May 28, 2010

The American Jobs and Closing Tax Loopholes Act of 2010 (the "Bill") was passed by the House on May 28, 2010, and includes a provision that generally will tax a portion of the income and gains associated with "carried interests" as ordinary income.  While the carried interest provisions of the Bill are substantially similar to legislation proposed last year, there are several important differences. 

The Senate is expected to take up the Bill during the week of June 7, after the Memorial Day recess. But, it remains unclear how these provisions will be received in the upper house.

This update summarizes the provisions of the Bill.  For discussion of previous versions of the carried interest provisions, please refer to our April 7, 2009 update, "Legislation Reintroduced to Tax Carried Interests as Ordinary Income" and our December 8, 2009 update, "House Moving Quickly on Tax Extenders Bill That Would Tax Carried Interests as Ordinary Income and Crack Down on Foreign Tax Evasion."

Ordinary Income Characterization

Under current tax law, a holder of a partnership interest is taxed on its allocable share of the partnership's taxable income.  Moreover, the character of that income to the partner generally is the same as it is to the partnership.  The Bill would create a special rule that taxes a portion of the net income allocated to a partner in respect of an "investment services partnership interest" as ordinary income, regardless of the character of that income to the partnership.  Thus, for example, where the partner is allocated capital gain in respect of an investment services partnership interest, the partner would be subject to ordinary income tax on a portion of that amount.  Likewise, any dividend taken into account for the purposes of calculating such income would not be not entitled to a reduced rate of tax as qualified dividend income

Similarly, under the new law a portion of any gain on the disposition of an investment services partnership interest would be taxed as ordinary income, and the holder would be required to recognize such gain without regard to any other income tax provision.  Consequently, a holder would be subject to tax even with respect to transactions that are generally tax free, such as certain contributions to corporations, transfers to family limited partnerships, and possibly gifts.  However, gain would not be recognized where an investment services partnership interest is contributed to a partnership in exchange for an interest in such partnership so long as the contributing partner makes an irrevocable election to treat the partnership interest received as an investment services partnership interest and complies with all reporting requirements that may be prescribed by regulation.

Notably, the Bill provides that in the case of individuals, the operative provisions taxing net income and gain as ordinary income is only applicable to 75% of such income or gain (and only 50% of such income and gain for taxable years beginning before 2013).  This percentage limitation is also applicable to the provision precluding qualified dividend income treatment to dividend income allocated to investment services partnership interests.  Similarly, where the new provisions require the recognition of gain that would not otherwise be recognized, only 75% of such gain is recognized (50% for tax years beginning before 2013) in the case of individuals, though all of such recognized gain is taxed as ordinary income.  However, this limitation only applies for only individuals, so other taxpayers (such as corporations and certain trusts) would be subject to ordinary income tax rates with respect to the full amount of income, gain, or loss.

While the new provisions in the Bill would recharacterize such income and gain as ordinary income, they would not recharacterize it as ordinary income from the performance of services, as formulated in some previous versions of the legislation.  Rather, they would modify the self-employment tax regime to require individuals to include any amounts allocated to them in respect of an investment services partnership interest as net earnings from self employment (though this, too, is subject to the 75% limitation in the case of individuals).  On its face, this revised approach suggests that even though these items would be taxed as ordinary income, they would not necessarily be treated as income from the conduct of a trade or business for the purposes of the rules dealing with unrelated business taxable income (UBTI) or as income that is effectively connected with the conduct of a United States trade or business (ECI).

A portion of losses that are allocated in respect of investment services partnership interests, or realized on their disposition, generally also are treated as ordinary losses.  However, such losses are subject to a variety of limitations that essentially limit the losses to the amount previously included in income as ordinary income in respect of the investment services partnership interest.  In addition, the Bill would specially account for losses that would be subject to the 75% (or 50%) when carried forward.

The Bill provides an exception for ordinary income treatment for both gains and losses on the disposition by an individual of an investment services partnership interest in a publicly traded partnership if the individual has not at any time provided investment services with respect to assets held by the publicly traded partnership.

