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On April 2, 2009, the House introduced legislation (referred to as the “Carry Bill”) which, if enacted, will significantly alter the current law taxation of the “carried interest” in a typical private equity fund. In almost every private equity fund, the fund grants to the general partner the right to an agreed percentage, usually 20%, of the aggregate net gains of the fund. Because the capital of the fund investors “carries” the general partner, this type of interest has come to be known in the industry as the “carried interest.”

Under current law, the grant of the carried interest is not a taxable event. The service provider (in this case, the general partner of the fund and its members) will also qualify as a partner on the date of grant, allowing it to report the 20% share of future profits in accordance with its character at the fund level. The general partner of a private equity fund and its partners will therefore avoid immediate tax upon the grant of the carried interest and will bear tax on most of the future gains at a 15% rate.

If the Carry Bill becomes law, however, the general partner and its members will be required to report net income with respect to the carried interest as ordinary income, subject to self-employment tax. The general partner must also report a net loss as ordinary, but may deduct the loss only to the extent of the previous allocations of net income.¹ In addition, if the general partner or its members sell an interest in the carry, they must report any gain as ordinary income as well. Any loss realized on the sale is also ordinary, but only to the extent of the prior income allocations.

As presently drafted, the Carry Bill will apply to the carried interest of virtually every private equity fund in the market. For some funds, the primary impact of the Carry Bill will be the one Congress intended: the conversion of all or substantially all of any income allocations to the general partner and its members from long-term capital gain (or other investment income) into ordinary income. For other fund sponsors, however, the mere reporting obligation will reach new heights of complexity. For example, the Carry Bill would exempt any net income allocable to the carry that is attributable to “qualified capital” of the general partner. Although this exemption is intended to benefit the general partner and its members, it will be very difficult to administer absent detailed regulatory guidance. A general partner's relative share of the fund's qualified capital, for example, will often vary from year to year or even within different periods of a same year. Indeed, these kinds of variations will tend to occur in any fund that reinvests profits or provides for priority returns of capital on unrealized investments. If the Carry Bill becomes law, the sponsors of these funds will be required to “bifurcate” the income of the general partner in a particular year between services and capital in a manner that properly reflects its relative share of the qualified capital of the fund on the date of each disposition (or other realization event).

The Carry Bill leaves many other questions unanswered. For example, one condition to relief under the “qualified capital” exception is that the partnership allocate profit and loss to the qualified capital of the service provider “in the same manner” as it allocates profit and loss to the capital providers. The capital providers, however, are typically entitled to only 80% of the gains on their invested capital. Is the general partner therefore taxable at a 35% rate (plus employment taxes) on the “excess” 20% return it derives from its own invested capital? In the authors' view, this portion of the return to the general partner should remain subject to tax in accordance with its underlying character.

The Carry Bill, if enacted, will fundamentally alter current law taxation of the carried interest. In the authors' view, the consequences of the Carry Bill to affected taxpayers are so undesirable that many fund managers will attempt to restructure the nature of their service compensation in an effort to avoid or mitigate its after-tax impact.

For more information, in the Tax Management Portfolios, see Needham and Adams, 735 T.M., Private Equity Funds, and in Tax Practice Series, see ¶5710, Nonqualified Deferred Compensation.

¹ If a loss is suspended under this limitation, the service provider may carry the loss forward and treat it as incurred in the following taxable year.