried interest is determined at the fund level. Thus, many managers pay tax at capital gains rates (currently 15 percent) on carried interest income, because the fund's disposition of its assets constitutes capital gain. This tax treatment has caused the carried interest to come under attack under a fairness argument that alleges wealthy fund managers bear less tax on their compensation than the rest of working America, an argument bolstered by allegations that many managers do not have (other than time, and thus, opportunity cost) "skin in the game" and are said to be using the investors' money to turn a profit without risk. However, the proposed legislation, as well as Obama's proposal, will arguably affect more than the wealthy fund managers.

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.2

Rep. Levin's bill and President Obama's proposed budget provide for a conversion of capital gain with respect to a carried interest into ordinary compensation income in the hands of the carry partner or manager. As a result, the carried interest could be subject to ordinary income rates as high as 39.6 percent, as well as self employment taxes. The application of the proposal is not limited to carry received by fund managers, but also applies to carry received by a person related to the manager or service provider. The proposal also converts all gain recognized on the sale or transfer (including transfer by gift and transfer to a controlled corporation) of a carried interest into ordinary compensation income.

Because the carried interest legislation has been around for so long, it has been fine-tuned with every new introduction so that, generally speaking, it is bulletproof. Rumors from Capital Hill have created speculation as to whether any bill ultimately passed will provide some leeway for managers that make substantial contributions to a fund, in line with investors. Accordingly, many managers have been making "significant" contributions, either through the managing entity or through an affiliate. Significance arguably varies from fund to fund and possibly from principal to principal. However, significant contributions will not prevent ordinary income characterization pursuant to the legislation currently proposed, as the legislation provides for a very narrow bifurcation of capital and carry. Some fund documents provide language to take into account a change in the law with respect to carried interest. However, many if not most investors in today's market are not willing to allow changes that create an adverse impact on investors.

Although it is evident that the House and the Obama administration have their eye on taxing the carried interest at ordinary rates, whether there is enough support in the Senate and the ability to focus on this issue this year may make the difference. With the potential for the election of additional Republicans, it may be a much harder road next year. Currently, the "extenders" bill may be next in line to be just the right vehicle to tack the carried interest legislation onto, as a much-needed revenue-raiser.

Endnotes

1 Paper pulp mills have used black liquor, the spent cooking liquor from the process that digests pulpwood into paper pulp, as an energy source for decades-to help reduce problems with water emissions, to recover and reuse processing chemicals, and to satisfy much of their electricity needs on-site. Congress's 2005 tax credit to reward and support the use of liquid alternative fuel derived from hydrocarbons had been expanded in 2007 to include the use of black liquor. See http://en.wikipedia.org/wiki/Black_liquor.

2 See the following Pepper Hamilton LLP Tax Alerts: "Carried Interest Legislation: Cross-Border Consequences" (December 31, 2007), available at http://www.pepperlaw.com/publications_update.aspx?ArticleKey=1041; "New York Making a Play to Tax Carried Interests" (December 23, 2008), available at http://www.pepperlaw.com/publications_update.aspx?ArticleKey=1335; and "Levin Levies Another Attack on Carried Interests" (April 8, 2009), available at http://www.pepperlaw.com/publications_update.aspx?ArticleKey=1458.

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