Qualified Capital Interests

Against this backdrop, there are carve-outs from the general ordinary income rules for investment service partnership interests that are "qualified capital interests."  Where allocations made to a partner in respect of a qualified capital interest are made in the same manner as allocations to qualified capital interests of unrelated partners that do not perform services for the partnership, the special ordinary income and loss rules described above do not apply.  However, a manager's qualified capital interest will not be precluded from such treatment where an allocation discrepancy results from a failure to self-charge carry and management fees.  In the case of tiered partnerships, allocations to qualified capital interests in a lower-tier partnership retain their character to the extent allocated to qualified capital interests in an upper-tier partnership, but such character would be lost with respect to interests in upper-tier partnerships that are not qualified capital interests.  Similar rules also exempt dispositions of certain qualified capital interests from the required recognition and ordinary income treatment described above.

A qualified capital interest generally is defined as the portion of a partner's interest in the capital of a partnership attributable to cash or property contributed to the partnership in exchange for the interest.  It also includes capital interests attributable to amounts included in the partner's income under § 83.  However, it does not include any portion of the interest acquired with proceeds of a loan (directly or indirectly) from the partnership or any partner thereof.

Investment Services Partnership Interest

An investment services partnership interest is broadly defined as any partnership interest (or interest in any other entity treated as a partnership for tax purposes) held by a person (or a related party) reasonably expected to provide a substantial quantity of investment advisory or management services with respect to certain specified assets.  Specified assets for these purposes generally consist of securities, real estate held for rental or investment, partnership interests, commodities, and options and derivatives with respect to such assets.  Family farms, however, are explicitly excluded.  Accordingly, the definition of investment services partnership interest would not include interests in most operating businesses.

Disqualified Interests

The Bill also would include provisions that apply similar rules to certain interests other than partnership interests that are received in connection with the performance of management services.  For example, stock, options, contingent or convertible debt, and derivative instruments in an entity other than a partnership or a "taxable corporation" are subject to similar rules.  For these purposes, a "taxable corporation" only includes domestic C corporations and certain foreign corporations subject to a comprehensive foreign income tax.  This rule appears to be designed to prevent the use of corporations organized in tax haven jurisdictions as "PFICs" to avoid the application of the new rules.

Publicly Traded Entities

Subject to limited grandfathering rules, income from investment services partnership interests generally are not qualifying income for publicly traded partnerships ("PTPs").  This rule would not apply to certain partnerships substantially all of whose assets are interests in PTPs or certain partnerships whose interests are convertible into interests in publicly traded real estate investment trusts (i.e., UP-REIT structures).

Profits Interests

The Bill also codifies the basic "profits interest" rule that a person who receives a partnership interest in connection with the performance of services is required to include only the liquidation value of that interest at that time.  In addition, the rule would treat the recipient as having made a § 83(b) election unless the recipient specifically elects out of such treatment.  It appears that this rule providing for the default § 83(b) election applies even if the partnership interest is not subject to vesting, although it is not clear why.

Regulatory Authority

Included in the legislation is also a provision explicitly directing Treasury to prescribe regulations that are necessary or appropriate for carrying out the purposes of the new provisions.  Specifically, the bill contemplates regulations to prevent the avoidance of the purposes of the new rules, to coordinate with other tax provisions, and to provide other modifications consistent with the purposes of the new rules.

Increased Penalties

Underpayment of tax required to be shown on a return in violation of the anti-abuse provisions included in the legislation would entail a penalty of 40% of the amount of the underpayment--double the usual 20% penalty for similar understatements.  These penalties would not apply if the tax treatment was adequately disclosed, there was substantial authority for such treatment, and the taxpayer reasonably believed that such treatment was more likely than not the proper treatment.

Effective Date

These provisions of the Act are generally effective beginning in 2011.

Gibson, Dunn & Crutcher LLP

Gibson, Dunn & Crutcher lawyers are available to assist in addressing any questions you may have regarding these developments.  If you have any questions, please contact one of the Gibson, Dunn & Crutcher LLP attorneys listed below, or your regular Gibson Dunn contacts.

New York
Charles F. Feldman (212-351-3908,
David B. Rosenauer  (212-351-3853,
Jeffrey M. Trinklein  (212-351-2344,
Romina Weiss  (212-351-3929,

Washington D.C.
Art Pasternak  (202-955-8582,
Benjamin Rippeon (202-955-8265,

Los Angeles  
Hatef Behnia (213-229-7534,
Paul S. Issler (213-229-7763,
Sean Feller (213-229-7579,
Dora Arash (213-229-7134,
J. Nicholson Thomas (213-229-7628,

Orange County 
Gerard J. Kenny (949-451-3856,
Scott Knutson (949-451-3961,

David Sinak (214-698-3107,

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