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By Steven D. Bortnick, Esq., and Timothy J. Leska, Esq.
Pepper Hamilton LLP, New York, NY, and Philadelphia, PA, respectively
Taxing Carried Interests
In the past, Congress has attempted to tax partnership income related to a carried interest as ordinary income from the performance of services, and New York State and New York City have attempted to subject such income to New York State tax and the New York City unincorporated business tax. Rep. Levin's proposal is similar to these prior federal proposals, but in this case, eliminates the most egregious element that would have taxed gain on enterprise value as ordinary income.
Under current law, the character of any income recognized by a fund flows through and retains its character at the partner level. Thus, fund managers who hold carried interests are allocated their share of the capital gain recognized by the fund on its disposition of stock in a portfolio company, and would pay tax at a current rate of 15% on their share of the long-term capital gain. Qualified dividends (i.e., dividends from U.S. corporations, publicly traded foreign corporations and foreign corporations entitled to the benefits of a tax treaty with the United States) also are taxed at 15% (through the end of 2012). Consistent with President Obama's Framework for Business Tax Reforms, H.R. 4016 would convert this gain into ordinary income in the hands of the carry partner (and treat otherwise qualified dividends as non-qualified), subjecting the carry partner to tax at a current maximum rate of 35% (39.6% beginning in 2013), plus self-employment taxes. Accordingly, the proposal, like its predecessors, would significantly increase the tax burden of fund managers by changing the character of the income that flows through to them from the fund.
The proposal applies to "investment services partnership interests." An investment services partnership interest is any interest in an investment partnership that is acquired or held by any person in connection with the conduct of a trade or business by such person (or a related person) involving the performance of services (directly or indirectly) of the type typically associated with fund managers.
Rep. Levin's press release that accompanied his proposal couched the issue in terms of fairness. The release states that the legislation is intended to "fix the carried interest loophole and ensure that income earned managing other people's money is taxed at the same ordinary income tax rates as the income earned by millions of other Americans for services that they provide. Certain investment managers - including private equity managers - now benefit from a loophole that allows them to pay a reduced 15 percent tax rate on income received as compensation, rather than ordinary income tax rates up to 35 percent that all other Americans pay."
H.R. 4016 also would change the character and, in certain cases, the timing of the fund manager's income on the disposition of a carried interest. Although, under current law, a sale of a partnership interest generally results in capital gain, the proposal would convert all of the gain recognized on the sale of a carried interest into ordinary income, which is subject to self-employment tax. Moreover, the proposal would require fund managers to recognize as ordinary compensation income the difference between the fair market value of the interest and its adjusted basis upon any disposition of a carried interest, notwithstanding the existence of other, long-standing statutory provisions.
Unlike the prior version of Levin's proposal, rather than taxing dispositions by gift or upon death immediately, gain would continue to be deferred, but the partnership interest would be treated as an investment services partnership interest in the hands of the person acquiring the interest. Moreover, the amount that would have been treated as ordinary income upon sale by a decedent is treated as income in respect of a decedent and, thus, retains its ordinary character and is not eligible for a basis step up at death. Additionally, rather than taxing gain on the contribution of an investment services partnership interest to another partnership (as the prior version would have done) immediate gain recognition can be avoided if the transferor elects to treat the transferee partnership interest as an investment services partnership interest.
Tax on Enterprise Value
Prior versions of the carry proposal had the (hopefully unintended) potential to tax the gain on the sale of the investment management or advisory company as ordinary income in the same manner as gain on the sale of the carry vehicle. H.R. 4016 avoids this result by amending the definition of investment services partnership interest to refer to an interest in an investment partnership. An investment partnership is a partnership substantially all of the assets of which are stock, securities, rental/investment real estate, investments in partnerships, commodities, cash, cash equivalents, options or derivative contracts with respect to the foregoing. Additionally, more than half of the capital of the partnership must be attributable to qualified capital interests not held in connection with a trade or business. The proposal prevents the avoidance of the ordinary income taint on investment services partnership interests by providing specific rules for tiered partnerships.
Easing Up on Penalties
H.R. 4016 retains the special 40% penalty contained in prior proposed legislation for underpayments related to the avoidance of the carry provisions and related regulations. The current proposal also eliminates the reasonable cause exception to the application of the penalty. However, H.R. 4016 provides that the reasonable cause exception is available if the facts affecting the tax treatment of the item are adequately disclosed, there is substantial authority for such treatment and the taxpayer reasonably believed that such treatment was more likely than not the proper treatment.
Pepper Perspective: H.R. 4016 is more evidence that some in the House and the Obama administration are serious about taxing income from carried interests as services income. However, the likelihood of passage in the near term is unclear. The proposal likely would have the President's support. The exclusion of the so-called enterprise value tax and the ability to avoid penalties for underpayments related to avoidance of the carry legislation may appeal to a broader group within Congress. However, H.R. 4016 makes no attempt to carve out half the gain from assets held for more than 5 years that was included in the Senate version as an accommodation to the venture capital industry, which had made a late game play during the last go around on this topic. We will continue to follow this issue closely.
For more information, in the Tax Management Portfolios, see Needham, 735 T.M., Private Equity Funds.
© 2012 Pepper Hamilton LLP
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