Publications

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On December 9, 2009, the US House of Representatives passed a bill (H.R. 4213, the Tax Extenders Act of 2009), that would adversely affect managers of private equity, venture capital, real estate and hedge funds.

The bill, which is closely similar to the bill introduced in April by US Representative Sander Levin (D-MI), would (1) tax carried interest gain as ordinary income that is subject to employment taxes, (2) clarify that an interest in a partnership or LLC received by a service partner or member generally will not be subject to tax upon receipt, and (3) treat carried interest income as non-qualifying income for a publicly-traded partnership.

Carried Interest Rule

The legislation would tax as ordinary income, and not as capital gain, any income or gain that is attributable to an “investment services partnership interest.” An “investment services partnership interest” is any partnership interest (including an LLC interest) held by a person if, at the time the interest was acquired, it was reasonably expected that the person would provide (directly or indirectly) a substantial quantity of the following services:

1. Advising the partnership regarding investing in, purchasing or selling any specified asset

2. Managing, acquiring or disposing of any specified asset

3. Arranging financing with respect to acquiring specified assets and

4. Any activity in support of any service described in (1) through (3)

“Specified assets” include securities, real estate held for rental or investment, partnership interests, commodities and certain options and derivative contracts with respect to any of the foregoing. Note that the bill includes only “real estate held for rental or investment,” thus apparently exempting an operating real estate business.

The proposed ordinary income treatment would also apply to gain on the disposition of an investment services partnership interest, including gain on the transfer of such an interest to a corporation or another partnership that might otherwise be tax free. Any gain inherent in appreciated property distributed to the service partner would also be taxed currently as ordinary income, despite the normal non-recognition rule for such distributions.

Income or gain attributable to the service partner’s capital that is invested in the partnership would not be covered by the legislation and could continue to qualify for capital gain treatment, subject to certain conditions. The undistributed excess, if any, of taxable income allocated to a partner over losses and deductions allocated to the partner would increase the amount of the partner’s capital for this purpose. However, the exception for the service partner’s own invested capital will not apply if the capital is attributable to a loan from (or guaranteed by) the partnership or another partner.

In addition to the regular tax at ordinary income rates, the service partner would also be subject to self-employment tax on the income from the carried interest (limited to the 2.9 percent Medicare tax, if other compensation exceeds the Social Security wage base). However, the ordinary income treatment of the service partner should not adversely affect the investors in the fund, since the amounts allocated to the service partner would still be treated as a distributive share of partnership income. Since the allocation of that distributive share of income to the service partner would reduce the amount of income allocated to the other partners, without the need of any deduction, the other partners would not be subject to the limitation on miscellaneous itemized deductions or the disallowance for alternative minimum tax purposes that would apply in the case of a regular compensation payment.

The bill would also apply to less traditional carried interest arrangements. For example, if a person performs investment management services for an entity and holds a “disqualified interest” in the entity, then income or gain from that interest would be treated as ordinary income if the value of the interest is substantially related to the amount of income or gain (whether or not realized) from the assets with respect to which the investment services are performed. A “disqualified interest” would include, for example, convertible or contingent debt, options to acquire stock or debt, or derivatives entered into with the entity or an investor in the entity, but would not include a partnership interest, non-convertible, non-contingent debt or (except as provided by regulations) stock in a “taxable corporation.” A “taxable corporation” includes a domestic C corporation or a foreign corporation if substantially all of its income is either (1) subject to US tax as effectively connected with a US business or (2) subject to a comprehensive foreign income tax.

A stock investment generally would not be a “disqualified interest” under the bill. Thus, the manager of a private equity fund could make a direct co-investment with the fund in the stock of a portfolio company. However, the manager would be subject to tax under general income tax rules if the stock is worth more than the manager pays. Also, it is not clear in this situation whether the manager could borrow from the fund to make the investment, or have its note guaranteed by the fund, without triggering the ordinary income rules.

Private equity funds should also note that the individual managers of a portfolio company that is taxed as a partnership, such as an LLC, and is operating a business would not be subject to the ordinary income rules on their interests in the portfolio company. For example, their gain on the sale of their interests in the portfolio company would continue to be eligible for capital gain treatment. This assumes that they are not providing investment management services to the portfolio company.

The Treasury would be authorized to issue regulations to prevent avoidance of the provisions of the bill. Under the bill, the penalty for underpayment of taxes due to a violation of the new statutory rules or the regulations is 40 percent, rather than the usual 20 percent, and the reasonable cause exception to the application of the penalty is limited to situations in which there has been full disclosure of all relevant facts and certain other conditions are satisfied, including a “more likely than not” belief that the tax treatment is proper. The bill would be effective for taxable years ending after December 31, 2009.

Receipt of Partnership Interest

The bill also clarifies the tax treatment of the initial receipt of a partnership (or LLC) interest in exchange for services. The interest will be taxed to the service provider based upon the excess of the “liquidation value” of the interest at the time of receipt (or at the time of vesting, if the service provider so elects—see below) over the service provider’s cost or other tax basis. “Liquidation value” is the amount the service provider would receive at that time if the partnership’s assets were sold for their fair market values and the proceeds (less liabilities) were distributed to the partners in liquidation. This tax result is generally consistent with current Internal Revenue Service guidance.

Example: A service provider pays $100 for an interest in a partnership that (except for the $100 contributed) represents solely a right to share in future profits and future appreciation in the value of the partnership. In such a case, the service provider will not be taxed on the receipt of the partnership interest, since the liquidation value of the interest at the time of receipt, i.e., $100, does not exceed the service provider’s cost for the interest.

Under the bill, the service provider will be treated as having made a Section 83(b) election to have the tax consequences determined at the time the partnership interest is received, and not at the time of vesting, unless the service provider affirmatively elects otherwise. For restricted stock and other unvested property transferred for services, however, the regular Section 83(b) election rules continue to apply: A timely Section 83(b) election is necessary to ensure taxation at the time of the original transfer of the property, rather than at the time of vesting.

Publicly Traded Partnership

A publicly traded partnership generally is taxed as a corporation. However, under current law there is an exception if 90 percent or more of the publicly traded partnership’s income is “qualifying income,” generally passive income such as interest, dividends and capital gain. Under the bill, carried interest income that would otherwise be qualifying income (because it consists of capital gain) will not be qualifying income if it is recharacterized as ordinary income under the general carried interest provision described above.

This change would effectively impose corporate-level taxes on fund advisory or management companies that sell ownership interests to the public. This treatment would not apply to certain publicly traded partnerships that are owned by a real estate investment trust or to a partnership substantially all of the assets of which consist of interests in publicly traded partnerships. Also, partnerships that are publicly traded partnerships on the date of enactment would be grandfathered and would be exempt from this provision for 10 years.